Join Rudi’s Journey: The Next Bubble

This story features AUSTIN ENGINEERING LIMITED, and other companies. For more info SHARE ANALYSIS: ANG

By Rudi Filapek-Vandyck, Editor FNArena

It may seem odd today, but when I presented in front of an ATAA audience in October last year, I pointed decisively in the direction of "pick and shovel" service providers to mining and energy companies as the next logical focus for investors in the Australian share market, only to witness scepticism and wariness flying back at me. Despite my best assurances at the time, questions kept on being asked about how solid the outlook for these companies could possibly be in the face of a global credit crunch and falling commodity prices as a result of banking and debt problems in Europe.

Things have changed dramatically over the past three months. Firstly, I cannot meet or greet or spot a stockbroker on television or in the newspaper and he's talking up some personal favourite in this particular sector. Cardno ((CDD)) seems to be high on everybody's list these days. Then there's Seymour Whyte ((SWL)). And Decmil ((DCG)). And Ausdrill ((ASL)). And Macmahon ((MAH)). Even Campbell Brothers ((CPB)) features a lot these days in viewers questions on a popular evening program on financial TV.

It's probably no coincidence then the usual questions about OneSteel ((OST)) and Lynas ((LYC)) here at FNArena are now being matched with enquiries about Brierty ((BYL)) and Logicamms ((LCM)). I had a look at Logicamms a few months ago but decided it was too micro, even though there is research available from Bell Potter. Prior to the enquiries, I didn't know Brierty existed. A rally of more than 24% since late last year probably explains the origin of this sudden interest.

I updated my research on the sector this week and the results are ab-so-lu-te-ly stunning. The mainstream press (and most market commentators) cannot get enough of pointing out the Australian share market is already up 5% for the year, or double digits higher since the bottom in September last year, but wait until you see the numbers I discovered…

My e-booklet "The Big De-Rating", released in November last year, lists 50 companies that are directly leveraged to capital expenditure by miners and energy companies, both onshore and offshore. There are probably 20 more, so let's assume we have a pool of 70 names listed on the Australian Stock Exchange. More than half of these companies have decisively outperformed the broader market since December.

Within this group, differences range between extreme and even more extreme. Companies such as RCR Tomlinson ((RCR)), up 9% in past weeks, UGL ((UGL)) and Mermaid Marine ((MRM)) have all outperformed the index, but they have been left behind by double-digit performances for the likes of Ausenco ((AAX)), Imdex ((IMD)), Cardno and Austin Engineering ((ANG)). Then there's a group that has rallied in excess of 20%, including Macmahon, Ausdrill, Seymour Whyte, Brierty and, yes indeed, the best-of-the-best in the sector, Monadelphous ((MND)).

Then comes a group that rallied more than 30%, including Forge Group ((FGE)), NRW Holdings ((NWH)) and Maxitrans ((MXI)). It still gets better though as stocks such as Mastermyne ((MEY)), Coffey International ((COF)) and Ludowici ((LDW)) jumped by up to 87% (admittedly, there's an offer on the table for shareholders in Ludowici). The best performer I was able to find is Maverick Drilling ((MAD)) with a 100% improvement in share price this year.

One soft conclusion to draw from all this is that investors have (re-)discovered the service providers on the back of renewed risk appetite following the ECB's monetary injections in December. One other conclusion that can be drawn is that, as far as all these stocks are concerned, the horse has now bolted and there's little value left for the Johnny-come-latelies beyond January 2012.

Yet, I don't think the second conclusion is accurate. I think these meaty price gains over the weeks past show how cheaply priced and neglected these stocks were prior to this rally. It also shows the sector is made up of relatively smaller companies, with lower trading volumes and scant research from brokers (that last part is improving). Also, the recent history behind names such as Leighton Holdings ((LEI)) and Coffey International reminds investors this sector is not without its risks.

Above anything else, however, I do not think this is the end of the opportunity for equity investors. I think that what we are experiencing is the beginning of what will ultimately become one Big Bubble in the share market. Thus share prices have much further to go from here.

The "secret", or so to speak, to buy into this sector stems from the fact that resources giants such as BHP Billiton ((BHP)), Rio Tinto ((RIO)) and global energy majors will spend more on new and existing projects in the next few years than they have done during the past decade. BHP alone, for example, is scheduled to spend some $20bn in capex this year. This is more than 14 times total annual revenues for Monadelphous. That's just BHP, and just this year.

Bottom line: this sector has only just started to see the early beginnings of what will be a truly once-in-a-generation boom time and the next three years or so should provide truly unprecedented cash and workflows. These past weeks have seen some big contracts come rolling in. For Leighton. For Decmil. For Downer EDI ((EDI)) and others. Many more will follow.

In simple stockbroker parlance this means: the risks are firmly to the upside.

This is why high quality stocks such as Monadelphous and Campbell Brothers are now trading above stockbroker targets. I think the bias for these stocks remains to the upside, so don't panic if you are a shareholder about whether to take profits or not. A second very important reason as to why I continue to like this sector is because many of these companies are very good dividend payers. After all, it's the combination of strong earnings growth and strong growth in dividends that has made Monadelphous the best investment option available on the Australian Stock Exchange throughout the past decade.

To prove my point: even on a present year (FY12) Price-Earnings ratio (PE) of 17.6, Monadelphous shares still yield an estimated 4.7%. This is projected to grow to 5.5% in FY13. One of my other favourites, Fleetwood Corp ((FWD)) yields 6.6% and 6.8% respectively. Both are fully franked.

All this looks like very good news for those who added one or some of these stocks to their investment portfolio in the past, but what to do if you haven't got your piece of the action yet?

I think investors eyeing this sector should start by adopting a rather agnostic attitude to "valuation". Remember: risks are skewed towards positive surprises and as long as risk appetite remains strong (as it is now and has been throughout December and January) investors will show willingness to pay more for good fortune later. In layman's terms this means the share price for companies such as Monadelphous and Campbell Bros is likely to remain expensive for longer. Unless Europe throws some really bad news at financial markets, chances are these share prices won't become truly "cheap" again in the near future.

Observe, for example, how quickly the share price for Bradken ((BKN)) is recovering after a disappointing interim result earlier this week.

Here's how I would play this sector from here on.

For the likes of Monadelphous, Campbell Brothers and WorleyParsons ((WOR)), which are all quality companies but already trading above consensus targets, I'd be looking at buying into dips, realising that I am a little late to this party. (I might even hope that Europe causes a temporary sharp retreat in risk appetite!) To form an idea of what exactly investors are buying into, ignore F12 forecasts and concentrate on FY13. This is an important feature for the sector as a whole. Where most companies in the share market will likely be battling downgrades and cuts to forecasts in the months ahead, this sector will more likely enjoy upgrades and increased forecasts.

As an example: on current forecasts for FY13 and assuming a slight decrease in the current PE ratio, Monadelphous shares can easily surge to $25.50 in the year ahead. This represents a total investment return of some 15% (of which 4.8% in dividends) starting from today's "expensive" share price. Calculations for Campbell Bros and WorleyParsons look pretty similar.

There are still companies that are equally enjoying the momentum and still trading below consensus target, which means we can stick with data for the current year to form an initial opinion and venture into FY13 afterwards (or much later if we wanted to). Names that fit this mould include Miclyn Express ((MIO)), Emeco ((EHL)), Programmed Maintenance ((PRG)), Mermaid Marine, NRW Holdings and Cardno. Some of these stocks are still double digits away from targets suggesting there remains a lot of potential to catch up on this year's expectations, still.

The sector also contains a lot of micro-caps for which there's often no research available. Investors thus only have the past, company info, the share price and the overall sector outlook to concentrate on. This is a different kind of game, with names such as GR Engineering ((GNG)), GRG International ((GRG)), Brierty, Maverick Drilling, Mastermyne and Maxitrans. Note some of these names are covered by one leading stockbroker only, or by smaller players inside the industry.

Lastly, some of the names in the sector have failed to properly participate in the rally thus far. Transfield Services ((TSE)) comes to mind. Watpac ((WTP)) is another example. This is where price action probably speaks a thousand words. Be very careful and don't automatically assume a bargain is up for grabs. It might well turn out the complete opposite.

For more names: see "The Big De-Rating".

On a risk-reward assessment, this sector represents more potential than most other sectors and at a relatively lower risk profile (because of the booming market dynamics). Of course, as time goes on, there's a genuine prospect for share prices to go absolutely ballistic. Also, with limitations in equipment, labour and credit/financing to announce themselves, investors will have to stay alert for the potential for negative surprises.

The experience of the past years has shown share prices for the quality names in the sector can be pretty resilient during times of risk aversion. This is not necessarily the case for the higher risk names. Also, with a (much) stronger AUD looming as a major danger for company earnings in the year(s) ahead, for many of these companies the currency is much less of a threat, if at all.

Lastly, there are some important lessons to be drawn from the experience with Matrix Composites & Engineering ((MCE)). Remember? One year ago about every investor and his pet seemed to have an interest in Matrix. The share price ran from $3 to $9 in less than nine months. Today, the share price is back at $3.15. Trading volumes are pathetic. Literally nobody ever mentions Matrix. (Kudos to JP Morgan who kept a Sell rating (Underweight) and maintained throughout the hype the shares were not as valuable as commonly assumed.)

Boom and bust. It's all part of the share market. Always has been. Always will.

(This is the second part of the series "Join Rudi's Journey". The first part was published on February 1 and is available on the website under the tag "Rudi's Views". To be continued.)

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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