Under The Hood – June 2014

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In this week's Weekly Insights:

– Under The Hood – June 2014
– All Eyes On 'Super' Mario Meeting
– CLSA's About Face On CoverMore
– Supermarkets Not Super-Safe
– Your Editor Amongst The 30
 

Under The Hood – June 2014

It's impolite to look a gift horse in the mouth, but when you're about to buy a second hand car, it's no less than common sense to first take a look under the hood.

One would have to be a blind bull not to see the immediate earnings outlook for corporate Australia is a bit fragile right now. Consumer sentiment is suffering from Canberra-itis, business leaders say they have the right investment intentions but evidence is patchy, the upturn in domestic building and construction is slower than usual and uneven, iron ore has surprised to the downside and the Aussie dollar is still around US93c.

This is also the underlying theme in recent share market updates by strategists at Deutsche Bank and at BA-Merrill Lynch. Both acknowledge most surprises have been toward disappointment so far this year and corporate Australia is probably staring at some more downgrades to earnings forecasts in the weeks/months ahead.

The difference between both is how they advise investors should deal with this. Deutsche Bank, a firm equities bull, retains confidence in that earnings momentum shall re-emerge in Australia, either later this year or in 2015, on the back of better momentum in the US and the rest of the world. As such, Deutsche Bank strategists think it's best to remove a little risk from portfolios, but without becoming too defensive overall. Strategists at BA-ML, on the other hand, carry more of a bearish streak and they are worried; about consumer confidence, about the challenges ahead for the Australian economy and about analysts' projections for profit margins, which seem too high in the face of BA-ML's macroeconomic analysis for the year ahead.

BA-ML's conclusion is thus:

"We are increasingly of the view that FY15 earnings forecasts are too optimistic. This assessment derives from our proprietary top-down model, which gives us visibility for earnings growth over the next 12 months. Taken literally, the model suggests no earnings growth for the market next year. Consumer sentiment is a key input into predicted growth, and unless we see a rebound in sentiment there could be material downgrades ahead."

Before we delve deeper into the views and remedies put forward by both, let's first take a look under the hood of the Australian share market as things stand at the beginning of June (four more weeks and we're half-way calendar 2014 and only two months away from the next reporting season).

There's a whole raft in financial indicators and calculations that are being cited by financial analysts and commentators in an attempt to assess whether there's still enough value in Australian shares. The numbers cited usually show a lot of variation with some experts referring to last year's actuals (outdated, thus irrelevant) but even on consensus FY14 numbers the variations observed this year seem a lot larger than usual.

Here at FNArena we remove the obvious outliers from calculations, like small biotechs or mining companies that are expected to grow by 100% or whose PE is sharply negative or outlandishly positive, and as such we derive a "clean" underlying Price Earnings ratio for the ASX200. At the beginning of June our average PE for the Australian share market sits at 17x for FY14 projections, which is well above the long term average of circa 14.5x. This suggests the market is currently expensive.

However, given we are only weeks away from the August reporting season, when companies will confirm, surprise or disappoint and analysts will be updating and reviewing their valuations and projections, it is not unusual for PEs to look bloated this time of the year. It can be argued projections for FY15 are a better measure for the share market's true valuation, even with the precise outcome of FY14's performance still an unknown. Our FY15 average PE for the ASX200, ex-outliers, sits at 15x. Still expensive.

Underpinning both PE calculations are average growth in consensus earnings per share (EPS) projections of 11.5% and 10.7% respectively for FY14 and FY15. The first number is underpinned by some hefty growth numbers for mining companies before the weakness in iron ore and on the back of improved market dynamics for nickel and aluminium. Next year's growth is partially carried by the energy sector where maturing LNG projects are anticipated to bring about big jumps in cash flows and profits.

What none of these numbers show is how polarised the Australian share market has become post-GFC with robust, reliable industrial franchises, preferably with an attractive dividend yield, now consistently (?) trading at a premium to the rest of the market and with most of the rest at a sizeable discount. So those averages above may be less applicable in today's share market because the premiums priced-in for the likes of Telstra ((TLS)), Woolworths ((WOW)), Domino's Pizza ((DMP)) and CSL ((CSL)) are masking the fact that many others, including Fortescue Metals ((FMG)), Arrium ((ARI)), Wotif.com ((WTF)) and NRW Holdings ((NWH)), are today trading on what looks like -on face value- garage sale "everything must go" give-away prices.

A similar picture emerges when we look at analysts' price targets for individual stocks and the gap -positive or negative- that remains. Under "normal", pre-GFC circumstances, investors would shy away from stocks trading at too high a premium (negative gap with consensus price target) unless a positive earnings surprise appears to be forthcoming, which triggers higher targets, but buying cheap and shorting what looks expensive has been a heart wrenching, shirt-losing strategy so far in 2014. Short-term volatility aside, with more question marks arising for profit growth and margins for the quarters ahead, is it really feasible this underlying dynamic is about to change?

The table below tells the story for the Australian share market. The selected 21 stocks represent more than 65% of the ASX200. It's probably a fair assumption these stocks will determine how far the index can rise or fall in the year ahead. Observe how most of the financials are near consensus price target, while industrials ex-banks are often well above target, and energy stocks still have room to move and miners remain well below targets.

One other conclusion to draw from the table is that it can hardly be a surprise the ASX200 has not been able to decisively move away from 5500. That seems about the level when the banks and the likes of Telstra, CSL, Wesfarmers and Woolworths are all trading above target (thus making them "expensive") and they alone cannot possibly push the index any higher, unless we really want to see those stocks trading at crazy valuation levels. If we want to see the index at 6000, we need to see meaningful contribution from the miners, the energy sector and laggards such as QBE Insurance ((QBE)) and Westfield Group ((WDC)) – without a significant de-rating for the popular stocks on a premium.

Within this context, consider the abovementioned Deutsche Bank strategists have now delayed their timing for when the ASX200 is likely to surge above 6000. At the start of the calendar year, 6000 was set as the target for December 2014, but now the target for year-end has been lowered to 5700, with the index projected to reach 5900 by mid-next year and 6100 by December 2015.

It's not Deutsche Bank's core message, but one can read the above as: give Australia's industrials stocks and financials enough time, and they will get the index back above 6000, eventually. Note that for most of the 21 companies above, expectations for earnings growth in FY15 are rather modest, certainly below the present average for the year. Exceptions are CSL, Rio Tinto ((RIO)), Westfield, Suncorp ((SUN)), Origin Energy, Oil Search ((OSH)), QBE Insurance and Santos ((STO)) for whom expectations are for high growth next year.

The picture becomes even more lopsided when we look at all 200 stocks in relationship to their target. No less than 126 are, as at the beginning of June, trading below target and 100 stocks are at least still 4% away from target. This again shows how polarised the current share market is with a minority including Treasury Wines Estates ((TWE)), Shopping Centres Australasia ((SCP)), Village Roadshow ((VRL)) and Sydney Airport Holdings ((SYD)) enjoying a solid premium, while the larger part of the index still shows a gap to clear.

Admittedly, the minority group of premium stocks includes several candidates under M&A interest (quelle surprise!) while the larger group includes companies surrounded by uncertainty and big question marks, such as QBE Insurance, Toll Holdings ((TOL)), smaller energy stocks and miners, and mining services providers.

So how can investors best use this information in their strategies? If we accept that a tougher environment for corporate margins and profits indeed lays ahead, focusing on a potential de-rating of today's popular industrials and banks seems a bit futile given their relative robustness will continue to shine, even in the absence of positive momentum and upside earnings surprises. The table below is from Macquarie research and shows forward profit projections in case the Australian dollar refuses to move below US90c.

What stands out is the benign growth, but growth nevertheless, for banks and property trusts, while projections for "resources" are being carried by the energy sector, in particular those companies whose LNG projects are expected to come online sometime in the 18 months ahead. Industrials are clearly expected to outshine all other sectors, except energy, for the two years ahead, despite the fact that exporters and multi-nationals like CSL, ResMed ((RMD)), Brambles ((BXB)), Amcor ((AMC)) and Ainsworth Gaming ((AGI)) should be impacted by less favourable FX translation.

Companies with access to offshore growth nevertheless remain favourites for most strategists.

(Source Macquarie Research).

Market strategists at Deutsche Bank believe investors should probably cut some risk from their portfolio, without turning too defensive. Deutsche Bank's model portfolio is Underweight miners, Overweight energy, Underweight banks and Overweight utilities. The strategists recently added exposure to REITs, insurance and healthcare.

Strategists at BA-ML have two convictions: one is domestic earners face a challenging time as expectations of a broad-based cyclical recovery are scaled back. The highest conviction is that some US earners like QBE Insurance, ResMed and Bluescope ((BSL)) will outperform.

BA-ML's biggest concern is the implied margin expansion for Industrials (ex banks) in FY15. If current analysts' projections are correct, 4.5% sales growth will translate into 11% earnings growth. The strategists are skeptical and suggest this is where the next disappointment will stem from: domestic oriented industrials that cannot deliver the margin expansion expected.

Candidates that seem poised to disappoint rather than meet expectations, according to BA-ML, include Qantas ((QAN)), Myer ((MYR)), Aristocrat Leisure, Ansell ((ANN)), Primary Health Care ((PRY)), Leighton Holdings ((LEI)), WorleyParsons ((WOR)), JB Hi-Fi ((JBH)), Toll Holdings, Coca-Cola Amatil ((CCL)) and Woolworths.

BA-ML's analysis of the Australian share market also includes a chapter whereby the strategists identify stocks that are enjoying both positive earnings and share price momentum, suggesting these stocks are more likely to outperform. Stocks identified include three of the major banks (laggard National Australia Bank ((NAB)) not included), market darlings Flight Centre ((FLT)), REA Group ((REA)), Domino's Pizza, Navitas ((NVT)), Ardent Leisure ((AAD)), Ramsay Healthcare ((RHC)) and G8 Education ((GEM)), building materials stocks, large energy producers, financials outside the banks, REITs, as well as industrials such as Cardno ((CDD)), Recall ((REC)), Seek ((SEK)) and Brambles.

Investors familiar with my concept of All-Weather Performers will have noticed many of the stocks mentioned on the positive side are considered part of this select group (see also below).

Others might bemoan the fact the story of the Australian share market seems to remain stuck with largely the same companies that have been responsible for most of the positive price action since mid-2012. Don't assume the banks are due a significant de-rating, unless the context changes dramatically. The same applies in reverse for miners and their services providers.

Paying subscribers who like to receive the ASX200 in relation to consensus targets as well as an up-to-date share price overview of All-Weather Stocks can send an email to info@fnarena.com.

All Eyes On 'Super' Mario Meeting

It's time to stop jawboning and show some real action. At least, this seems to be the general sentiment when it comes to Europe, the ECB and "Super" Mario (Draghi). This week, Thursday June 5, the world will finally find out what exactly the European Central Bank is up to and whether Mario Draghi has more up his sleeves than sweet, soothing words.

If you are like me, you wish you had had the foresight and book a holiday for this week. By the time of our return, it would be all over and let's move on. Now we have to endure an excruciating flow of pre-meeting analyses and expectations. The good news: soon it'll all be over. Or not. Never underestimate the Europeans (and that's something the South Americans should bear in mind as well during the upcoming WorldCup Football in Brazil).

For those who'd like to participate in the pre-meeting preparations and anticipation, but don't want to do any work like reading and thinking about it, FX specialists at Brown Brothers Harriman have put together a handy overview of what can be expected under what scenarios (see below). Note EONIA stands for Euro OverNight Index Average, in other words it is the 1-day interbank interest rate for the eurozone.

On the other hand, investors might also want to consider some wise advise from CBA's FX guru Peter Dragicevich: "Given the move lower in EUR since the May ECB meeting, a lot appears to be priced in. The ECB simply 'meeting expectations' may see EUR recover post the meeting in a classic 'sell the rumour, buy the fact' scenario." Financial markets… there's so much more to it than being bullish or bearish and getting the timing right…

CLSA's About Face On CoverMore

It was probably one of the most controversial analyst reports pre-IPO this year, with CLSA stating travel insurance is a great business, at face value, but entry barriers are low and products are too much commodity to warrant any form of long term investment, hence investors received the advice to shun freshly offered shares in Cover-More ((CVO)). But all that changed once company management and CLSA analysts met face-to-face.

Today, CLSA's view is that Cover-More represents a unique way in the manner the company has structured the relationship with their capital provider (insurer) "whereby CVO is effectively a manufacturer who rents the balance sheet of an insurer, thereby controlling every other element of the process". On this basis, admits CLSA, prospects, in the medium term, look good. In other words: "We wuz wrong". CLSA upgraded to Outperform in May but the share price has caught up rapidly, by now trading in the vicinity of the revised $2.35 price target.

At this level, the PE ratio is 24.7x, the prospective dividend yield (FY14) 1.4% and the outlook is for single digit growth only. Not on CLSA's revised outlook though, which now suggests 20%+ plus in EPS for FY15. Dividend yield for the year ahead is 8c (3.4%).

Supermarkets Not Super-Safe, Warns Morgan Stanley

Investors in Australia have treated supermarket operators Wesfarmers ((WES)) and Woolworths ((WOW)) as super-safe defensive investments, worthy of a premium valuation, but, warned analysts at Morgan Stanley on Monday, that view might be put to the test in years ahead. MS analysts have conducted a detailed analysis of new store roll-outs by Coles, Woolies and Metcash ((MTS)) and found the overall quality has been in decline since 2011.

One of the stand-out observation in the report is that 65% of Woolworths' new stores opened since 2011 have been in postcodes that already have a Woolworths store. Taking guidance from the UK experience, the analysts think both Coles and Woolies will now focus on increasing their gross margin and thus create fertile ground for competitive discounter Aldi whose inroads are only to become more harmful to the incumbents. The remedy would be to close stores, pay less out to shareholders and accept a temporary dip in profitability, offer the analysts, but what are the chances of that happening?

Morgan Stanley cut its earnings estimates for the years ahead, but the revised estimates are still largely in line with what most peers have penciled in without the grand warning of a potential de-rating for the sector, Woolworths in particular. The analysts believe diversification will provide more of an offset for Wesfarmers and Metcash. Its rating for Woolworths is Underweight, combined with In-Line for the sector overall. But it's the price target that will attract everybody's attention: $31. Only the long-standing bears at BA-Merrill Lynch sit lower, at $27. Consensus sits around $35.50 (and that's including BA-ML but excluding MS). The share price is closer to $38.

Your Editor Amongst The 30

Last week, Business Insider Australia published its list of "30 Of The Best People To Follow On Twitter For Australian Economics And Markets News" and Your Editor was included on position number 29. Thanks to Robert for pointing it out. Here's the full list: 

http://www.businessinsider.com.au/presenting-30-of-the-best-people-to-follow-on-twitter-for-australian-economics-and-markets-news-2014-5#x1
 

(This story was written on Monday, 26 May 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(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

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

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

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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RUDI ON TOUR

I have accepted an invitation from the Australian Shareholders' Association (ASA) to present to members (and others) in Wollongong on June 10.

DETAILS

Date:       Tuesday 10 June 2014
Time:       6pm
Venue:     Illawarra Master Builders' Club, 61 Church Street, Wollongong
Subject:  The share market – always different, always the same    
 

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