Rudi On Thursday

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

(This story was originally published on Wednesday, January 20, 2010. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).

At the start of last week (day one of my official return from holidays) one hedge fund asked me about my best trading idea. If I had a few hours to make up my mind, and I had to make one trade, which one would it be?

I instantly responded: go short oil.

It’s a pity I couldn’t see the faces of staff at the hedge fund, as the correspondence was done via email, but it was clear from the follow-up emails they thought I was either joking, or I had lost my marbles.

Go short oil? Had I somehow missed that the global economic recovery was becoming reality? Experts had started talking about US$100 per barrel again, just read the newspapers!

On that particular Monday, crude oil futures were trading near US$84/bbl. Last night they put in an unexpected sharp rally, but they’re still below US$80 and, if my view proves correct, heading for a return back inside the US$70-75/bbl trading range. Note, for instance, that despite crude oil’s rally on Tuesday, energy stocks were one of only two sectors in negative territory on the Australian share market during Wednesday’s session; the other is Information Technology.

I could be wrong, of course. For all I know a sudden outbreak of extremely cold weather in the Northern Hemisphere, or an announcement by China it will further increase its strategic reserves, could easily push crude oil futures back to US$84/bbl. But the message I am trying to get across, and the reason why I use the above example, is don’t just look at one key element -in this case: the solidifying economic recovery- to determine your trading and/or investment strategy this year.

Though it may be less apparent for those who only look at financial markets with a short term (trading) horizon, intrinsic valuation will come to the fore at some point, especially since most experts seem to think that excess global liquidity will be reigned in this year, implying the weight of money will increasingly play a lesser role as the year matures.

To put it very simply: higher economic growth in key regions should translate into higher corporate profits and into higher demand for energy and base materials. Thus prices for companies and for commodities should move higher. But what if these price rises have already occurred?

In the US the main discussion among investment experts seems to be whether market leaders such as Apple, IBM and Microsoft -all on a big winning streak thus far this year- still represent value beyond their present upward momentum. Short term traders might reason I’ll play the stock as long as it moves, but for investors with a longer term focus the question is not that easy. If all the upside, or nearly all of it, has already been accounted for, then these stocks should no longer be bought at present levels.

Now that we’re mentioning it: I wouldn’t necessarily be afraid to have a higher than usual proportion of my investment portfolio in cash. It beats owning shares that seem stretched from a valuation point of view, but it also allows one to jump on any opportunities that might come along as we move through 2010.

Much has been said about the market’s potential on the basis of expectations for FY11, and I myself have been a firm advocate for using FY11 projections to gauge where today’s true market value is located, but most companies in Australia will only report their full FY10 numbers in August, which is still more than seven months away. In the meantime, a lot of FY11’s upside potential is being priced in today.

I have observed, for instance, total recommendation downgrades by the stockbrokers FNArena monitors daily is now outnumbering the number of upgrades for the second week in a row. That’s two out of two so far this year, as the first week saw hardly any research released. One downgrade in particular caught my attention: following the release of a production report that was much better than market expectations last week, analysts at Citi nevertheless downgraded Rio Tinto ((RIO)) shares to Neutral.

Their reasoning? Most of the good news is now priced in. As a token of their conviction, Citi analysts stated that in case of any meaningful rally in the shares, they would have no doubt and become sellers of the stock. Now that is conviction!

Most stockbrokers currently have a price target for Rio Tinto shares between $80 and $90. Citi itself is positioned at $83. FNArena’s average price target stands at $82.64.

On pure Price-Earnings multiples considerations, Citi analysts seem a bit harsh in their assessment. After all, Rio Tinto shares are only trading on 11.3 times consensus forecasts for FY11, which is far from excessive. Consider, for instance, that BHP Billiton ((BHP)) shares are on a multiple of 12.7, Asciano ((AIO)) is on 19.4 and even Woolworths ((WOW)) and CSL ((CSL)) are both on a multiple of 15.2.

However, Rio Tinto has yet to report its full FY09 results as its fiscal year runs to December. As such, FY11 for Rio Tinto is six months further off today than it is for most Australian companies. In addition, the above mentioned FY11 PE ratio is on the basis of the average AUD value over the past twelve months. At the present AUD/USD value of 0.92-plus the implied PER for fiscal 2011 instantly jumps to 13.3.

Looked upon with a positive state of mind, this still seems to leave further room for share price appreciation, especially with iron ore prices likely to surprise this year and with most metals trading above consensus price projections. But let’s not forget the start of Rio’s fiscal 2011 is still nearly twelve months away. On FY10 numbers, and taking into account the present value of the AUD against the USD, the PER jumps to 16.

Add-in the fact that Rio’s PER hardly ever reached as high as 14.5 (let alone 16) during the period 2005-2007 and one is inclined to have more sympathy for Citi’s view. This becomes even more the case given a growing army of experts is questioning whether prices for the likes of crude oil, copper and gold have not moved too high too rapidly between December and early January.

I have already indicated in the opening paragraphs of today’s story where I stand in this matter.

For BHP Billiton, whose fiscal year concludes six months sooner than Rio’s, the FY11 PE multiple currently stands at 12.7 (on average FX values for the past twelve months). However, if we take guidance from today’s AUD/USD value, the PER jumps to 14.5.

On a positive note, if we apply the Australian share market’s longer term average forward looking PER of 14.5, then both BHP and RIO seem fully priced, but not excessively so. This, of course, on the understanding that normally the longer term PE multiple applies to the year immediately ahead, which in this case is FY10, not to 18 months into the future (2011).

One important factor for investors to watch during the upcoming reporting season is what’ll happen to earnings and dividend expectations for FY11. Some experts believe there is simply not much room left for FY11 projections to rise further, which seems but a reasonable assumption given most growth expectations for the year are in between 20-40%.

Here are a few examples, randomly picked from FNArena’s R-Factor on the website (with consensus growth expectation for FY11):

– Emeco ((EHL)) – 50%

– National Australia Bank ((NAB)) – 30.7%

– Qantas ((QAN)) – 74%

– AJ Lucas Group ((AJL)) – 84%

– OneSteel ((OST)) – 89.5%

– Ten Network ((TEN)) – 36.9%

The obvious question from all these figures is: does further confirmation of global economic recovery still have the potential to further increase growth projections for FY11, or have analysts already accounted for as much in their present projections?

Another way of looking at the Australian share market is that, according to FNArena’s consensus forecasts, a little over half of S&P/ASX200 companies are currently trading on at least 14.5 times projected FY11 earnings per share. This automatically implies that nearly half of the companies is not.

Some of these companies come with exceptionally low multiples, like Boart Longyear ((BLY)) and Sunland Group ((SDG)) for example, with FY11 PE multiples of 1.65 and 2.89 respectively. But there are many others with less exceptional multiples (and thus likely less risks) including the likes of (again randomly picked):

– Hastie Group ((HST)) – FY11 PER 8.32

– Telstra ((TLS)) – 9.62

– Oz Minerals ((OZL)) – 9.95

– Elders ((ELD)) – 10.54

– QBE ((QBE)) – 12.37

Special mention: all banks still seem to represent good value on FY11 metrics. Only CommBank ((CBA)), which traditionally commands a sector premium, seems relatively fully priced on a FY11 multiple of 13.3.

Another group worth mentioning are healthcare stocks and other defensives. On pure PE multiples these stocks are mostly trading on above market multiples (see examples of Woolworths and CSL earlier in this story) but compared with historical multiples most of these defensive stocks are valued below the multiples they usually enjoyed prior to 2009.

One factor to keep in mind is that healthcare stocks in Australia come with lots of USD exposure.

The reason why I end on a relative value note is because have I noticed professional investors are increasingly looking into alternative value propositions (“alternative” as in “outside the usual movers and shakers that pushed the market in 2009”). It may well be that, as the usual suspects start running into valuation headwinds (RIO, BHP, CBA), the market might make a switch into lesser valued stocks, which in itself could keep the rally going for longer.

Having said this, I do think the ASX200 index undertook an attempt at conquering the 5000 technical resistance level earlier this month, and the attempt was readily and bluntly rejected by Mr Market. As far as my information goes, the market is now waiting for direction in between support at 4850 and resistance at 5000.

As far as Rio Tinto goes, technical resistance lies at $80, while for BHP Billiton it is at $44-$44.50.

All these resistance levels are near, but they still leave further room to move upwards.

More worrying is the fact that 1150 for the S&P500 in the US historically has tended to be a tough barrier to move past. And guess where the index closed at yesterday? Wham bam, right on the mark!

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)

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