The Switch Is On!

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

By Rudi Filapek-Vandyck, Editor FNArena

And just like that… good news just keeps on coming out of the woodwork for the Australian share market.

The Australian dollar dips temporarily below US90c. Prospects for global growth seem poised for the second half and Chinese data have started to surprise to the upside. It had been a while.

The pace of ratings downgrades for Australian equities has slowed considerably and some stocks in the resources space are actually experiencing upgrades to growth forecasts. Market strategists at Deutsche Bank highlighted on Monday the underlying trend is still negative, as far as earnings estimates are concerned, as double-digit EPS growth for FY14 is probably a few steps too high, still. But, emphasises Deutsche Bank, this does by no means imply the outlook looks sombre nor trouble for corporate earnings in Australia.

Quite the opposite. FY14 is poised to become one of the better years for growth Australia has seen in a while. If current estimates of profit growth above 10% on average prove too high, and those estimates will have to be re-adjusted to, let's say, high single digit growth, that will still prove a lot better than any of the years since 2008. And there's always room for surprise on the resources side of the market, of course.

The good news story is likely to extend beyond September 7th when the next Federal government will be elected. I have no personal preference for either side of the political power struggle in Australia, but fact is both the business community and the financial sector would like to see a Coalition government replacing Rudd II. Tony Abbott not losing the First Leaders Debate and the latest voter polls indicating the Coalition is in the lead is thus yet another good omen for corporate Australia and for the share market.

Iron ore price estimates have started to move upwards too. Now this is an intriguing new development and one that deserves a few extra paragraphs. For good measure, and despite some of the early euphoric responses elsewhere, a longer term downtrend in prices remains the premise for just about every analyst covering the sector. But in the light of higher than anticipated prices, supported by a tighter than projected seaborne market, analysts have started to lift price estimates for this year and possibly 2014 too.

CBA analysts are still forecasting a price of around US$100/tonne from 2015 onwards (when Goldman Sachs is projecting US$85/t). And BA-Merrill Lynch analysts, whose market update put a rocket under share prices on Monday, also still expect the price to average US$100/t in 2015, and lower in subsequent years.

But for the quarters ahead price momentum risk appears to the upside, and thus BA-ML has lifted its 2013 forecast to US$131/tonne. The average price forecast for 2014 has remained unchanged at US$110/t, but for the year to June 2014 (FY14) the price forecast has gone up to US$121/tonne. In essence, what these latest forecasts suggest is that prices will be higher in the nine months ahead, but they are still expected to drop from next year onwards.

BA-ML analysts observe a combination of less supply from India and elsewhere and stubborn higher demand from China are likely to keep prices higher than what just about every expert has penciled in. Combine this with a much softer Aussie dollar and the impact on corporate profits for the Australian iron ore sector is quite dramatic.

Again, look at the finer details and you will find that what BA-ML analysts effectively have done is to pull forward the price/earnings momentum for the sector, with iron ore producers in Australia now anticipated to enjoy a stellar year in FY14, but then due a pull back in the year after. Below are the key growth data as published by BA-ML on Monday.
 

These developments have also impacted on the two juggernauts in the sector – BHP Billiton ((BHP)) and Rio Tinto ((RIO)) – and both share prices have moved quite nicely higher in recent weeks. An interesting observation was published by sector analysts at Credit Suisse, also on Monday. It turns out BHP's average forward looking Price-Earnings ratio (PE) is 14 over the past twenty years. If we look back over the past 80 years, it still is 14. "It is nice to know that some things remain the same", observed the analysts at CS.

So where are we now? FNArena's Stock Analysis shows BHP shares are presently trading at 14.5x times consensus FY14 EPS forecast when measured on the average AUDUSD for the year past. However, if we change the FX translation input to todays sub-92c, the PE drops to 13.2x. Add upward momentum to forecasts and it is not difficult to see how current share price momentum can carry further. The consensus price target of $38.95 suggests 6% upside in share price appreciation alone, without taking into account the shares going ex-dividend soon.

For Rio Tinto, the gap between share price and consensus target is still 22%. For Fortescue Metals ((FMG)) it is 10%. For Atlas Iron ((AGO)) it is 11%. Apart from the fact these numbers suggest there is still enough potential upside to have a lot of investors excited about these new developments, they also suggest that, somehow, the market has been extra-harsh on Rio Tinto compared with even the smaller players in the resources sector.

Below is Credit Suisse's chart for BHP's long run forward looking PE. Something to print out maybe?
 

With resources companies regaining investor attention, surely some will think time has come to also cast an eye over mining services providers? Beaten down share prices surely look attractive at these levels?

Here, however, I think a stern warning and a repeat reminder are still but appropriate: this sector is in a multi-year downtrend. One year of higher than anticipated commodity prices is not going to change the fact that global expenditure by miners and exploration companies is now firmly in a downtrend. Note that economists' projections for resources capex in Australia is not expected to fall off the proverbial cliff until… 2015.

(There's still the underlying question whether commodities are in a sustainable uptrend with analysts at CS, for example, reiterating on Monday most of their price forecasts for the years ahead are well below market consensus. The same analysts are also of the view that mining equities are too cheaply priced, even in the face of such prospect).

Investors are hereby reminded that analysts at Morgan Stanley released a two-series in-depth assessment of the mining services sector exactly one week ago, and predictions such as "The unwinding of the E&C capex profile has only just begun. Stocks are yet to price in the full extent of the decline ahead with the risk of a disorderly collapse growing" should make every investor think twice before committing any funds to stocks in this sector, regardless of temporarily improving market sentiment.

The problem with a multi-year downtrend is that share prices look cheap on relative short term prospects and that immediate earnings may not be the ideal benchmark for what lies ahead. A point also made by the analysts at Morgan Stanley. Here's another paragraph from their report to consider: "After 11+ years of strongly improving Australian E&C conditions, we are now entering the grips of a multi year down cycle with E&C capex set to fall at a double digit pace through CY14-16".

Morgan Stanley preemptively slashed all earnings forecasts in the sector and now rates all stocks Underweight (which translates into "Avoid" or "Sell"), with the exception of WorleyParsons ((WOR)) which is still rated Overweight ("Buy").

Below are forward projections by Morgan Stanley for the size of work available for the sector in the years ahead. Observe how the first of the negative years is this year and how small the overall decline appears on the chart compared with what is expected for the years ahead. Now think about what has happened with share prices for uranium producers and gold miners, who both have struggled with multi-year downtrends in years past.

Still think things couldn't possibly get worse? Let's address this matter again in 2014, and meanwhile we'll keep a close eye on those cheap-looking share prices.
 

(This story was written on Monday, 12 August 2013. It was published in the form of an email to paying subscribers on that day).

(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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THE AUD AND THE AUSTRALIAN SHARE MARKET

I have been researching and writing an eBooklet titled "The AUD and the Australian Share Market". From late July onwards this eBooklet has become part of the bonus package that comes with a 6 or 12 months paid subscription to FNArena. If you are not as yet a paying subscriber, maybe now's the time to consider joining?

My previous eBooklet (see below) is also still included.

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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

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Rudi On Tour

– I will present at the Trading & Investing Expo in Melbourne, August 23-24 (where FNArena will host a booth) – ticket promotion to follow – title of presentation is "What Works In The Share Market?"

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

– I have also accepted an invitation to present to ATAA members in Canberra in late November

– I might give my final presentation for the year at the ASA's Sydney Investor Hour in December

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