Rudi On Thursday

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

The world has once again dramatically changed in front of our eyes and nowhere has this become more visible than in securities analysts updating their views and valuations for Australian stocks. A few examples, randomly taken from today’s (Wednesday) research updates:

– Analysts at Citi kept Allco Finance ((AFG)) on Buy, but decided to lower their earnings expectations by up to 25% for the next few years. As a result, the broker’s price target for the stock has fallen from $12.69 to $5.88. This is still 97% above Tuesday’s closing share price.

– Analysts at Deutsche Bank kept their Hold rating for GPT ((GPT)) intact but lowered their forecasts by 5% arguing changing market circumstances could put up to 10% of GPT’s forecast earnings at risk (implying there’s an additional 5% at risk). Their price target has dropped from $4.70 to $3.81.

– Analysts at ABN Amro retained their Buy rating for Harvey Norman ((HVN)) and their forecasts largely intact following another strong second quarter sales report. However, the target price has been pulled back from $7.76 to $6.63.

All three examples confirm the trend over the past two weeks: earnings expectations are being scaled back and the same goes for twelve month price targets as investors are no longer prepared to put a similar multiple on companies that are now operating within a quickly changing global environment. The second factor also explains why the All Ordinaries index in Australia is gradually losing its premium over the S&P/ASX200 index: smaller companies in general have enjoyed a larger re-rating of price/earnings ratios (PERs) than the big caps over the past two years. Now that global economic growth is slowing this process has gone into reverse.

A simple mathematical example shows the importance of these two factors:

Asssume company XYZ Enterprises tends to trade on a projected profit multiple of 15. Market consensus believes this year’s profit per share will be $1. Before the correction XYZ’s share price would have been around the $15 mark.

Fast forward and research updates by securities analysts believe it is safer to slice off 5% from this year’s profit expectations. Under normal circumstances, this would logically translate into a revised valuation of $14.25 -assuming a multiple of 15 times 95c- a net loss in value of 5%. However, reduce the multiple to 13 and what you get is a new valuation of 12.35 – of loss of nearly 18%.

And this example only uses two rather modest changes. Imagine what happens in case earnings forecasts are being lowered by 25% (as in the case of Allco Finance above) and when PE ratios come down from 20+.

Nowhere is this better illustrated than in the market’s top ten stocks of potential investment return which is calculated on the difference between share prices and average price targets plus projected dividend estimates. Usually this top ten list carries a few problem stocks with projected potential returns of 50%+ followed by perennial underperformers such as News Corp ((NWS)), Macquarie Infrastructure ((MIG)) and Downer EDI ((DOW)) whose potential value is estimated some 20-30% above what their share prices are trading at.

However, today each stock in this top ten list is showing a potential total return of more than 100% for the year ahead. This is not solely a reflection of the severity of the correction that took place this month, but also of the fact that calculations and valuation models by securities analysts still have to catch up with the new reality.

For what it’s worth, FNArena’s top ten list on Wednesday afternoon, amidst an overall sharply higher Australian share market, reads as follows:

1.) Centro Retail Group – projected total return for the year ahead ((CER)): 471%
2.) Centro Properties Group ((CNP)): 333%
3.) Commander Communications ((CDR)): 244%
4.) AED Oil ((AED)): 235%
5.) HFA Holdings ((HFA)): 224%
6.) Allco Finance ((AFG)): 173%
7.) Perilya ((PEM)): 164%
8.) Tishman Speyer Office Fund ((TSO)): 136%
9.) Macquarie DDR Trust ((MDT)): 124%
10.) Babcock & Brown ((BNB)):119%

Of course, nobody can and should take these projections serious. I am only using this as an illustration of how much this market has been disconnected from its roots since November last year, and how much in re-adjustments needs to be done.

The above examples also show us the importance of the upcoming results season with companies either confirming their growth paths, or not, and with securities analysts using these operational updates to adjust their ratings, forecasts, valuations and price targets. Currently the FNArena Bear-Bull Indicator has sank to an all time low (meaning the relative number of Buy ratings in the market is at an all time high) which, I would argue, is fairly consistent with a market that has lost some 18% in a few weeks only. However, for investors looking to pile up on value opportunities post the massacre of indiscriminate selling orders the challenge will be to avoid the valuation traps.

One of the possible ways to do so is to zoom in on recent research assessments. For instance, Citi analysts initiated coverage on fledgling gold producer Avoca Resources ((AVO)) with a Buy rating on Tuesday placing a $2.80 price target on the shares that were trading at $2.17 at the time. One would assume their assessment should remain free from significant re-assessments in the months ahead.

Similarly, UBS commenced coverage on Bradken ((BKN)) on the same day with a Buy rating and a maiden $8.50 price target, some 26% above the share price on Monday.

Citi has been very active in adding new stocks to its research portfolio this month, as the broker also issued maiden research reports on uranium producers Energy Resources of Australia ((ERA)) and Paladin ((PDN)) on Monday. Both companies are rated Buy with price targets of respectively $26 and $7.70 – 26% and 43% above Friday’s closing share prices.

Last week, Merrill Lynch added broadband infrastructure provider Pipe Networks ((PWK)) with a Buy rating and a $5.50 target, 17% above the share price at the time, as well as broadband internet provider iiNet ((IIN)) also with a Buy rating and a $2.73 price target, suggesting upside of close to 20% (including dividends).

On January 11, Citi initiated Downer EDI with a Buy rating and a price target of $6.90. According to the analysts, if management cannot right the wrongs in the short term a breakup of the group will become inevitable (suggesting value will be released one way or another).

The upcoming results season will provide both analysts and investors with plenty of opportunities to divide the winners from the losers. This will also assist in getting rid of a lot of froth in market expectations and broker ratings and that can only be a good thing for all parties involved.

Till next week!

Your editor,

Rudi Filapek-Vandyck

(as always supported by the Ab Fab team of Greg, Chris, George, Grahame, Joyce, Pat, Paula and Sophia)

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