Rudi On Thursday

This story features ELDERS LIMITED, and other companies. For more info SHARE ANALYSIS: ELD

I am sure that if I would ask everyone to broadly categorise the share market in a few types of stocks we would ultimately all end up with the same three labels: the higher risk stocks that potentially offer higher rewards, the boring middle-of-the-road ones offering limited downside and the popular ones that tend to enjoy a higher pricing because everyone wants a piece of it.

This week, while I was busy checking, updating and analysing our new research tool (soon to be officially launched) I discovered that our new service in essence reveals how the market divides Australian equities along these three labels, and prices them accordingly.

As you would expect, the more risky ones are priced cheaply. Assuming the market knows how to price in risk, I have to conclude that the highest risk in the Australian share market is currently concentrated in stocks such as DUET ((DUE)), Alesco ((ALS)), Elders ((ELD)), Macquarie Infrastructure ((MIG)) and AWB ((AWB)).

Take into account this research only includes S&P/ASX200 companies.

On the basis of consensus forecasts for fiscal years 2010 and 2011, both for earnings per share growth and for dividend yield, and the relative valuation as measured by price-earnings ratios, these stocks are presently, relative to the rest of the index, the most cheaply priced stocks. But as I said before, there is a good reason why these stocks are cheap: most investors are not genuinely interested – the risk-reward balance is being perceived as negative. That’s why these stocks are cheap.

If I scroll down the list of the S&P200, I can make the assumption that what goes for the top five stocks I just mentioned, probably goes for the first 60 stocks on the list – or to be more precise: until number 58, which is Qantas ((QAN)). On current expectations Qantas will achieve EPS growth in the order of 95% in FY10 and 42% in FY11, which is on anyone’s account very impressive.

The shares are by no means priced accordingly, trading on an implied FY11 PE ratio of 11.6 and this makes them look like a relative bargain (still a little bit pricey though – that’s why our system ranks the stock at position 58 and not closer to the ones mentioned above).

The problem is, however, how much trust can investors put in these forecasts? Under normal circumstances forecasting financial figures for airlines is already tricky, and we are nowhere near normal circumstances. Apart from the price of crude oil, Qantas is also facing increased competition on several fronts and businesses are still minding costs, which means less travel on the corporate credit card.

All these risks combined make for an unusually wide disparity in market views and expectations. This, by the way, is not something that uniquely applies to Qantas, but to the share market in general. Imagine this: the lowest marker among the stockbrokers in the FNArena universe, RBS Australia, thinks investors should not pay more than $1.70 for the shares -which is 26% below the closing share price on Wednesday- while the highest marker, JP Morgan, sees the share price run up to $2.95 in the twelve months ahead; implying a gain of nearly 30%.

Let’s hope the upcoming results season in Australia will, above anything else, achieve one important thing: to bring analyst expectations more in line with each other.

Other stocks to be found in between Qantas and the risky top five include Emeco ((EHL)), Boart Longyear ((BLY)), Centennial Coal ((CEY)), Iluka ((ILU)) and Virgin Blue ((VBA)) – all are randomly picked and I am sure none of these names is a surprise. But what about Telstra ((TLS))? According to this survey Telstra is one of the cheapest priced stocks, certainly if one takes into account the shares are projected to generate around 9% in dividends for each of the coming years.

What really caught my eye though is that all the banks – and I mean all of them: from the regionals to the majors to Suncorp-Metway ((SUN)) – are also included in the top 58. This despite some hefty growth projections for many of them in FY11, including 37% EPS growth for National Australia Bank ((NAB)) and 34% for CommBank ((CBA)).

Investors are awaiting more capital raisings and their suspicion has been confirmed with a larger than expected raising by ANZ Bank ((ANZ)) recently and a follow-up by National on Wednesday. If present forecasts are anything to go by, few analysts would deny there is value to be had on a 24-month horizon, it’s just that a patient investor is likely to have the chance to add some more at cheaper price levels, so why not wait?

On a sectoral comparison, the banks are without any doubt the most cheaply priced in the market right now. Especially when we take into account they all come with above standard dividend yields.

Once we move past Qantas on the list, we gradually move into what I would loosely describe as the landscape of dullness – these stocks exert little excitement, being expected to achieve growth in single digits, in combination with a dividend yield around or a little above the market average of 4-5%. These stocks have been priced accordingly – as a rule of thumb, a PE ratio between 8-10 is in place.

The good news is: for most of these stocks any downside should be fairly limited. Boring and steady keeps a standard investment portfolio away from big disasters and the owner not awake at night. Similar to the first group, as we scroll deeper down, the less cheap stocks appear to be. Before we know it we are making the transition to stocks that can trigger some more excitement, but this comes with a relatively higher pricing.

I think the division between group two and three starts taking shape at around position 100 which, as at today, is reserved for AXA Asia-Pacific ((AXA)). In between Qantas and AXA we find the likes of QBE Insurance ((QBE)), Pacific Brands ((PBG)), Westfield ((WDC)), Tower Australia ((TAL)) and Foster’s ((FGL)).

Other stocks that arguably do not fit in the “dull but safer” category, but that are nevertheless priced in between Qantas and AXA, include the likes of Incitec Pivot ((IPL)) – looks cheap on a FY11 PER of less than 9 – Abacus Property Group ((ABP)) – no growth, but pays a high dividend – and Mount Gibson ((MGX)). The latter comes with a prospective near-doubling of EPS in FY11 which would put the stock on a cheap multiple of 8 today, but investors are obviously not taking any of it for granted just yet.

Upcoming share market star Infigen Energy ((IFN)) comes with some hefty growth rates (66% and 18% for FY10 and FY11 respectively) but its PE ratios are similarly high (30 and 26), but so are the projected dividend yields (6.7% and 7.1%). In the end, it all comes down to one’s personal goals and strategy, and to your personal risk profile.

The further we move away from AXA and Infigen, the higher the overall popularity of the stocks we encounter. First we come across retailer Harvey Norman ((HVN)) – further down is David Jones ((DJS)) – then it’s News Corp ((NWS)), Downer EDI ((DOW)) and Isoft ((ISF)). At position 122 we find Energy Resources of Australia (ERA)).

ERA has some hefty growth in front of it the coming years if we can draw conclusions from what has currently been pencilled in, but then again the shares are trading on a PE of over 13 for FY11 – not very expensive, but not exactly a bargain either. Woodside Petroleum ((WPL)) is further down on the list, implying the shares are relatively more expensive, but this is only because Woodside is expected to achieve modest growth in FY10, and then a big step-up in FY11.

On a two-year horizon, Woodside shares today are trading on a FY11 multiple of 12.5. This would make them a relatively cheaper option, but because we rank all shares on both FY10 and FY11 projections, the system ranks ERA as relatively cheaper.

From the moment we take this new application live on the website, you will all have the opportunity to gauge these details for yourself.

Further down we find Paladin Energy ((PDN)) and Rio Tinto ((RIO)). The latter has been ranked higher most of the time during the weeks past, but this week’s rally has continued to push the shares lower on the rankings. In an odd contradiction, the opposite has been happening for BHP Billiton ((BHP)). This is because the rankings are not only influenced by share price movements, but changes in analyst forecasts can have a big impact too.

For example, ANZ Bank and National used to switch regularly in being the cheapest priced major bank in Australia – until ANZ Bank surprised with its recent capital raising. From the moment analysts incorporated the larger dilution in their models, ANZ Bank found itself at the back of the queue, close to Westpac ((WBC)) and Commbank. (This also illustrates the market does have a logic when implementing these re-pricings).

In BHP’s case, the shares looked more expensive when they were struggling at $32 than since they  bounced back above $36. This is because analyst expectations have been on the rise too. At present, BHP’s earnings per share are expected to improve by close to 50% in FY11 (after a decline by 16.5% in FY10). Both expectations for FY10 and FY11 have risen steadily over the past weeks.

BHP shares are still not particularly cheap, trading on an implied FY11 multiple of 12.4 – but at this rate they are becoming relatively cheaper by the day.

Most stocks below BHP on the list appear too highly valued for what appears to be in store at this point in time. Austar ((AUN)), Iress ((IRE)), Cochlear ((COH)), Alumina Ltd ((AWC)), Boral ((BLD)) and Santos ((STO)) are all below BHP and all are trading at lofty multiples, often with low or no dividends to show. Newcrest Mining ((NCM)) is there too, as is Lihir Gold ((LGL)).

Of course, all forecasts are based upon yesterday’s assumptions and changes in building approvals or commodity prices can have a relatively large impact, while companies such as Iress and Lion Nathan ((LNN)) are trading above normal multiples because of take-over speculation. Santos and Alumina are probably too.

The final twenty stocks or so on the list are what I would euphemistically call La-La-Land stocks. FNArena either could not find any reliable forecasts for some of them, or the multiples are so out of synch with present projections that we can safely assume that whatever moves these stocks, it certainly does not include earnings or known fundamentals.

Stocks in the bottom twenty include Oil Search ((OSH)), ROC Oil ((ROC)), Murchison Metals ((MMX)), Karoon Gas ((KAR)) and, of course, Fortescue Metals ((FMG)).

Lining up stocks while looking two years ahead also reveals which companies have effectively run out of growth: Goodman Group ((GMG), Tabcorp Holdings ((TAH)), Fleetwood Corp ((FWD)) -but paying out a hefty dividend nevertheless- QBE Insurance, Westfield, Sigma Pharmaceuticals ((SIP)), Transfield Services ((TSE)), Downer EDI, SMS Management and Technology ((SMX)), United Group ((UGL)), Leighton Holdings ((LEI)), Ansell ((ANN)) and ROC Oil.

And imagine this: according to current projections Wesfarmers is expected to see its EPS decline by 30% in FY10 and then rise by 30% the following year. Don’t make the mistake in thinking this is a stand-still over the two years. It isn’t. It’s a big step backwards.

All of the above will change over the seven weeks or so that lay ahead. It’ll be interesting to see stocks de- and re-rate as investors switch their preferences and as securities analysts amend their forecasts at the same time.

Interesting times ahead, yes, indeed.

With these thoughts I leave you all this week,

Till next week!

Your editor,

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

P.S. – My continued analysis on CSL ((CSL)) has generated quite some interest over the past weeks. As the shares refuse to join in the broader share market rally, and with analyst expectations relatively steady, I can report the shares look relatively more attractive every day. As at today, CSL ranks close to Paladin and Rio Tinto, which is at the relative cheaper end of the popular section of the share market.

A few weeks ago, CSL would rank below BHP Billiton which just shows how relatively expensive the stocks were priced when the rally started in March and the Talecris acquisition fell apart. One could still argue though that with momentum supporting commodities, and thus earnings projections and share prices for Paladin and Rio Rinto, CSL shares might have to become a little more cheaper, on a relative basis, before they’ll genuinely land on the radar of investors again.

Investors should also take into account that part of CSL’s future growth will evaporate as the USD weakens, while the likes of Paladin and Rio Tinto might be a net beneficiary of this.

P.S. II – Reported economists at Westpac this week: “Chinese demand for both iron ore and crude oil volumes is highly seasonal. The strongest months for iron ore imports are March and April. The strongest months for oil are January, April and May. The period July through October is a soft patch for imports of both commodities. Special factors have amplified the usual seasonality so far in 2009, implying that the regular seasonal weakness later in the year may represent a material negative jolt for the commodity markets.”

And here is the chart that goes with the warning:

 P.S. III – In what might be an apt add-on to all of the above, analysts at BA-Merrill Lynch believe changes in analyst expectations are one of the major drivers behind share prices (I could not agree more). As such, the analysts keep track of a monthly comparison between so-called Contenders and Defenders. The first are stocks that have low multiples but whose analyst expectations are on the rise. The second group has high multiples, but expectations are in decline.

As you would expect, Contenders tend to outperform Defenders and they did so on a global scale in June. Banks in Asia-Pacific region, as well as Energy companies here are included in the Contenders group. Asia-Pacific telecoms are part of the Defenders.

(If you read this story through a third party distribution channel the chart above might not be included. Our apologies for this, but it is technology that is to blame).

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