Rudi On Thursday

This story features IRESS LIMITED, and other companies. For more info SHARE ANALYSIS: IRE

(This story was originally published on Wednesday, 9 September, 2009. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).

Not everyone looks at the share market with the same goals and intentions. For traders seeking shorter-term momentum opportunities, the quantum desk at Macquarie lined up several small cap stocks this week that generate high scores on the Macquarie Alpha model. This model takes into account measurements such as profitability, market momentum, growth and various technical indicators.

Among the stocks that score the highest on all rankings combined is financial data and service provider Iress ((IRE)), with Macquarie analysts reporting the company’s shares score “extremely strongly” on quality scores, profitability, growth ratios and technical indicators. That may well be the case, but FNArena data indicate Iress shares might not be ideal for investors looking to lock in longer term opportunities.

The R-Factor, which compares ASX200 constituents on the basis of growth, valuation and dividends over fiscal years 2010 and 2011, ranks Iress as “relatively expensive”, with the stock ranking 154th. Also, Macquarie’s own fundamental analysts (Outperform) did raise their price target to $7.89 a little over two weeks ago, but the share price has already cruised well past the $8 mark.

If market consensus expectations are anything to go by, Iress, whose fiscal year ends in December, should only manage to increase earnings per share (EPS) by single digits in the two years post the current one (2010 and 2011). Dividend yield is a (slightly) below market 4%-something. The shares were trading below $7 as early as late July. Today, Wednesday September 09, they are once again rising, trading at $8.43 with less than one hour before the close of trade.

As such, Iress shares might as well be considered a prime example of the dilemma investors in the share market are faced with right now. Amidst fresh year-high index levels, and with every expert and his dog predicting September-October will see consolidation, if not a pull back or correction, what do we do? Do we continue to chase momentum (as that seems to have worked well over the months past) or do we keep ourselves at arm’s length from the daily noise and market movements to seek relative value-opportunities instead?

It’s all related to what our personal goals are and what the horizon is behind our investment strategy. Analysts at JP Morgan this week advocated investors should take a step back and forget about direct momentum for now (despite how tempting these stocks well may be).

This is because on their analysis, which takes today’s share prices into FY12, many of the stocks that enjoy positive momentum are starting to look pricey. To put this in the context of their analysis: on JP Morgan’s assessments today’s share prices for popular stocks translate into rather optimistic assumptions for the years ahead, assumptions that are not impossible, but that look stretched nevertheless.

This means the risk that these implied earnings and margin assumptions will not be achieved in the years ahead are now greater than ever.

JP Morgan’s research only covers 100 stocks. Names that are considered to be trading on stretched valuations and possibly too optimistic earnings projections are Crown Media ((CWN)), Boral ((BLD)), Computershare ((CPU)) and Leighton Holdings ((LEI)).

Companies such as BHP Billiton ((BHP)) and Rio Tinto ((RIO)), as well as James Hardie ((JHX)), Asciano ((AIO)) and Transfield ((TSE)) are considered relatively pricey as well, though not to the same degree as the earlier mentioned names.

Yet, as we monitor the share market daily, these names are more often than not among the risers of the day. This is the problem with market momentum, it doesn’t necessarily favour the value opportunities at hand, but it does ultimately push up share prices too far for fundamentals to justify. This brings back images of November 2007, and even of August 2008.

On my calculations, which are derived from FNArena’s consensus data, which I regard as a better tool than stockbrokers’ in-house numbers, the Australian share market is now incorporating more than 17 times EPS forecasts for FY10, but also nearly 14 times (13.96x) FY11 forecasts.

As far as I am concerned, this is the single most important factor that all investors should be paying attention to. You might as well forget about the September-gloom predictions, or whether China will step on the brakes or not. A share market that is already trading on 14 times FY11 forecasts can only be described as “pricey”.

Consider, for instance, that we’ve only just left the August results season behind us (those consensus data are very fresh) and that we still have to wait eleven more months before we know the exact outcomes of the 2010 fiscal year for Australian companies. Above all, using today’s data and multiplying by 15 -the historical average for the Australian share market- provides us with a value for the ASX200 index of 4858; that’s only 336 points above the close on Wednesday.

Within this context I note it has been a popular theme in certain corners of the share market to call the index at 5000 by Christmas (less than four months away). This is by no means beyond the realms of possibilities. However, what we need to achieve this target is higher forecasts, and they won’t come without ongoing improvements in economic data.

Also, it can hardly be regarded a surprise that many an expert eyes has started to zoom in on small caps; large caps already appear “pricey” (as witnessed by a FY11 multiple of 14).

Within this context I can report that Macquarie’s quant analysts also favour SMS Management and Technology ((SMX)), Mermaid Marine ((MRM)) and Navitas ((NVT)). The two lowest ranking quant stocks are PanAust Ltd ((PNA)) and PaperlinX ((PPX)).

Market strategists at Credit Suisse are now talking about a share market that appears “fair value”. I guess, within the above context, this is more a case of seeing the glass as one quarter empty instead of three-quarters full? I note that, similar to JP Morgan, Credit Suisse is trying to gauge valuations on FY11 and FY12 projections (dubbed “mid-cycle valuations”).

Whereas JP Morgan observes traditional defensive mastheads such as Woolworths ((WOW)) and CSL ((CSL)) also look relatively “pricey”, strategists at Credit Suisse nevertheless believe a more defensive portfolio positioning seems but the cautious thing to do. Credit Suisse still sees plenty of candidates among small cap companies that fit the “high quality, not pricey” bill.

There are good quality companies that missed out on the recent rally, such as Ramsay Health Care ((RHC)), Tower Australia ((TAL)) and Invocare ((IVC)). Others, including SAI Global ((SAI)), Austbrokers ((AUB)), Redflex ((RDF)) and Austar ((AUN)) are simply “inexpensive in their own right”.

In addition, argues CS, there is a whole queue of small cap stocks that, for various reasons, still represent excellent value on a longer term buy-and-hold strategy, including (in no particular order) McPherson’s ((MCP)), Alesco ((ALS)), STW Communications ((SGN)), Spotless ((SPT)), Henderson Group ((HGG)), Emeco ((EHL)), Fantastic ((FAN)), Clough ((CLO)), Pharmaxis ((PXS)), Navitas and Dominos Pizza’s ((DMP)).

Important note: these companies are solely selected by Credit Suisse and a quick look through Stock Analysis and the R-Factor (both available on the FNArena website) immediately reveals that certainly not everyone in the market agrees with all these names.

Interestingly, JP Morgan’s research shows some companies can still rely on a so-called “Value Buffer” (read: it doesn’t seem they will have to beat market expectations to justify present valuations). These include most banks, Lend Lease ((LLC)), Tattersall’s ((TTS)), Telstra ((TLS)), Goodman Fielder ((GFF)) and various others.

This is in line with what the FNArena R-Factor is indicating.

Always remember: valuation in itself is never a good enough reason on its own to force the market into a pull back, but it does make overall sentiment more vulnerable to setbacks in general. Also, if there ever was a convincing contra-argument about why all the cash on the sidelines will not be immediately put to work in the market, a case of seemingly stretched valuation is probably as powerful as any other reason.

(But watch what happens when the market does retreat).

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 at FNArena)

P.S. 1 – The strategy team at Credit Suisse changed its tactical sector allocation to a more defensive bias this week. This involved moving Overweight Healthcare and Domestic Defensives (from underweight, so that’s a double upgrade) as well as moving Overweight Industrial Services and companies leveraged to business capex. The change also involved moving Underweight Mining and Consumer Discretionary (from Marketweight) plus moving to Marketweight Diversified Financials (from Overweight). For the shorter term, the team advocates switching to high quality defensive small caps (see names mentioned above).

P.S. 2 – Daniel Goulding, publisher of weekly The Sextant Report, maintains the share market is at or near its near-term peak. His preferred scenario is one whereby the Australian share market will retreat circa 8% over the next two weeks. One of the arguments that feeds his doubts about the sustainability of this rally is that when the 2000-2003 bear market transformed into a new bull market the overall market recovery was widely carried. This time around, however, the group of companies that continues carrying the index to higher highs remains relatively narrow.

P.S. 3 – Merrill Lynch analysts conduct a monthly analysis, on a global scale, dividing sectors and individual stocks between Contenders and Defenders. The first group involves companies whose earnings forecasts are rising faster than average, while their Price-Earnings ratio is usually below average; the second group are companies for which expectations are falling faster than average plus their PER is usually above average.

There are at present no Australian companies in the broker’s Asia-Pacific list of Contenders, but several are on the Defenders list. (It goes without saying that Contenders tend to outperform Defenders and August was no exception, albeit only marginally so).

The following Australian companies are included on BA-ML’s Asia Pacific Defenders list: Transurban ((TCL)), Perpetual ((PPT)), Woodside Petroleum ((WPL)) and Newcrest Mining ((NCM)). Origin Energy ((ORG))-controlled Contact ((CEN.NZ)) in New Zealand is on the list too.

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