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, 17 June 2009. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere.)

Every once in a while I write a story that attracts more questions and responses than usual. Last week’s editorial (see Rudi On Thursday, repeated on Monday, 15 June 2009) has proved to be one such story.

I guess the most asked question was: how can someone who has been saying for weeks that shares in BHP Billiton ((BHP)) and all four major banks look overpriced all of a sudden start talking about a “rare and exceptionally positive” prospect for the Australian share market?

The short answer is: a different time frame. I remain of the view, even after the losses booked over the past few days, that BHP Billiton shares are overpriced and that Australian bank shares look expensive too. In fact, I think most blue chips in Australia are far from cheap, especially since we don’t know yet what precisely lies ahead of us.

But all those considerations are short term.

If I extend my view further into the future, I can confidently say a “rare and exceptionally positive” prospect currently lies ahead for the Australian share market.

The main reason why this is has to do with the severe economic freefall we have just witnessed, in particular in the fourth quarter last year and the first quarter this year. As such, and no matter how gradual, slow or aenemic the economic recovery might turn out to be, the global economy will end up in a better shape than where it was – and this goes by default for corporate profits too.

This is what makes today’s situation so special: nearly all companies on the Australian stock market -okay; let’s call it an overwhelming majority- will be reporting higher profits in fiscal 2011 than this year or next. Whether this will still be the case in FY12, I don’t know, but I’d be cautious in extrapolating too many positives too far into the future.

While doing my research last week, I asked myself: what would I do if I were a fund manager with a longer term focus who had missed out on most of the March-May rally? The answer is simple and straightforward: I’d put my money to work, in a gradual fashion (buy in the dips) and I would be seeking stocks that look relatively good value on FY11 prospects.

BHP Billiton, priced at $35-something would not be among these stocks. Unless I believed the next acquisition would bring in the fireworks, or that prices for oil and base metals have much further to run from here. In all fairness, prices for commodities may well be higher in 2011 than where they are today, and this should have a positive impact on the BHP share price. But I also believe that these same prices are too high today, which probably translates into some sort of a correction at some point – this means I should be able to jump on board the BHP Billiton express at cheaper entry levels. All I have to be is patient.

I would definitely include the banks though. Australian banks, that is. There will still be plenty of bad developments and announcements forthcoming from their international peers, but here in Australia all competition is getting squeezed out of the market, so once bad debts and provisions for these bad debts have been taken care of, the major four will squeeze their customers as hard as they can. And profits will jump.

Most companies in Australia, small and large, are in a similar situation as the major banks: once the tail end of this economic recession disappears, their profits will grow, or grow faster.

Enter FY11.

For those who remain yet unconvinced, I have tried to visualise the concept (I do realise that any five year old could do a better job, but that too is besides the point):

The key point to remember is: it doesn’t matter how aenemic the economic recovery is that will follow next, it will always be better in two years from now than where we come from.

As a matter of fact, the most likely scenario to prove me wrong would be a much stronger recovery in 2010 followed by a relapse later. Under such a scenario it is likely that share prices will run up much higher and much quicker and they may well be on their way back when the market focus shifts into FY11. But would that be such bad news?

Note that the public discussion among economists and market strategists is all about how soon and how strong the coming recovery will be; nobody doubts the fact that some sort of recovery is next.

I also believe this prospect will prove the remaining doom and gloom prophets wrong; at least for now. Some of them are anticipating a general relapse of the markets at a later stage. Is this realistic? I do know it is possible. What we call the bear market of the 1930s consists in essence of one bear market, followed by a brief economic recovery, followed by a second bear market that culminated into World War II.

And from the early sixties, throughout the seventies, until the early eighties shares in the US went up, and down, and up, and down – but after nineteen years they were still at the same level as where they were in the sixties.

In between, investors enjoyed rallies like the one we witnessed since March, and they faced corrections like the six months prior to March.

I believe the positive prospect of FY11 hanging in front of the share market virtually guarantees we won’t see a return to the lows of March anytime soon. That is, unless something happens that could impact on this prospect. There is a whole list of potential party-spoilers: from a new Lehman experience; to an unorderly sell-off in the US dollar; to a repeat of 9/11; to a war over North Korea’s nuclear ambitions.

I could easily add a sudden and permanent spike in global inflation (hyper-inflation?), rapidly rising bond yields and oil back at US$147 per barrel, and rising – but when was the last time the world was completely devoid of any threats or dangers?

This is why, I think, market experts at BCA Research, despite pointing at increased chances for a general share market retreat, reported earlier this week “our valuation, fundamental and cyclical technical indicators remain positive on equities on an absolute basis and relative to bonds”.

This is why, I think, experts such as Marc Faber agree in that the underlying outlook for asset prices remains positive (Faber is widely known as the publisher of the Gloom, Boom and Doom Report. He believes central bank liquidity in combination with a weaker US dollar will do wonders for asset prices). This is also why US market strategists at Citi in the US believe the S&P500 index may well overshoot their year-end target of 1000.

Do I still share the skepticism, worries and concerns some of you have been emailing me? Absolutely! And I am convinced that what we have available right now in forecasts regarding FY11 will be amended, adjusted and corrected multiple times before we get to 2011.

But all that is superceded by what I tried to visualise above.

With these thoughts I leave you all this week.

Till next week!

Your editor,

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

P.S. I – Something to think about from Dave Bhagat, Senior FX Advisor at Silicon Valley Bank’s Global Financial Services:

“Currently, equities are struggling to advance further in most regions except Asia, weighed down by surging commodity prices, soaring bond yields and a perception they have gone up too far and too quickly. If I am right and growth and inflation expectations are ratcheted down in Q4, this will provide a more favorable backdrop for equities, but only in those markets where growth expectations remains alive and well. I believe that is when we will see another wave of outflows from developed markets into the better performing emerging markets, and it is this capital movement that will be the catalyst for further emerging currency gains.”

P.S. II – Strategists at UBS made some changes to their Model Portfolio this week, removing risk trades Rio Tinto ((RIO)) and WorleyParsons ((WOR)) and adding the more defensive AGL Energy ((AGK)). Other stocks on UBS’s Key Call List are Computershare ((CPU)), Crown ((CWN)), Incitec Pivot ((IPL)) and Westpac ((WBC)).

P.S. III – Each month quant analysts at BA-Merrill Lynch compare performances between “contenders” -low PER stocks with rising earnings expectations- and “defenders” – high PER stocks with falling earnings expectations. In May contenders outperformed, but defenders had done better in the two preceding months. In fact, contenders only outperformed in five out of the past twelve months, but over the period as a whole they nevertheless outperformed by 5%.

It will be interesting to see how two profit warnings, by Nufarm ((NUF)) and Lihir Gold ((LGL)) will impact on the contenders’ performance this month. Other stocks on the Contenders list are currently Caltex ((CTX)), Commbank ((CBA)), Toll Holdings ((TOL)), Energy Resources of Australia ((ERA)), Downer EDI ((DOW)), Billabong ((BBG)), Orica ((ORI)) and Harvey Norman ((HVN)).

The list of defenders consists of Macquarie Airports ((MAP)), Macquarie Infra ((MIG)), Axa Asia-Pacific ((AXA)), BlueScope Steel ((BSL)), Iluka ((ILU)), Qantas ((QAN)), Perpetual ((PPT)), GPT ((GPT)), Brambles ((BXB)) and Fairfax Media ((JFX)).

P.S. IV – CSL ((CSL)) shares’ absolute underperformance since March must be turning the stock into a contrarian investor’s wet dream, the shares are definitely testing the nerves (and conviction) of investors who bought prior to March. CSL shares changed hands for $38 in February, yet four months later, and after the broader market rallied close to 30%, the shares still appear to be treading water around $30.

No prizes for guessing why CSL at present is the most highly rated stock in the Australian share market.

Thanks to feedback from Southern Cross Equities analysts Stuart Roberts, I can report that CSL’s historic average Price-Earnings Ratio (PER) is around 25 (see also chart below provided by Roberts). The shares are currently trading on a PER of around 15. Even if a weaker USD will shave off some of the growth in the years ahead, this will probably be compensated by the extra-upside from flu vaccines.

CSL is expected to continue growing at double digit figures (20%) in the years ahead, in other words: above market speed. Even if one believes the stock won’t return to a multiple of 25 anytime soon, that type of profit growth in combination with a potential recovery in the multiple (let’s say to 18) should do wonders for the share price – but when?

For investors who are not in a hurry one wonders whether the uncertainty about the exact timing should matter.

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