Lack Of Value? Or Too Many Investors Chasing The Same Ideas?

This story features HARVEY NORMAN HOLDINGS LIMITED, and other companies. For more info SHARE ANALYSIS: HVN

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, Editor FNArena

One does not need advanced software packages or many years of first hand experience around the traps to see that the Australian share market is struggling to push the S&P/ASX200 index beyond 6700.

Simply draw a chart of Australia’s major shares index over the past few weeks and you instantly see the market has tried four times to push the index beyond 6700 and every time the attempt failed and shares rapidly retreated. Depending on how the market will fare over the next few sessions, we may now be experiencing a fifth attempt since mid-October.

To some market observers there is no secret why the market is finding it difficult to move higher from here: it’s a valuation issue. The idea that the Australian share market is currently at fair value, if not slightly overvalued, was confirmed by a survey by two journalists of the Australian Financial Review on Monday.

Eleven out of eighteen stockbrokers and other financial institutions that provided their projections for the S&P/ASX200 index forecast the index would be at its current level, or lower, in three months from now. Six from these experts believe the index won’t be higher in six months either.

The two most positive projections came from AMP and Commonwealth Bank signaling the index could be at 7000 by January and by 7200-7250 at the end of April next year. This implies further maximum upside potential of circa 5 to 8% on a three to six months horizon, dividend payouts not included.

Other indicators seem to point to a similar conclusion. Since early September the balance between recommendation upgrades and downgrades for individual stocks has swung in favour of more downgrades and the pattern has remained in place for ten weeks now. The past seven days alone saw 43 downgrades versus 20 upgrades.

Most of these downgrades are being issued because share prices are believed to have run too far ahead of their underlying valuation. Think Harvey Norman ((HVN)), or JB Hi-Fi ((JBH)), or the Australian Stock Exchange ((ASX)). Even BHP Billiton ((BHP)) and Rio Tinto ((RIO)) received some downgrades recently due to short term valuation issues.

My personal favourite indicator is the gap between price targets for the major banks and their share prices. History shows that whenever share prices for the major banks exceed brokers’ price targets they are poised for a pull back – this often means the rest of the market is due for a retreat as well.

Four weeks ago I reported share prices for the likes of Commonwealth Bank ((CBA)), Westpac ((WBC)) and St George ((SGB)) were trading above average twelve month price targets while National ((NAB)) and ANZ ((ANZ)) were each staring at a small gap only. Less than a week later the market retreated.

I also wrote that the most logical way to create further upside was for the banks to positively surprise with their FY07 results. ANZ failed in its attempt, but Westpac and St George did exactly that while management at CommBank reiterated its operational targets. As a result securities analysts raised their forecasts, and price targets, for most of the banks. (National Australia Bank reports this Friday).

However, as the higher price targets were met by rising share prices, the major banks landed exactly in the same position again by mid last week. All it took was for further subprime/CDO wobbles to resurface in the US and share prices in Australia, including the banks, pulled swiftly back from new record highs.

So where are we now? With the exception of ANZ (recent disappointment) all major banks are again trading near their average price targets. This again would suggest the Australian share market is poised for another confrontation with its valuation limits, and soon.

The difference with four weeks ago, however, is there’s no short term prospects left for further increases to price targets. With the exception of National Australia Bank (FY07 report on Friday) all major banks have now reported, either through FY07 results or at the annual shareholders meeting in the case of CommBank – so whereto from here?

Some market experts have argued the next upside should come from increasing price/earnings (P/E) multiples. The argument is that as confidence in China’s economic resilience grows so will the market’s confidence in the sustainability of demand for energy and resources. As the rest of the world views Australia as a lower-risk leverage opportunity into this Asian growth story, the market as a whole is likely to be re-valued, hence the higher PE ratios, which translates into higher share prices and an index that can confidently move beyond 7000 and higher.

But maybe the Australian share market doesn’t need such an “act of investor mania”.

It’s not just the banks who saw their price targets move higher over the past four weeks. The same applies to many other companies, such as Telstra ((TLS)) for instance. A detailed analysis of current valuations and share price targets for all 231 individual stocks in the FNArena database that are at least covered by five out of ten experts we monitor has revealed that current average price targets for exactly 50% of these stocks suggest further upside potential of at least 8% (dividends not included).

This group (representing about half of the S&P/ASX200 index) comprises of many financial stocks -from HFA Holdings ((HFA)) to Mortgage Choice ((MOC)) to Austbrokers ((AUB))- and many financial service providers -from Computershare ((CPU)) to Henderson Group ((HGI)) to Tower Australia ((TAL)).

In addition, this group also contains many exporters whose earnings have been hit by the strong Australian dollar, such as Billabong ((BBG)) and ResMed ((RMD)), but also remarkably many energy and base metals companies such as ROC Oil ((ROC)), Zinifex ((ZFX)) and even Rio Tinto and BHP Billiton.

So maybe the real question is not whether Australian shares are nearing full valuations, but whether investors aren’t chasing the same group of stocks – and thus a narrower scope for returns while ignoring opportunities elsewhere?

Also, the fact that BHP and Rio Tinto are still in the cheaper half of the market (determined by the difference between share prices and average price targets) suggests we’re far off from a resources mania still.

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