Rudi On Thursday

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

(This story was originally published on Wednesday, 10 June 2009. It has now been republished to make it available to non-paying members at FNArena and readers elsewhere).

As far as market symbolism goes, the Australian share market could have hardly picked a better day to roar to a new multi-month high on Wednesday. On the same day Australia’s leading financial newspaper, The Australian Financial Review, printed on its front page “Super returns worst on record”; a story about how superannuation funds are poised to post double-digit losses for their members this fiscal year.

On the same cover page a secondary story is titled “Investors brace for downgrades”; how companies in Australia will be issuing profit downgrades and more write-offs in the weeks and months ahead.

The S&P/ASX200 index jumped more than 2.2% to 4024.40, a new seven-month high. Other equity markets throughout Asia put in a similar performance on the day, if not better.

Could there be a bigger contrast even if they tried at the newspaper?

Weeks ago I would have argued this sharp contrast between news flow and share market performance illustrates how financial markets are taking their guidance from elsewhere these days, and how they’ve temporarily disconnected from what’s going on in the real world.

This time around, however, I don’t think that is the case. I think investor focus has shifted and as such, yes, it can be argued share markets have disconnected themselves from the real world, but that is exactly what they should do if they want to live up to their role as a forward looking indicator.

The main news brought to you by the AFR is, to put it simple, yesterday’s reality. And so is the fact that corporate profits will take a hit this financial year. As a matter of fact, many companies will see their profits take an even deeper dive in fiscal 2010.

Under normal circumstances, such a subdued prospect would continue to hang over the share market as the Sword of Damocles; ready to chop off the heads of the market bulls, ready to force this rally into reverse at some stage – because ultimately, the share market must obey the direction of company profits for shareholders.

But not this time.

This time -and I dare to state this without the slightest hesitation- prospects for the share market are rare and exceptionally positive.

Forget about greenshoots, this rally has long surpassed the concept of “economic greenshoots” and of “less bad” economic data (though you will hear and read these terms for a while longer). From now on this rally is all about the future and, regardless whether you believe in a V, W or U-shaped economic recovery, the future is bright.

This is because of the severity of the global economic and financial crisis that has dogged financial markets between late 2007 and early this year. That same crisis will continue to impact on corporate profits for another year or so. But fiscal 2011 should see a rebound in corporate profits and that is the luxury currently hanging over this share market: investors will be hard pressed to find many companies that will not increase profits from the low levels that have become the norm during the present phase of the downturn.

I did some research into the matter this week and I had to try really hard to find any company that is anticipated to report lower earnings per share in FY11 in comparison with profit expectations for August next year. This automatically makes the upcoming results season a side-event. Some experts have warned the upcoming results season will mark the deepest trough in this downturn as far as company profits and more bad news revelations are concerned, but I think it won’t deter share markets from continuing their rally.

As long as any bad news now doesn’t impact on likely profits in FY11, why should it?

For investors whose aim is not to ride along the share markets’ present day momentum, but to buy and hold for a longer period instead, this rare situation has opened up a true bull market scenario: given that profits for shareholders will be higher for almost every stock on the market in FY11, this should translate into a higher share price and higher dividend payouts by then.

The news should even be better than that: coming from a period of negative economic growth overall price-earnings ratios (PERs) in 2011 might also be higher than today’s. This would certainly be the case for the market as a whole, though not necessarily for each individual stock. During the boom years of 2003-2007 the Australian share market saw its PER run up as high as 15 (average for the S&P200 stocks). This time around the market’s PER is again at 15 but that is on FY09 estimates; hardly anyone but journalists at the AFR care about these numbers.

On FY10 estimates the PER is closer to 14, indicating corporate profits should improve, on net balance, into next year, but not dramatically so. This bodes well for FY11. However, I estimate present expectations for FY11 profits probably put the Australian share market on a PER of 10-11.

The market doesn’t even have to return to the good old multiple of 15. A combination of recovering profits plus a higher multiple will translate into higher share prices. It is a luxury investors thought they would not see again for many years to come, I am sure.

I hope that, by now, you all see the kind of rare opportunity that is presently hanging in front of this market. In fact, this might be why share markets are unlikely to retreat any time soon.

As far as individual stocks go, here are a few observations:

– BHP Billiton ((BHP)) shares are currently trading on a PER of 21; unheard of and never seen during the boom years that preceded this downturn. However, if we take a look into FY11 estimates the PER drops to 16.5. This is, by historical standards, still high. Note that BHP shares command a market premium these days as they are a standout not only in the Australian share market, but also as the largest and mightiest commodity producer in the world. Of course, were price forecasts for copper, crude oil and bulk commodities to increase significantly, this would have a direct impact on BHP’s profits, and thus push the PER lower.

– Woodside Petroleum ((WPL)) should by FY11 enjoy the benefits from a higher oil price, plus a big jump in profits. On next year’s estimates the shares are at a lofty multiple of close to 24; driven by market belief that prices for energy will only go up from here. On FY11 forecasts, however, Woodside shares appear an absolute bargain, trading at a multiple of 12.5 only.

Just as an example of what such a double-whammy could mean for Woodside’s share price: $3.42 times a standard market multiple of let’s say 15 (very conservative in a buoyant oil environment) would push up the share price to $51.30 – a gain of nearly 20% (ex-div) from where the shares are today. However, raise the earnings per share (EPS) multiple to 19 and the potential share price gain increases to more than 50%.

– Things do not seem equally buoyant for James Hardie ((JHX)) though. On present forecasts for FY10 the shares are on a multiple of 24, and a stronger AUD is likely to lift the PER even more. On FY11 forecasts the multiple falls to around 14.5; better, but far from fantastic. On FY12 forecasts, however, the PER falls to close to 9. Of course, the risks to these forecasts are for a quicker than anticipated recovery in the US housing market.

– For Boral ((BLD)), which has a greater leverage to the Australian housing sector than James Hardie, the metrics appear more attractive: a FY10 PER of almost 23, but on FY11 forecasts the multiple shrinks to 13.5.

– Wesfarmers ((WES)) is one of the stocks that is currently not expected to achieve profit growth in FY10 compared with FY09, but in FY11 the up-trend in EPS should resume. On present estimates the multiple for FY10 is close to 19, but on FY11 projections this becomes 14.5. Still far from cheap though. Maybe investors should punt on a positive surprise from the Coles turnaround?

– Battered and bruised CSL ((CSL)) looks relatively cheap today, and the shares only look even cheaper on future projections. Current FY10 forecasts see the shares trading on a multiple below 15 (historically 30 was more like the norm); on FY11 estimates the multiple drops to 13.5.

– Various retailers look cheap as well. The Reject Shop (TRS)) is currently trading on a FY10 multiple of 14.7; this becomes 12.5 on FY11 estimates. For Billabong ((BBG)), the numbers are 12 and 10.5 respectively.

– Not every dog will automatically become more attractive over time. Ten Network ((TEN)), which has held the dubious title of least recommended stock in the Australian share market for many months now, is currently still trading on what seems a highly inflated FY10 PER of 27. On FY11 estimates the multiple still stands at an above market 16-plus. And for equally low rated PaperlinX ((PPX)) the news is hardly better. Given the benign operational context, plus the fact that the company is effectively at the mercy of its bankers, investors are only prepared to pay ten times (10.5x) next year’s projected profits. But even on FY11 estimates the multiple still stands at nearly 8, indicating the low expectations that are currently pencilled in for the company’s future.

– Remarkably, I found, is that both leading gold producers in Australia, Newcrest Mining ((NCM)) and Lihir Gold ((LGL)) on present market expectations should hardly achieve any profit growth in FY11. Any investment on a longer term time frame thus remains very much dependent on what an investor’s expectations are for the gold price.

– What about Australian banks? Freed from the shackles of bad debts and balance sheet restraints all the major banks look excellent value on a two-year horizon, with present multiples of between 11.5 and 12.9 dropping to 8.8 for National Australia Bank ((NAB)) and 10.4 for Commonwealth Bank ((CBA)). Investors should also take into consideration that by then the sector multiple should have risen from the current 12-something to closer to 14.

The impact of such a double-whammy is probably best illustrated through NAB shares; currently the cheapest among the majors on both FY10 and FY11 estimates. Assuming a multiple of 13.5 (meaning the discount vis-a-vis the others remains in place, which is far from certain) with present market consensus of an EPS of $2.50 in FY11, it would deliver a share price of $33.75; this implies a gain of 52.5%, dividends not included.

– The same time-frame brings equally relief to some of the infrastructure players. ConnectEast Group ((CEU)) for instance, is expected to halve its losses per share by F11 and to have raised its dividend payout by 1c to 3c again (raised from FY10) meaning the shares are currently trading on an implied FY11 dividend yield of 9.8%.

Of course, I don’t expect this window of opportunity will remain open for ever and ever. It is possible, as more and more investors will do the same maths, that share markets will swiftly move to price in most (if not all) of the FY11 potential well in advance. As such, I am more concerned about the share market’s outlook for the first half of next year. Once all this potential is incorporated in share prices, what could possibly come next?

I guess we’ll start worrying about this when we get there.

With these thoughts I leave you all this week.

Until next week!

Your editor,

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

P.S. I – Having written repeatedly about the Coppock Indicator since mid-last year, I discovered this week I casually forgot to formally end the subject. For those who still had any doubts, and who have missed the fact that other media and commentators by now have also picked up on this indicator, at the end of May the Coppock Indicator formally signalled the end of the bear market for all major equity indices, including the All Ordinaries in Australia.

According to my information, this is the eleventh time since 1900 the indicator has generated a Buy signal for long term investors in equities. On two occasions only the Buy signal proved false: in 1938 and in 1942.

P.S. II – Analysts at GSJB Were have conducted their own research into FY11 profit leverage for Australian companies. On their assessment companies that should benefit most from increasing margins in FY11 include Virgin Blue ((VBA)), Hills Industries ((HIL)), BlueScope Steel ((BSL)), Spotless ((SPT)), Billabong ((BBG)), Boral ((BLD)), Amcor ((AMC)), United Group ((UGL)), Qantas ((QAN)), Adelaide Brighton ((ABC)), Harvey Norman ((HVN)) and Sims Group ((SGM)).

P.S. III – FNArena is continuing to work hard on a related, new application for its website. This new addition will assist investors in finding the best earnings growth at the most attractive price in the market. I have mentioned this project before, and many hours of data gathering, calculations and checking have since gone by. We are currently incorporating FY11 forecasts and expect to reveal the new tool shortly.

Click to view our Glossary of Financial Terms