Rudi On Thursday

This story features TELSTRA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: TLS

(This story was initially published on Wednesday, October 28, 2009. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere).

I ran into one of the widely known household names in the Australian financial sector recently. I know he is a paying subscriber to FNArena and I am always proud to know that the size and the quality of our readership has continued improving throughout the years. Certainly, the presence of high profile investment experts in our database of readers only further highlights our achievement.

We exchanged a few comments about financial markets. I asked a few questions, he provided some answers, then fired a few questions back. I suspect he probably wouldn’t appreciate me quoting him from that conversation, and as I haven’t told anyone about it, not even the people who work at FNArena, I can share some snippets and observations, while retaining our market expert as an anonymous source of wisdom.

It’s all about the message, not about the messenger.

The two key points I took home from that brief conversation was that he seemed to have few doubts, if any, about the medium term prospects for the Australian share market. Buy good companies, with good management, that pay good dividends, at not too expensive price levels, and stick to it and your portfolio should be all right – that probably sums it up quite nicely.

Similar to other experts, this one is a firm believer that the US economy should not be underestimated, but above all that global momentum is swinging towards India, China and the rest of Asia, and Australia is going to benefit, big time.

What I also picked up, however, is that he seemed less confident about whether the share market could avoid another sell-down in the shorter term. This certainly took me by surprise – all this happened before this late October share market weakness kicked in. Though he quickly indicated that any such weakness would only make the long term valuation bargains even more attractive.

I concur.

Amidst a barrage of media reports and commentaries about how expensive the share market looks this month, and about whether we have returned to the 2007 Great Bubble Heights in terms of overall valuations, I remain of the view that investors who are looking into investing in the Australian share market with a longer term view should focus on FY11 consensus forecasts.

While I personally came to this approach by analysing and thinking about the prospects of the share market earlier this year, I do note a growing number of market experts have since started to suggest similar approaches, or come out publicly in support of current FY11 expectations. That second element is important, because this market approach would crumble to nothing without confidence in these estimates.

If anything, say these experts, current analyst forecasts for the years ahead are probably too low. This for the simple reason that, coming out of the trough of what could be a crisis much, much worse, all analysts probably prefer to remain on the safer side for the time being. They all remember having been wrong for too long during the downturn between late 2007 and early this year.

One such expert is chief investment officer at the Commonwealth Bank, Ron Bewley. Another one is Head of Equity Research at ING Investment Management in Australia, David Langford.

Both Bewley and Langford have come out in public these past few days and advocated that:

– analyst forecasts for FY10 and FY11 are probably too low
– the share market only looks fully priced on FY10 forecasts, but still represents good value on FY11 estimates

Normally, such prospects would act as natural support for the share market, preventing it from falling too far as investors who missed out on the rally thus far this year would be keen in getting in at lower levels. This has been the main reason (the combination of these two factors) why I believed the share market was likely to remain well-supported in the months ahead, and any correction/pull back would remain nimble.

There is one big factor that can still prove me wrong. The reason why some experts, such as my anonymous source at the beginning of this story, are less sanguine about the underlying strength/support in global share markets is because there is still so much scepticism out there about whether the economic recovery will prove to be sustainable.

While this is understandable after what we’ve all witnessed over the last year plus given the many problems that are still hanging over governments, central banks, consumers, banks and businesses in large parts of the developed world, it has turned a big representation of the investment community into momentum traders. These “investors” -maybe we should call them traders instead- have been happy to buy shares here and there as long as overall momentum was onwards and upwards. But what if momentum evaporates?

This is the concern that is currently spooking the global investment community. It doesn’t necessarily mean the global recovery story will be in tatters any time soon, but the point is it doesn’t have to be to trigger some more serious losses than what we’ve seen thus far. Of course, the irony of it all would be that share markets would be recording losses at a time when overall confidence amongst strategists, economists and central bankers seems firmly on the rise.

I know I have said this many times before, but: watch the US dollar.

Most other investors across the globe are doing exactly the same thing.

Of course, if you are amongst those investors looking to buy into the share market, and you don’t have a short to very short time focus only, most of the above should have the same effect as heavenly music on a lazy Sunday morning. As long as you can detach yourself from those commentators who are still looking at FY10 metrics only, and from the mainstream and financial media who essentially always operate behind the curve, no matter what. (By the time these sources of commentary catch up with the theme it is probably time to start exiting the market).

When I look at FY11 consensus projections, I see many industrial companies still trading at multiples of 9-10, I see dividend yields of 5-6-7% (not even mentioning Telstra ((TLS)), I see miners and mining services providers at multiples below 10, I see banks at multiples below 12 (not all of them though) and with dividend yields above 5% (all of them).

If you are an investor looking to join the ride on the premise that share markets should be higher in the year ahead, even if they can go lower in the short term, I strongly suggest you centre your research around FY11 estimates. All this information is available on the FNArena website. I am not using anything myself that is not available to all paying members.

At the end of the day, beauty (in this case: value) is in the eye of the beholder.

When I read through today’s Australian Broker Call Report, my attention was immediately drawn by two very positive reports on McPherson’s ((MCP)). I spotted the term “re-rating”, in combination with strongly upgraded earnings forecasts, and price targets around 20% above the present share price.

I am not saying I would rob the bank tomorrow and put it all into McPherson’s shares, but it’s this type of information that can be found in the daily Broker Call Report at least a few times per week. And unless I have prior knowledge that would deter me beforehand, I would most certainly consider this as worthy of my attention, and of further research into the stock.

On another note, I was reminded recently by a few readers of this weekly editorial that I highlighted young and upcoming internet infrastructure provider Pipe Networks ((PWK)), now a few months ago already. You’ll probably immediately understand why I was reminded about this if I tell you that the share price has appreciated by between 38-52% since (depending on what date exactly one takes guidance from).

I am obviously pleased that even after such an outstanding run, management has guided towards further upgrades for market expectations for the years ahead. The average price target is still double digits above the share price (even after those gains), though I must admit the Price-Earnings ratio (at above 15) is no longer as attractive as when I first pointed at the stock (dividend yield is 1.5% and 1.9% only). I would still think Pipe remains worthy of my attention, though.

I think Prime remains a prime candidate for further upgrades to FY11 estimates. Here’s why ING’s David Langford thinks the same applies to the market in general: companies have been relentlessly cost cutting and are now reporting earnings in line with market expectations on marginal growth in revenues (at most). Once top line growth starts to improve (hopefully in 2010) this will provide greater leverage to earnings than is currently projected by analysts.

Here’s one reason why you all should remain cautious nevertheless: market consensus is always wrong, according to the anonymous source mentioned earlier, and it’s probably fair to say current consensus is still on the cautious side, as illustrated, for instance, by earnings projections in Australia that assume no growth on average for companies this fiscal year compared to FY09.

But that still means that if consensus is wrong we can still go either way: to the downside as well as to the upside.

What did our expert say again? Buy good companies, with good management, that pay good dividends, at not too expensive price levels, and your investments should do all right.

With these thoughts I leave you all this week,

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always firmly supported by the Ab Fab team at FNArena)

P.S. I – I thank ING Investment Management for the beautiful historical overview depicting the average PE ratio for the Australian share market. Previously, I pointed out that calculations and historical references vary between 14.5 and 16 for this measure. I think I am going to refer to 14.5 from now on.

P.S. II – Those who want to see the broadcast of a presentation by David Langford on Friday, here’s the link:

http://www.rainmakeritv.com/pages/video/2250784/

P.S. III – All paying members at FNArena are being reminded they can set an email alert for my editorials. Go to Portfolio and Alerts in the Cockpit and tick the box in front of Rudi On Thursday. You will receive an email alert every time a new editorial has been published on the website.

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