Rudi On Thursday

This story features ILUKA RESOURCES LIMITED, and other companies. For more info SHARE ANALYSIS: ILU

(This story was originally published on Wednesday, August 19, 2009. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).

There are many ways to put your hard earned cash to work in the share market, and none of them is by definition “wrong” or “incorrect” as different investors have different goals, skills and horizons. However, I am certain many investors with a long term strategy will have been pleased to read the conclusions from an analysis conducted by Russell Investments this week (see “Value Investing Delivers Long-Term Excess Returns” on the FNArena website, 18 Aug 2009).

For those who missed it: Russell’s historical data-research concluded that investors who focus on undervalued stocks in the share market are likely to outperform the market over the longer term. One second conclusion from the research equally struck me: on average buying undervalued stocks tends to translate into relative underperformance for about 30% of the time.

The latter is no doubt related to the fact that undervalued stocks often need a catalyst to be (re)discovered by the market, or a change in trend, and both might take some time. Buying undervalued stocks often equals investing against the present trend. Thus any investor who puts his cash to work in stocks that are not part of the ruling popularity contest should be prepared to look like he made the wrong decisions for a while.

It’s not that we didn’t already know this. Various newsletters have built their present subscriber base via against the trend investment tips, often dressed up as being “contrarian”. But it’s good to be reminded, for those who are looking to rebuild and re-arrange their long term investment portfolios, that patience, research and valuation still count, and they do pay off over the longer term.

The difficulty with such an approach at this point of the cycle is, however, that buying undervalued stocks can end up in real disasters. As investors might find out in the months ahead there is still a very good reason why some companies on the stock market are cheaply priced, it’s called risk. And risk can still equal disaster, even if the overall environment has improved significantly since February this year.

However, one potential approach to minimise the chances to run into the next ABC Childcare Centres or Babcock and Brown is to zoom in on analyst expectations for the next few years and to pick some of the stocks that today are underpriced for what should lie ahead in terms of growth and dividend yield.

Market strategists at UBS have conducted such a survey and they released their findings last week. I thought it was a good idea to see how their findings compare with FNArena’s newly developed R-Factor. For those who missed it: the R-Factor allows a view of two years into the future, comparing market consensus projections for earnings growth, share price valuations and dividend yields on a relative basis for all ASX200 constituents.

The aim is similar as the UBS survey: to reveal which stocks seem relatively cheaply priced, and which stocks don’t. As said above: the R-Factor takes a two year horizon.

UBS strategists David Cassidy and Dean Dusanic have managed to identify eight stocks that appear cheap at today’s share prices in comparison to underlying expectations for FY11. These eight stocks are:

– Crown Limited ((CWN))
– Iluka Resources ((ILU))
– BHP Billiton ((BHP))
– National Australia Bank ((NAB))
– Macquarie Group ((MQG))
– Fortescue Metals Group ((FMG))
– OneSteel ((OST))
– ANZ Banking Group ((ANZ))

My first comment would be the survey results were published last week, with the survey itself probably a little older. A lot can happen in a week, or ten days, especially since we are in the middle of an extended share market rally, as well as in the middle of a pivotal reporting season with expectations in general  firmly on the rise.

Nevertheless, my first conclusion after seeing the list was that the rest of the market probably doesn’t necessarily agree with Fortescue on that list, but all the others should be okay.

I have been arguing for months, including on BoardRoomRadio last Friday, that longer term investors can hardly go wrong by putting some Australian bank shares in their portfolio. This remains the case, even after the strong rally in bank shares over the past weeks. UBS lists two majors plus Macquarie. The last upgrades by securities analysts have pushed CommBank ((CBA)) back to the fore as the number one bank in Australia. This may well change again by the time the next round of upgrades hits the other banks, but for now it should be noted that forecasts remain on the rise, and so too are price targets and valuations, and while EPS growth forecasts for FY11 seem to have come down a bit for CommBank, this is only because they have risen for FY10.

I don’t want to repeat everything FNArena has published on this subject in the months past, but if one can buy the lowest risk market leader at an implied FY11 Price-Earnings ratio of 11.6 with an estimated dividend yield of 6.2%, it should be clear there’s still value to be had in this share market.

BHP Billiton ((BHP)) which I consider as one of two market leaders in Australia (the other one is CommBank) is today trading at an implied FY11 PER of 12 and a yield of 3.5%.

Anyone looking for relative value without having to take on board relatively high risks should look no further. I am happy to simply nod in the direction of UBS strategists. The fact that they add Macquarie Group is no doubt based on more bullish projections by UBS’ banking analysts in comparison with the rest of the market. It does underline the theme of value and banks.

Similarly, the presence of Fortescue highlights the value represented by bulk commodities with a strong link to China and global steel demand. Forecasts are rising and the world is gradually warming to near-term prospects for steel and related commodities. Whether this makes Fortescue shares cheap at present levels is likely to remain a subject of public discussion for a long while.

Having OneSteel on the list must be the result of personal preference as current market forecasts clearly show a preference for BlueScope Steel ((BSL)). On this basis the R-Factor ranks BlueScope well ahead of OneSteel in terms of future growth and present share market valuations.

The R-Factor ranks Iluka among the cheapest stocks in the share market on a two-year horizon, so that falls in line with UBS’s assessment. Crown too is relatively lowly ranked (indicating relative value) but what strikes me is that after an expected stellar growth year in FY10, market consensus is for a significant slow down in growth for FY12.

UBS strategists also generated a list of stocks that appear cheaply priced today on FY12 projections. Names on this list are:

– BlueScope Steel
– James Hardie ((JHX))
– Sims Group ((SGM))
– Qantas Airways ((QAN))
– Asciano Group ((AIO))

My first response: BlueScope Steel, aint that funny? (see above) My second response is: James Hardie and Asciano are trading at multiples well above the market, leading to some comments elsewhere that whoever buys at present levels must have an horizon beyond FY11. This is exactly what the R-Factor indicates as well. These stocks look all but cheap in the present, but looking beyond FY11 they may well be.

Note the R-Factor, on a two year horizon, ranks James Hardie as among the most expensive stocks in the market.

As far as Qantas goes, a few weeks ago the R-Factor suggested the shares were among the most undervalued in the market. In the meantime the shares have now fallen into the middle of the pack (today, Wednesday 19 August) they are at position number 100 – right in the middle of the ASX200 stocks). This puts the shares, driven by strong projected growth, on a FY11 PER of 14.5 (above market, with dividend yield of 4.9%, also above market).

UBS analysts must have some bullish expectations for FY12 too.

Sims Group seems good value too, with strong growth projected, a dividend yield of 4.2% and still only a PER of 13 on FY11 estimates.

Throw BHP, OneSteel, Fortescue, BlueScope and Sims Group into one basket and it is clear we have a central theme: steel.

UBS strategists have also identified stocks they believe are still undervalued on shorter term metrics (FY10), these stocks include Transfield Services ((TSE)), Aristocrat Leisure ((ALL)), OZ Minerals ((OZL)), Rio Tinto ((RIO)), Bank Of Queensland ((BOQ)), Amcor ((AMC)), Incitec Pivot ((IPL)), Fairfax Media ((FXJ)), Bendigo and Adelaide Bank ((BEN)), West Australian News ((WAN)), Lend Lease ((LLC)), WorleyParsons ((WOR)), Harvey Norman ((HVN)) and News Corp ((NWS)).

I am not so sure whether such companies will make up for their present valuation gap if investors are not convinced that more good news lies beyond FY10. Maybe the upcoming results releases will have to prove this could be the case?

I note a strong presence of the media in this shorter-term list, as well as the regional banks. UBS seems to support my view that BHP is the better long term leverage to economic growth than Rio Tinto at this stage (as supported by the R-Factor too). I also note some of these stocks seem good value on expectations beyond FY10 too: Lend Lease looks much better value on FY11 projections according to FNArena consensus forecasts than UBS suggests. The R-Factor is equally kinder to Oz Minerals on a two year horizon.

And last but not least: the strategists have been so kind to line up stocks that look expensive on FY12 projections as well. These stocks include: Perpetual ((PPT)), Aust Worldwide Exploration ((AWE)), Leighton Holdings ((LEI)), Alumina Limited ((AWC)), AXA Asia Pacific ((AXA)), Woodside Petroleum ((WPL)), ABB Grain ((ABB)), Paladin Energy ((PDN)), Toll Holdings ((TOL)), Wesfarmers ((WES)), David Jones ((DJS)), Brambles ((BXB)), Boral ((BLD)), CSR ((CSR)), Billabong ((BBG)), Computershare ((CPU)), Westpac ((WBC)) and JB Hi-Fi ((JBH)).

I note quite some consumer related stocks are on this list, as well as the appearance of the first Australian bank. A surprise is definitely Woodside (as the stock is looking relatively good value on FY11 projections). Wesfarmers is, on the basis of present projections, expensive on all time horizons: FY10, FY11 and FY12. That has thus far not stopped the shares from lively participating in the market rallies.

The R-Factor clearly shows little growth is currently expected for Toll Holdings and for Computershare. Paladin shares are on relatively high multiples, and the same applies to AWE and Leighton Holdings. Aluminium is nobody’s preferred metal for the years ahead.

Maybe I can add that small cap specialists at Credit Suisse last week decided to add Alesco ((ALS)) to their list of preferred small cap stocks in the market. Alesco is according to the R-Factor one of relative bargains in the market (my suspicion is the market doesn’t yet believe in its recovery potential and this is why the shares haven’t caught up yet).

The R-Factor lists peers Molopo Australia ((MPO)), Nexus Energy ((NXS)), Arrow Energy ((AOE)), ROC Oil ((ROC)) and Oil Search ((OSH)) all as at least as expensive as AWE shares on a two year horizon.

Throw in Paladin and Woodside and I see a clear theme here as well: energy.

With these thoughts I leave you all this week.

Till next week!

Your editor,

Rudi Filapek-Vandyck
(as always supported by the Ab Fab team at FNArena)

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