Rudi's View | Nov 06 2006
By Rudi Filapek-Vandyck
The surge to new record highs by Australia’s share price indices has led to some highly predictable responses by the country’s leading stockbrokers and equity researchers.
As both the S&P/ASX200 index and the All Ordinaries surpassed the 5400 stockbrokers have responded by increasing their year end targets for the benchmark indices. JP Morgan strategists were the latest to update projected index levels with the broker stating on Monday its December 2006 target for the ASX200 had been lifted from 4,980 to 5,330.
The broker cites a lift in market consensus earnings expectations as the main reason behind the decision, but that doesn’t take away the fact that its upwardly revised target remains below today’s index level. JP Morgan’s June 2007 target went from 5,300 to 5,480 on the belief that further consensus earnings upgrades are likely. The December 2007 target has been revised from 5,850 to 5,930.
The latter suggests Australian shares have on balance less than ten percent left to appreciate over the coming fourteen months. This appears in line with projections at several other brokerages, take or leave a percent or two.
On Merrill Lynch calculations an All Ordinaries index of just below 5400 translates into a projected FY07 Price Earnings (P/E) ratio of 14.4. The sector PE ratio for Australian banks is 14.5. This would seem to contradict the view of several market strategists that Australian banks have again become too expensive following another bumper full year results season over the past two weeks. Especially since most banks are about to pay out their end of fiscal year dividends. History shows banking stocks tend to recover relatively quickly from going ex-dividend. Usually it takes less than a month for banking share prices to reach their pre-dividend share price levels again.
With dividend yields in the vicinity of 5% and all banks expected to increase their dividends in the year ahead, even on the lowest forecasts in the market, it would seem a good choice to stick with the banks. However, average price targets by ten leading experts in the local share market tell a different story.
Current average twelve month price targets for banking stocks suggest all banks in Australia should be trading near, at or even below their current share price levels in twelve months from now.
Taking the implied share price potential from these targets as a guidance, the current pecking order in the Australian banking sector is: Westpac (WBC) on position number one with a projected share price appreciation of 3.5%, followed by National Australia Bank (NAB) with a projected potential of 1.5%. ANZ (ANZ) comes third with less than one percent left in projected share price appreciation.
All other banking shares are expected to trade below Friday’s closing share prices in twelve months time. Bendigo Bank’s (BEN) average share price target is more than 11% below Friday’s price level. Commonwealth Bank (CBA) is second last with an average price target implying downside of 5.3% in the year ahead.
Not one of the banking stocks is expected to match the projected market advance of circa 10%.
Notable exceptions are investment bankers Macquarie Bank (MBL) and Babcock & Brown (BNB) whose average price targets imply upside potential of 15% and 20% respectively. Macquarie Bank shares bear a forecast dividend yield of 3%+ while B&B’s forecast yield is circa 2%.
A quick look at the insurers, including Suncorp-Metway (SUN) which is both banker and insurer, shows a similar picture as for the eight traditional bankers. With most property trusts considered expensive by securities analysts this raises the obvious question: where will the next ten percent of market upside come from?
On Merrill Lynch estimates, industrial stocks in Australia are currently trading on a FY07 PE of 16+. That number becomes 17.7 if one leaves out the banks. Leaving out all financial stocks takes the PE number to 18.7, or 17.7 ex-News Corp (NWS). Obviously, these valuations are impacted by the arrival of private equity “barbarians” in Australia as well as the prospects of media consolidation under the proposed new regulatory framework from next year onwards.
When it comes to fundamental valuations it would seem the market will need to be driven by resources stocks again if it is to reach broker targets by the end of calendar 2007. On average resources stocks are currently only trading at 10 times projected FY07 earnings. In addition, commodity bulls such as Barclays Capital and GSJB Were believe prices for natural resources are likely to positively surprise in the year ahead. The view found support at Rio Tinto’s (RIO) recent management presentations to the investment community in the UK and Australia.
This would suggest the odds are in favour of further increasing earnings forecasts for resources companies. This will push the sector PE even further down if share prices don’t advance.
Resources stocks are currently being treated as a proxy for global economic growth. It may take a while still before the international investment community feels comfortable with the housing slow down in the US and more administrative measures being applied in China. But unless the US economy experiences a hard landing (the R-word) and drags the rest of the world with it, which would hit demand for commodities hard, it would appear that value seekers in today’s market are best off with commodities.
It won’t be plain sailing though. Credit Suisse experts pointed out recently that most of the commodity and energy futures markets are currently in contango, meaning the longer away the contracts are dated, the more expensive they are. This makes it costlier for investors to roll over expiring contracts. Credit Suisse believes the market is to remain in contango from here on and this will act as a technical brake on spot prices.
Also, recent fund flow data in the US suggest US investors have all but given up on the Commodities Super Cycle. Unless they have a better insight in how the US economy is going to fare over the next few months, chances are they’ll need to catch up again at a later stage.
As things stand right now uranium, iron ore, copper, nickel, zinc and lead seem prone to surprise on the upside, while steel, crude oil, coal and aluminium seem likely to disappoint. Precious metals are expected to rise further. The ruling theme for soft commodities (agri-products) has become climate change instead of oil substitution.
At this point in the cycle though, all insights and projections can reverse rapidly. Larger players with diversified earnings, such as Rio Tinto and BHP Billiton (BHP) are therefore a lower risk option compared to single commodity companies.
Recommendation downgrades by the ten experts monitored by FN Arena have now outnumbered upgrades for seven weeks in a row (see also graph 2 above). Rio Tinto and BHP have not been immune, but both still enjoy nine Buys out of a maximum of ten.
Only Babcock & Brown Wind Partners (BBW), Emeco Holdings (EHL), Gloucester Coal (GCL), MFS Ltd (MFS), Perseverance Corp (PSV) and Tassal Group (TGR) do better with 100% Buy recommendations. However, none of these stocks are covered by all ten experts.