REPEAT Rudi’s View: The Divide Between Uncertainty And Value

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FNArena editor Rudi Filapek-Vandyck shares his views and insights on irregular basis with subscribers. Occasionally, these views are made accessible to non-paying members and readers elsewhere. This story was originally published on Wednesday, June 23, 2010.

By Rudi Filapek-Vandyck, Editor FNArena

Something odd has happened these past three weeks. The balance between recommendation upgrades and downgrades has shifted in favour of more downgrades.

This is odd because usually there is a strong correlation between stockbroker recommendations and share prices. If share prices continue moving up, downgrades start to filter through as stockbroker price targets are reached and exceeded.

Alternatively, if share prices continue to fall there's usually a spike in stockbroker upgrades as share prices are deemed too cheap.

This time, however, the usual correlation no longer seems to apply. The first two weeks of June saw the share market bounce back from another sell-down in May, but stockbroker upgrades and downgrades remained in balance.

And now that shares are back in decline there's no predictable spike in upgrades, but instead a widening gap in favour of downgrades. In the week to Monday, downgrades were outnumbered upgrades by 29 to 12. Two days later and the balance has widened further to 31 against 7.

What's happening?

In two words: lower earnings. Back in April I observed how earnings expectations had stopped rising in Australia as downgrades and ongoing upgrades started to equal each other out for ASX200 companies. Since May, however, the underlying trend has turned negative. There are now more downgrades than upgrades to future earnings for Australian companies and the average growth profile for the market in its entirety has been on a sliding scale since.

Should we get worried?

I don't think it matters, as the market obviously already is. Every day media reports talk about widespread concerns about what might come from Europe and disappointment about what China could have done, but didn't and about US data failing to live up to the recovery promise – but falling earnings expectations… this really makes things very concrete and tangible.

All of a sudden, what seemed like an absolute bargain yesterday, looks a little less of a bargain today, despite the share price weakening, and what will happen tomorrow?

It is this uncertainty that is keeping investors on the sidelines. It is difficult to accurately gauge what the real value is of what is on offer when the trend is downwards.

This is why the upcoming results seasons in the US and in Australia will be very important. On both occasions companies will have to come up with the goods and show the market they truly can deliver on promise and potential. The Australian share market has already been hit by the first company downgrades to earnings guidance, but let's be fair, few investors will lose sleep over Sigma Pharmaceuticals ((SIP)), Elders ((ELD)) or Alesco ((ALS)). These profit warnings have nevertheless contributed to the current negative trend in earnings expectations and rating downgrades. Another contributor has been falling metals prices, with producers of zinc and aluminium in particular seeing expectations lowered as securities analysts update their models.

To put all this into perspective: in April the average growth in earnings per share for ASX200 companies stood between 5-6% for the financial year ending on June 30th. On my latest calculations, this has now dropped to 4-5%. Keep in mind this includes some heavy adjustments for the companies that have come out with profit warnings.

In other words: yes, the underlying trend is now negative, but it's not like the wheels are about to fall off anytime soon.

As far as fiscal 2011 goes, earlier projections of 20%-plus growth had already fallen below 20% in April, and that's still where they are today. (Note: this too implies a minor negative net change as comparable growth for FY10 has fallen). Again, it's not like analysts are using chainsaws these days to adjust their previous estimates, unless the company is called Elders, Alumina Ltd or Sigma.

This does not take away the fact that global economic growth is trending lower, having peaked in the second quarter, and this will no doubt keep the underlying trend in corporate earnings negative. How negative? That's something we will have to find out in the months ahead. In the meantime, the drop from 5000 to 4500 has not necessarily pushed the Australian share market into absolute bargain territory. On my calculations, the Australian share market is still valued at nearly 16 times FY10 profits; still well above its long term PE multiple of 14-14.5.

If we take guidance from FY11 consensus estimates, the market's multiple is still 13. While this keeps the door open for further upside on multiple expansion alone, it remains yet to be seen how far the multiple will rise because of falling earnings estimates (as opposed to rising prices). On my calculations, it will require a drop of 6% in average FY11 expectations to push the AX200 to a multiple of 14. In other words: the average growth in earnings per share next year would have to drop to 13% from 19% now.

As things stand right now, that seems like a big ask, especially since bulk commodities are likely to remain positive contributors for a while yet. But such a “correction” is certainly not impossible – it'll all depend on how much economies slow down in the months ahead.

(Note that falling earnings and slower economic growth usually translate into lower multiples, so investors should not assume that share markets cannot go much lower, even with earnings projections only falling slightly).

Market averages, however, only tell us a limited part of the story. Plenty of individual stocks are now trading on single digit Price-Earnings (PE) multiples based on consensus data for FY11 and these include the likes of National Australia Bank ((NAB)), Fortescue Metals ((FMG)), Rio Tinto ((RIO)), BHP Billiton ((BHP)), the regional banks and Qantas ((QAN)).

In fact, 47 out of the top 200 companies in Australia are currently trading on a single digit FY11 multiple. For some of these companies, this might prove the correct risk-reward proposition. For the majority of these companies, however, I find it hard to believe this will prove to be the case.

If we raise the bar to a maximum multiple of 11, 68 companies comply, including Telstra ((TLS)), QBE Insurance ((QBE)), Macquarie Group ((MQG)) and ANZ Bank ((ANZ)). If we raise the bar to a maximum of 12, 79 companies comply, including Commonwealth Bank ((CBA)), Western Australian Newspapers ((WAN)) and Lend Lease ((LLC)).

48 companies are expected to pay out at least 4% in dividends next year (FY11), 38 companies should pay out at least 5%, while only 28 are projected to pay out 6% or more. The latter group includes all the banks, both BlueScope Steel ((BSL)) and OneSteel ((OST)), Fleetwood ((FWD)), Downer EDI ((DOW)), Ausenco ((AAX)) and David Jones ((DJS)).

Mind you, none of the above will prevent share prices from potentially falling further, and we know that future expectations are in decline, but for longer term investors who believe that a repeat of 2008 simply is not on the cards, there should be plenty of value opportunities to pick from.

All information mentioned above about downgrades and upgrades, PE ratios, dividend yields and consensus expectations is available daily to all paying subscribers of FNArena via tools such as R-Factor, Stock Analysis and The Australian Broker Call Report.

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box next to 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website.

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