The Times They Really Are A-Changing

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

By Rudi Filapek-Vandyck, Editor FNArena

Snippets from the week past:

– "Nations get the political leadership they deserve"

– "Australians are magnificent managers of adversity, and poor managers of prosperity"

– [BHP and RIO] returning cash to shareholders should not occur at the expense of developing and maintaining high value assets, say funds managers

– Central banks around the world are buying equities in record amounts. The Swiss National Bank and the Czech National Bank already have at least 10% of their reserves in equities

– Labor may be culpable of mismanagement of the country's finances but structural deficits as far as the eye can see cannot simply be attributed to this latest period

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If there is one easy to highlight misconception about what's happening in equity markets it is that everything begins and starts with exceptionally low bond yields and thus equities know only one master these days and it's called yield.

While not completely off the mark, it certainly isn't the whole story. How else would you explain the fact that REA Group ((REA)) shares are now trading on a forward Price Earnings ratio (PE) of 37? The PE drops to 30 on FY14 consensus estimates. At present level, which is a share price around $30.50, the implied yield from dividend payouts to shareholders is 1.3% for the total of FY13 and 1.6% for the whole of FY14.

Hardly the prospect that causes a yield hungry investor's heart to skip a beat or two.

What REA Group does offer is only available in limited quantities in the Australian share market or elsewhere: it's high quality growth that looks solid, strong and sustainable. Two weeks ago, I called this the Black Caviar effect ^(*). Neither the label nor its underlying theme have changed since and nor will they anytime soon, judging by the weak underlying trend in global economic data that is currently in place.

REA Group is not the only one. Invocare ((IVC)) is now trading on a PE of 25 (23.9 on FY14 estimates) and implied dividend yields of 3.2% (FY13) and 3.4% (FY14) respectively. Amcor ((AMC)) shares are now on a PE above 17, which doesn't seem that much when compared to the likes of REA Group and Invocare, but for Amcor this is as high as the PE has been over the past decade or so.

Alas, for most risk adverse investors (as opposed to: riding high on jubilant risk appetite), there are not enough of such stocks around to absorb all the funds that are flowing into equities. So here comes the second choice (yes, second choice, not first): companies that may not have a lot of growth in prospect, but at least they pay out dividends and those payouts in themselves look pretty solid and sustainable. "Low risk" if you want to put it that way.

Again: not exactly evidence of risk appetite is it?

The most obvious examples in the Australian share market, and they do get all the attention every day, are the Big Four Banks and Telstra ((TLS)). According to general consensus (not including me), banks were supposed to go through a rough time right now with authorities demanding less leverage and more constraints, but instead their share prices have been responsible for most of the hard work behind the rise in major indices in Australia.

Once upon a time banks' PEs running up too high was a sure sign the share market was due for a pull back, or worse, but today Westpac ((WBC)) is trading on a PE of 15 and CommBank ((CBA)) shares have gone one step further: PE 15.6. To put both these numbers into context: PE ratios for banks typically range between 9-12 during times of hardship and between 13-15 when there's no cloud in the sky. Back in 2007, when blind exuberance ruled global financial markets, banks' PEs peaked at 15.

Telstra's PE is now at 16.4 (16 on FY14 estimates). According to Morningstar data, the last time we saw Telstra on this high a PE was also back in 2007 when the PE reached beyond 17.

Note that Bloomberg pointed out last week, in a story that received worldwide coverage, that central banks the world around are increasingly adding equities to their mix of reserve allocations. Given central banks' traditionally conservative nature, I don't think anyone will dispute those funds are more likely to find their way in the above mentioned two categories of stocks rather than in Atlas Iron ((AGO)) or Acrux ((ACR)), to pick two random stocks on the more risky side of the ledger.

Fund managers cannot possibly continue to add more and more of the same shares to their investment portfolios, even though these are the names that continue to carry the share market. Or can they? Smaller investors have the option to look for the next opportunity amongst small and medium cap stocks. Names such as Nick Scali ((NCK)), Silverchef ((SIV)) and Royal Wolf ((RWH)) come to mind, but for funds managers these names simply are No Go territory. Too small. Not enough volume. Off the radar.

So where does one go to?

Luckily, Woodside Petroleum ((WPL)) injected one fresh idea into the mix last week: how about energy companies and miners re-allocate more of their cash flows towards investors and shareholders? The idea looks like a real novelty in Australia, but then Australian companies are seldom at the forefront of new developments in the world of finance and investments. Big Energy companies in Europe have been yielding 5% for many years and gold producers around the world are turning themselves into solid dividend payers, but not in Australia just yet. Over here it was left to Woodside to put projects on the back burner and pay out more cash to shareholders. Hallelujah!

Hallelujah? Maybe.

Woodside is, sort of, in a unique position in that large projects are approaching the final stage of significant investment and there's a reasonable prospect the company's bottom line will benefit from next calendar year onwards from rising domestic gas prices on Australia's east coast. (Poor us living in NSW). Plus it'll probably take a few more years before the global explosion in shale gas developments will genuinely start impacting on Asian gas prices. Seems like an ideal window to stop worrying about growth prospects beyond 2017 and to reward shareholders in the meantime. After all, and this has been one of my favourite market observations in the years past, loyal shareholders haven't seen much in terms of returns since 2006 – seven long years ago.

What goes for Woodside should also apply to the likes of Oil Search ((OSH)) and Santos ((STO)), albeit a little further down the track, but what about BHP Billiton ((BHP)) and Rio Tinto ((RIO))?

Strictly taken they are not in the same position as Woodside. Not only has all the present cash flow already been allocated to future expansion projects, there doesn't appear any support from future product prices either. On Monday, Macquarie analysts lowered their copper price estimates for the next few years to well below today's price, even after the recent sell-off. (Equally noteworthy: this happened after Rio Tinto's announcement of production losses in Utah). Deutsche Bank analysts have turned themselves into USD bulls. Their assumption is that this will create additional headaches for commodity bulls in the years ahead.

On Monday, Deutsche Bank updated its predictions for what a resurgent USD might mean for the price of crude oil. Assuming everything else remains the same, the analysts suggest the price of a barrel of Brent is now in a gradual down trend, possibly on its way towards US$80/bbl on a two-year horizon. Will it ever get there and stay there? Probably not. It is likely OPEC will tighten supply to support the price, but the underlying thesis remains the same: there's no OPEC to support the price of copper or nickel or coal.

Regardless whether current market speculation will prove accurate or not (it'll probably depend on whether asset sales can be achieved in the short to medium term), here are a few things to consider for investors who are willing to play the dividend theme through commodity stocks (energy and miners):

– Over the past seven years (2006-2013) most large cap stocks in the sector the world around have offered loyal shareholders no return other than the dividends paid, at best

– Of the total returns since 2002 (past ten years), around one third has come from dividends

– During the nineties, which was the decade preceding the start of the Commodities Super Cycle, dividends were responsible for 50% of total return

– Large diversifieds, such as BHP and RIO, tend to find solid support when implied dividend yields rise to 4% (use a trustworthy source for this: see Stock Analysis on the FNArena website)

In addition to the third point: given dividends have never been particularly high for commodity producers, certainly not in Australia, the fact that dividends made up half of all returns throughout the nineties also gives an indication about the returns that were generated in general throughout that decade.

Another factor to consider is that while earnings are notoriously volatile for commodity producers, dividend oriented investors can draw solace from the fact that big iron ore producers such as BHP and RIO will continue to enjoy significant cash flows for years to come as their costs remain well below iron ore prices, even in case of a dramatic slump.

Whatever the pros and cons of BHP Billiton and Rio Tinto pleasing their long suffering shareholders with more cash pay-outs in the short to medium term, fact remains the overwhelming majority of producers, developers and explorers in the sector cannot join the global thirst for secure growth and solid dividends. It's not their nature so by default this can never be their game. If anything, most would be looking to raise more cash, either from shareholders or elsewhere, instead. This is not an enviable position to be in.

What does Woodside's switch towards pleasing shareholders with a substantial lift in cash dividends tell investors about what possibly lies ahead for the sector as a whole?

Some of the larger funds managers in Australia put the recent sell-off in commodity stocks on equal footing with what happened to media and technology stocks after the Nasdaq crash in March 2000. It's the end of an era with too many investors, big and small, having remained on board for too long.

UK commodity analysts at Citi, arguably the most bearish on the sector for a while now, last week still showed no mercy. They have kept only one Buy recommendation throughout the entire sector (Rio Tinto) and calculated that value would only start to emerge in the sector after share prices have weakened by yet another 10%. Those calculations were published before the mini-bounce that followed the latest sell-off.

What about all those soothing predictions about China managing its economy well, keeping solid demand growth underneath energy and industrial commodities? I have long argued many a commodities bull is ignoring the fact that prices are not solely determined by demand growth. It's all about the balance between demand and supply. Recent updates on commodity markets by investment bankers and stockbrokers all seem to have one observation in common: supply is catching up. For markets that have enjoyed years of deficits, the consequences can be significant.

Witness what has happened to the price of uranium since 2006. To the price of nickel since peaking at US$50,000/tonne. To the price of coal over the past two years. All of a sudden the focus shifts towards support levels around the cost of production. History shows these levels won't necessarily prevent product prices from possibly weakening even further.

History also shows it is during times of duress that future upswings are born as projects stall, are delayed or abandoned altogether and companies move into cash preservation, hibernation or out of business. Macquarie's latest update suggests metals markets should be ready for the next upswing at around 2016-2017. That's the good news. The flipside is we're still not even half-way in 2013. Bridging that gap will pose some serious challenges, both for companies as well as for investors.

One extra-complicating factor is that most experts and commentators seem to think that global yields on government bonds will simply normalise back to (much) higher yields in the years ahead. Is this genuinely an accurate expectation?

(To be continued another time).

^(*) See Weekly Insights from April 15: "Go Black Caviar Go!"

(This story was written on Monday, 29 April 2013. It was published on that day in the form of an email to paying subscribers).

DO YOU HAVE YOUR COPY YET?

At the very least, my latest e-Booklet "Making Risk Your Friend. Finding All-Weather Performers", which was published in January this year, managed to accurately capture the Zeitgeist.

All three categories of stocks mentioned in the booklet are responsible for the index gains post 2009 and this remains the case throughout 2013.

This e-Booklet (58 pages) is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com

(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. All views are mine and not by association FNArena's – see disclaimer on the website)

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Rudi On Tour in 2013

– I will present and contribute during the 2013 National Conference of the Australian Technical Analysts Association (ATAA) at the Novotel in Sydney's Brighton Beach, June 21-23

– I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm
 

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