Rudi On Thursday

This story features BENDIGO & ADELAIDE BANK LIMITED, and other companies. For more info SHARE ANALYSIS: BEN

(This story was originally published on Wednesday, 8 July. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).

There are easier things in life than trying to look two years ahead for the share market, in an attempt to determine which companies have the best growth prospects, and then relate this information back to calculate what the intrinsic valuation is behind today’s share prices.

Usually I would not recommend anyone to look much further than 18 months into the future – and that would be the absolute maximum. History shows both investors and analysts have a lousy track record when it comes to anticipating what lies beyond the next six months. It’s all made easy when markets are in the midst of a strong and clearly established trend, which allows for continuous extrapolation, but the overall picture blurs quickly under all other scenarios.

Let’s be honest: we humans are very bad in determining whether a trend will change, and when.

But rules are meant to be broken -at well-chosen moments in time- and as far as I am concerned this is probably one of such times. Because we are still only in the very early stages of what ultimately will be labeled “the economic recovery”, the short term outlook for corporate profits and for equity markets is much more uncertain than the medium term outlook.

Over the weeks past I have argued corporate profits in FY09 and FY10 are likely to mark the bottom in this global economic downturn, so to establish true value one would have to look past these years into FY11. The problem with this is that FY11 is still such a long way ahead, and the further we move beyond the next six months, the less reliable anything becomes in terms of forecasts.

While all this is true, we should never treat analyst forecasts as an absolute given. Instead, we should look upon them as simply one extra tool we have at hand to do our research, to build an opinion and to mould our view, and to assist when making investment decisions.

It is okay for some investors to chase the day-to-day, or the week-to-week share market momentum, but this certainly does not suit everyone. And as all types of investors have found out over the past 18 months: when there’s no longer a strong medium term uptrend carrying the markets, the price at which you purchase your stocks of choice does matter; and it can matter BIG time.

I believe the prospects for share market returns over the medium term (let’s call it the next 12-18 months) are positive. I have noticed an increasing number of highly regarded experts is expressing a similar view. Some won’t stretch their view beyond the next twelve months, others talk about two years-ish. Market strategists at BCA Research talk about a positive undercurrent on a five-year horizon in their latest market update.

Most of these experts agree defining any concrete forecasts for the short term is a mug’s game. The rally since March was predominantly headline driven, why would the subsequent correction be any different?

As long as prospects for FY11 remain positive, share markets will not succumb to new lows. It’s always good to keep this in mind. This is why, for instance, the above mentioned BCA strategists won’t totally exclude the fact that equity markets may well revisit the lows carved out in March at some point in the months ahead. They remain adamant though, if markets do it’ll be a platform for the next rally.

So how does a longer term investor look through the short term hubris?

Priority number one, one assumes, is trying to determine which companies look good on a see-through-the-trough basis, immediately followed by priority number two: to reduce the chances one is about to overpay for what looks like a good company to own.

Because I believe we are likely in the middle of a 1962-1981 type of share market environment -with similar index levels at the beginning and at the end of the period- investors should pay attention to sustainable dividends. Dividends are no longer a luxury, but should be considered a necessity for anyone with a longer term view in this type of market.

These are the three core elements I have taken into account during my research in the weeks past: projected growth, Price-Earnings ratios and dividend yields. And instead of trying to determine what levels should be considered “just” or “desirable” for each of the three components, a decision was made to compare everything on a relative basis: from stock to stock to stock.

The research completely ignored FY09 and focused on FY10 and FY11 instead, ASX200 only.

Outcome number one is a firm confirmation of what we all should know already: investors don’t like companies facing troubles, not with debt, not with assets or regulators, certainly not with asset valuations, not with anything really. So any company dealing with any such problems is readily abandoned. That’s why any research that tries to determine where the most value is located in today’s market by default ends up with names such as DUET (DUE)), Transpacific ((TPI)) and Babcock and Brown Infrastructure ((BBI)). On pure valuation metrics, these stocks look like once-in-a-lifetime bargains, but there is a reason why they are trading well below intrinsic valuations and stockbroker price targets: it’s called risk.

Some companies look boring, they should pay a relatively high dividend, but there are still risks and their valuation is an almost perfect reflection of this: modest, if not sober. A company such as Goodman Fielder ((GFF)) trades on an implied dividend yield of 8%-something, and its projected annual growth and PE ratios are similar. Boring thus, but when it comes to relative value Goodman Fielder shares seem to present a relatively good opportunity. The same goes for Corporate Express ((CXP)) and for media stocks APN News and Media ((APN)) and PMP ((PMP)); even though one could easily argue the latter should be considered in the high risk category.

Non-surprisingly, ACCC-threathened Cabcharge ((CAB)) equally ranks high on the relative value ladder of today’s share market, as does agri-tax scandal-impacted Bendigo and Adelaide Bank ((BEN)).

So far, the research hasn’t generated any surprises. Beaten down and/or abandoned stocks always offer the most upside potential because investors push down share prices too far, just like they push share prices too far up when they get excited. That’s why investors who can stomach the higher risks are attracted to these stocks. As such, one could say, my research has simply generated the statistical evidence behind the concept.

But scroll down the list and gradually the risk factor seemingly becomes less of an issue.

Immediately after Cabcharge we find Telstra ((TLS)). Sure, Australia’s most loved-to-hate blue chip is facing the threat of operational split and of possibly missing out on participating in the key National Broadband Network, but if anything, its shares are cheap (relative to the rest of the market) and if I can rely on stockbroker opinions in this matter, further downside for the share price, no matter what scenario the future might hold, should be negligible.

Note that on current forecasts, and at the present share price, Telstra shares yield a 9.5% dividend payout in FY11.

Stocks that end up in the slipstream of Telstra include Bank of Queensland ((BOQ)), Tatts Group ((TTS)), Sigma Pharmaceuticals ((SIP)), Boart Longyear ((BLY)) and Qantas ((QAN)).

Regarding the Flying Kangaroo, it has to be noted that the research only includes what we know right now. If the price of crude oil goes to US$300 per barrel in two years’ time (as predicted by some bullish hedge funds) then Qantas shares will most definitely end up looking very, very expensive at current share price levels. But none of the stockbrokers in Australia has currently penciled in any such scenarios.

Similarly, this also explains why commodity and energy stocks are presently among the most expensive in the share market. Prior to Wednesday, BHP Billiton ((BHP)) had been among the most expensive -both on historical and on a relative basis- constituents of the ASX200 index. Continuous losses for BHP shares have softened the relative comparison with the rest of the market, but the shares are still relatively unattractive – unless, of course, present forecasts for the likes of copper, iron ore and crude oil prove too conservative.

Even then, BHP shares are still trading on 12.8 times forecast FY11 EPS – and this is after a fall from around $38 per share to circa $32 now.

Shares in Rio Tinto ((RIO)) have equally shared in recent correction pains, but with an implied FY11 PER of below 10 and not much of a difference in projected dividends, the medium term value proposition looks much, much better at Rio. Again, this is on the basis of what we know now, and without taking into account that Rio Tinto arguably still faces some risks that are completely absent over at BHP Billiton.

Investors in banks are probably pleased to read that all banks look better value than either BHP or RIO, with each of the Big Four in Australia expected to achieve double-digit EPS growth in FY11 again. And this week saw National Australia Bank ((NAB)) overtake ANZ Bank ((ANZ)) as the relative best medium term value on offer. Courtesy of 32% projected EPS growth at a present multiple of less then 9 plus 7.6% in implied dividends by FY11.

The biggest surprise of the whole exercise was finding out that CSL ((CSL)) still doesn’t represent relative value, even though the shares have completely missed out on the share market rally.

With these thoughts I leave you all this week,

Till next week!

Your editor,

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

P.S. I – the FY11 project I have been mentioning a few times now is definitely in its final stages of development. FNArena is likely to proudly announce the new service on its website soon.

P.S. II – The two things that seem to be on everyone’s mind these days are Chinese imports of base metals and rapidly deteriorating technicals underneath global equity markets. Regarding the first factor, the big question is how much of the buying in the first half has been speculator-driven and whether the strategic reserves are now completed, or not? Regarding the second factor, half of the analyst community seems to be focused on the fact that indices around the world, including the S&P500 in the US and the ASX200 in Australia, have been carving out what appears to be a head-and-shoulders formations on price charts. I have written in the past that if confirmed such a pattern usually indicates a reversal in trend.

To mitigate any fears about a pending slaughter-fest, I happily point out that gold charts have repeatedly been showing head-and-shoulders since Q1 this year and the price has simply gone nowhere. That is: not to new depths. Gold has simply stopped trending higher. That is a reversal in trend too.

P.S. III – Analysts at Standard Chartered reported this morning their gauge of global risk appetite has again retreated into Risk Adverse territory. Not that we hadn’t noticed already, but it adds another bearish signal to the many posted over the last week or so.

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