Rudi On Thursday

This story features ALUMINA LIMITED, and other companies. For more info SHARE ANALYSIS: AWC

(This story has been republished to make it available to non-paying members at FNArena and readers elsewhere. It was originally published on Wednesday February 4, 2009).

Are equities cheap?

As I have stated repeatedly throughout the year past, it all depends on what lies ahead of us. Yet, at times, it seems market commentators and investment experts refuse to look forward, but they’d nevertheless tell you equities are cheap, so you should be considering getting in the market.

More losses for equities in January have again brought out expert calls that equities are starting to price in scenarios of a global depression, or worse. The argument then goes that such an outcome remains highly unlikely, hence the credo: equities are cheap.

What I find disturbing though, is that such views seem to have more to do with what I like to call “tunnel vision”, and not so much with what is going on in the real world at present. Here are two arguments I have come across over the week past in support of the view that equities are a bargain at current price levels:

1.) equity markets have now fallen more than 50% from their peaks in November 2007

Not wanting to sound disrespectful, but it completely beats me how this backward looking statement can ever provide an investor with any valuable insights into the future. As if the size of a price correction can ever be an indication of what the true value of an asset is. Some equities have now fallen by 98% and yes, I would argue with a fierce conviction that investors should not go anywhere near them.

2.) trailing Price-Earnings ratios (PERs) are near multi-decade lows

As I have stated in the past, I never understand why people use backward looking calculations to come up with a judgement about the value of an asset in the future. Admittedly, forward looking earnings projections by securities analysts have been well into la-la-land for too long since share markets corrected and the global economy went into a downward spiral, so they have failed to provide us with anything else than daily agony, and certainly not with any reliable insights of any sorts.

But to refer to last year’s reported profits instead? It should be obvious what is missing in these trailing PER calculations: the sharp drop in corporate earnings that is taking place across the globe. Many companies are no longer able to report a positive result (see Alumina Ltd ((AWC)) today) while others are reporting profits of up to 50%, or even more, below last year’s reported results (see BHP Billiton ((BHP)) today).

And yet, I’d still argue all this does not provide investors with any real insight into whether equity prices at present are at bargain values, fairly priced or maybe even expensive still?

Here’s one important trend I picked up prior, but which may well become more established this February results season: securities analysts are not just lowering their EPS and dividend forecasts, they have started incorporating lower forecasts for FY10 (versus FY09) for many ASX-listed companies.

The reason why this is important is because if this becomes a well-established trend, this will automatically create serious headwinds for any share market upside. To put it very simple: why would investors re-rate a given stock if next year’s profits are expected to fall, thus automatically pushing up the valuation of the stock at a later stage?

As such, I believe investors should concentrate on FY10 forecasts, more so than on FY09 estimates to gauge whether the shares they are buying represent value, or not.

I few examples I extracted from Stock Analysis on the FNArena website:

– Some of the banks are expected to grow their profits in FY10, but some are not. This, for example, puts CommBank’s ((CBA)) PER for current fiscal 2009 at 10.2, but on FY10 forecasts the shares are trading on a multiple of 9.8. For Westpac ((WBC)), however, this year’s PER stands at 9.6 and this becomes 9.7 as our attention shifts to FY10.

– A dramatic FY10 EPS decline is currently penciled in for Wesfarmers ((WES)) with the result that the shares are currently trading on a FY09 PER of what looks like an extremely cheap 7.4, but on FY10 numbers the ratio jumps up to 10.2. This comes on top of falling dividends for three years in a row.

– BHP Billiton ((BHP)) should be looking at negative EPS growth for both FY09 and FY10. However, the same cannot be said for Rio Tinto ((RIO)) whose earnings projections are from here on supported because of a difference in fiscal periods (Jan-Dec instead of July-June). In an odd manner, this largely insulates Rio Tinto from the downward trend as is becoming apparent for BHP Billiton.

– The changes in profitability in the two years ahead can be quite dramatic for oil and gas companies. Woodside Petroleum ((WPL)), for instance, is seemingly trading on an implied FY09 PER of 11.9. On FY10 forecasts, however, the multiple blows out to an above market PER of 16.9. The numbers are even more dramatic for Santos ((STO)) whose FY09 PER of 16.2 instantly blows out to 34.1 on FY10 estimates.

– Origin Energy ((ORG)), on the other hand, appears to be trading at a rather lofty FY09 multiple of 19.8, but if we take the FY10 forecasts into account, the multiple automatically falls to 15.1.

– Most media companies should report EPS declines for both FY09 and FY10

-  Shares of Wotif.com ((WTF)) are currently trading at an implied FY09 multiple of 16.1, but this instantly falls to 14.5 on FY10 estimates

As shown by these examples, not all companies are expected to see their earnings for shareholders (EPS – earnings per share/unit) decline between FY08 and FY10, but many of them are. This, obviously, creates a problem for the oft-mentioned PE-rerating for equity markets. Will investors be prepared to start paying higher multiples for companies in a declining profit environment?

My best guess would be they might, but only if their confidence is solid enough that profits will improve again from FY11 onwards.

Also, the cynics among you might argue why should we take any guidance from these securities analysts. Aren’t they the same ones that have been operating embarrassingly behind the curve for at least the past 16 months?

While the latter is unmistakably true, another truth is that these forecasts are all we have to work with and the market will, as these forecasts are returning to normalcy, increasingly start taking notice of them again.

There is a genuine chance that the adjustments that are currently flowing through the market in terms of profit forecasts may be part of a multi-staged process. As such, all February adjustments are likely to be followed up by more adjustments in between and after the August results season. Arguably, by then we (and securities analysts) should have a clearer picture about what FY10 might look like.

However, it can hardly be a luxury to start paying attention to new trends already.

Investors should note that all forecasts are based on current assumptions and they can change instantly, for example if oil or gas prices would start rising again. Also, earnings forecasts are not the only item for which shares are being judged, but they are an important factor. Other company specific characteristics may apply.

Those members who want to do more research into FY09 and FY10 forecasts I happily refer to the Stock Analysis section on the FNArena website. All data are updated daily.

With these thoughts I leave you all,

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always supported by the Ab Fab team of Greg, Grahame, Chris, Andrew, Pat, George and Joyce)

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