Rudi On Thursday

This story features OZ MINERALS LIMITED. For more info SHARE ANALYSIS: OZL

(This story was initially published on Wednesday September 17 but was only accessible for paying subscribers at the time. It has now been republished.)

One of the big advantages in reading as many analyst reports as we do at FNArena, and for such a long time too, is that you get over the initial enthusiasm of having found the unexpected, hidden treasure amidst all the daily upgrades and downgrades. If you do this long enough, and you make sure you don’t get blinded along the way, you eventually come to the same conclusion as with everything else in life: if it seems too good to be true, it probably is.

Reading daily analyst reports for many years has taught me that a Buy recommendation with a price target at a ridiculous distance above the current share price is NOT something to get excited about. It is, to the contrary, something that should trigger alarm bells ringing. It is a signal that something’s not right. Maybe the analyst who wrote the report has been smoking something he shouldn’t have. The least one can conclude is that he’s definitely not in tune with the market. Does he know something others have yet to find out?

As such one learns over time it is often the reasoning behind these ratings and price targets that is more important than the rating and target in itself.

I compare it with investors who start scouring market tables in search for the highest dividend yields. The lesser experienced these investors are, the more excited they tend to be about stocks that carry 11-12% and higher forecast dividend yields (excluding property trusts or infrastructure funds). What mostly follows is one of the hardest lessons of investing in the share market: finding out the market was simply pre-empting what analysts were about to put through their models; a much lower dividend pay-out or -worse- none at all.

And so it was with much amusement that I visited a financial magazine last week and found myself in the middle of the same youthful enthusiasm I recognised from years ago: someone had found a hidden treasure. Do you know, the person on my right said, GSJB Were has a price target 90% above the current share price! Unbelievable, someone else responded within a flash of a moment. I could swear I saw a sparkle in all four eyes.

I soon found out the conversation was about OZ Minerals ((OZL)), the ill-timed “merger” between beautiful bridesmaid Oxiana and ugly groom Zinifex.

When I returned from my trip I logged on to the FNArena website. A quick look under OZL in Stock Analysis taught me that out of the seven leading experts in our universe, Merrill Lynch had set the highest target price at $2.90. As I write this week’s editorial, after the market close on Wednesday September 17, Merrills target is 109.4% above the last closing price of $1.39 for OZ Minerals shares. I knew, of course, that GSJB Were’s target was much higher still as this week’s sell-off has been nothing but relentless, in particular for unloved stocks such as OZ Minerals.

GSJB Were has a target price of $3.20 for the shares, an extra 30c on top of the highest target in the FNArena universe.

Time to introduce warning number one: it is always very tricky to base your expectations on the highest marker in the market. In particular if there is a significant distance with the rest of the pack.

I remember, for instance, some journalists getting excited when Deutsche Bank issued a bullish report on uranium earlier this year, forecasting the price of yellow cake would surge to US$100/lb by the end of the year, and to US$125/lb next year. The problem with highlighting this report, as I pointed out at the time, was that Deutsche Bank’s expectations looked stretched, to say the least, with other experts shortly after cutting their expectations to prices of a more modest US$60-75/lb for this year and next.

Now that we’re approaching the end of the third quarter, and uranium spot prices are once again falling towards US$60/lb, who do you think will be proven correct: Deutsche Bank or the more modest forecasters?

(The FNArena Cockpit tells me the average price for yellow cake so far this year is US$68.54/lb, with a downward bias).

Any investor who intends to use the input from stockbroker recommendations should always, and above anything else, use his own judgement and insight too. Especially since most analysts cannot distance themselves from the calculated valuation behind the stocks they research. What is missing in these analyst reports is “sentiment”. As such, it doesn’t matter if a certain investment bank is intrinsically worth ten times the current share price. Nobody’s interested in buying the shares, but the analysts still rate it a Buy because the distance between valuation and share price is too large too ignore.

Now you know why 47% of all recommendations in our database consist of a Buy rating while share prices are going down, instead of moving up. Valuations don’t count for much in a bear market. It’s the missing element in all these reports that dominates the markets: investor sentiment.

There is one other side to all this. Analyst expectations are, collectively, by default behind the curve. Without spending too much time on why this is, let’s focus on the end outcome: in boom times this means their expectations are too low, and they have to catch up regularly. Once the trend has turned, however, the opposite is true and expectations have to be constantly scaled back.

Remember this for next time you see a major trend reversal for a particular sector, a company, or even a whole market or economy. The best most experts and commentators can come up with is “things are still not looking too bad” – the problem is, of course, that the information they are basing this view on consists of yesterday’s forecasts. It’s takes a while to get these forecasts updated. When they do, a new world emerges.

The past twelve months have generated plenty of examples that fit in perfectly with this scenario. Remember the mantra: Australian banks are not like their international peers, they remain safehavens? Or try this one: the Australian economy remains healthy, supported by Chinese demand for commodities.

Drawing a parallel with the examples above, it is rather easy for me to conclude that resources analysts are currently at the same stage where banking analysts found themselves after January this year: their expectations look more unrealistic as every new day ends, and even though many have already lowered price forecasts over the past weeks, more will need to be done.

Curious as I am, I had a look at the research report issued by GSJB Were from September 2nd. To my surprise, GSJBW analysts don’t seem very confident OZ Minerals shares will soon embark on a journey to close the gap between the share price and their target (currently a difference of 130%). In fact, when reading the actual report it is almost impossible to escape a general feeling the analysts are trying their best to temper any too high expectations regarding OZ Minerals’ prospects.

Take the following sentence for instance: “We think it will take at least 3-6 months for OZL to turn momentum around”. With that come a few caveats such as that management will have to deliver on the execution of the Prominent Hill project, as well as on the next acquisition: not paying over the top, but preferably purchase high quality growth assets on the cheap with immediate accretion to the bottom line.

And then there’s always the matter of the zinc price.

For OZ Minerals shares to rise as high as $3.20 spot zinc will have to rise substantially from current depressed price levels. Thus far, all those “surely it cannot go lower” expectations by metals and mining analysts have been proven wrong, just as their colleagues have been proven too optimistic after the trend had turned for banks and other financials.

What do analysts at GSJBW have to say about this? A turnaround in the zinc price is unlikely until a market deficit becomes apparant. The report suggests this may not happen within the next six months.

There you have it. Didn’t I say the most important information is not always in the recommendation or the price target?

Having said all this, there’s no denying OZ Minerals shares are dirt cheap at the moment. On GSJBW’s forecast the market is currently pricing the stock at 4 times-something next year’s (not FY08, but FY09) projected EPS of 31.5c (consensus 25.1c). A quick look at GSJBW’s projections also shows forecast FY10 EPS is currently at 30.6c, below the figure for FY09.

Given the current trend in metals prices, and analysts forecasts, it would appear the FY10 figure comes with a downward bias. This explains why the next takeover is so important: OZ Minerals management has to convince the market FY10 won’t be a year without growth.

In general, and I am taking my cue from past experiences, including the banks since January, what we are likely to see is that current price targets will come down in line with reality-adjusted earnings forecasts in the months ahead. It’s difficult to predict at this stage where these new targets will end up, and whether the shares will subsequently manage to close the gap, but it won’t be at 100% or more from today’s share price. I think that is a pretty safe assumption to make.

As such OZ Minerals is pretty much representative for most base metals related companies in the market.

The deleveraging process that is currently taking place, in combination with creeping doubts about economic growth in the US, Europe, elsewhere, as well as in China, still has a while to go. It is worth pointing out that at the time when GSJBW analysts published their report, OZ Minerals shares where trading at $1.73 with the analysts suggesting the shares were unlikely to weaken much further: “At current share price levels, we believe the market is factoring in most potential “bad news”.

Today OZ Minerals shares closed another 34c cheaper (from the $1.73 mentioned in the report).

I have suggested earlier that deflating earnings expectations by securities analysts is an essential part in working through the bad news phase of this bear market. There is no room for companies to generate positive surprises if expectations are too high while headwinds are building. This process is still ongoing. Earnings expectations for banks are once more being wound back. The same process for metals and mining companies is but in its early stages.

Next one in the queue is the energy sector. Deutsche Bank analysts still have an oil price projection of US$127 per barrel by year end. Others have penciled in average price forecasts of US$120 per barrel, or even higher for this year and next. How long before we start seeing those projections coming down?

Amidst all this, industrials companies in the Australian share market are gradually regaining the limelight as a result of the ever weakening Aussie dollar. A plunge from US97c to below US80c in a few weeks only is nothing but a free bonus for most Australian exporters. The overall expectation is now that the Aussie will end up closer to US70c sometime next year.

No wonder I already spotted one team of market strategists today who has started to sing the praise of Australia’s industrials, above its financials and resources stocks. Now, that’s what I would call a major trend change.

I have one more thought for those who’ve managed to stay focused this far: one of the worst kept secrets in the Australian market is that one of the better known tipsheets is in takeover talks with one of the medium sized financial service providers. This tipsheet has largely build its success on the commodities bull market of the past years. So what to think of the fact the owners are now thinking about cashing in?

With these thoughts I leave you all this week. Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always firmly supported by Grahame, Joyce, Greg, Chris, Todd, Andrew, Pat and George)

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