On Profit Warnings, Undervalued Utilities And Copper Stocks

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By Greg Peel

One thing stock market investors need to understand is the difference between “stock analysts” and “equity strategists”. The former use a “bottom up” approach to valuation, specialising in one sector and calculating forward earnings estimates to compare to current market pricing. Differences here lead to positive or negative recommendations.

The latter use a “top down” approach, focusing on the implications of macro fundamentals and then assessing how those might impact on sectors and stocks. It is thus not unusual, for example, for analysts at one house recommending a Buy on all bank stocks while the strategists at the same shop are recommending a Sell on the banking sector. This can make for interesting exchanges at the pub on a Friday night.

With that in mind, consider that JP Morgan's equity strategists continue to see evidence of potential pressure on profits across the whole index, based on greater competition, regulatory and political initiatives and technological change, all of which should lead to margin erosion.

The strategists highlight many individual cases:

The Cooper Review currently underway is pushing for lower fees and thus margins in the superannuation industry. The Queensland premier has just announced a review of motor insurance premiums, and not with the intention of increasing them.

Bank of Queensland's management has warned that were the credit spread applied by the market to residential mortgage-backed securities to continue falling as a result of recovery from the GFC, say to 50-75 basis points from the current 130 basis points, mortgage competition would once again be fierce. Not good for bank margins.

Australian regulators have just allowed for competition in stock markets; the US Commodity Futures Trading Commission is proposing stricter limits for commodities traders; the US Senate is considering new regulation on over-the-counter commodity trades and the International Monetary Fund is supporting the global concept of a tax on excess banking returns.

The Australian government is considering a resource rent tax to replace current royalties as a means of extracting a fair return from mining and energy for all Australians.

On the competition front, Tiger Airways is increasing its market share, US-based Costco has approval to open its first Sydney store and Woolworths ((WOW)) has lodged plans for twelve of its new Bunnings-competing hardware-houses. Telco junior iiNet ((IIN)) is looking to launch its own internet-based television service to compete with pay-TV.

And the Queensland government will extend a ban on additional gaming machines in the state for another two years.

Given all of the above, the JP Morgan strategists suggest the Australian stock market is overpriced.

The Global Equity Research (Australasia) team at UBS would win no prizes for communication skills, but then to suggest the members are the only stock analysts/strategists out there suffering from this shortcoming would be tantamount to suggesting only a handful of politicians are totally incompetent. You don't have to do Eng. Lit. 101 to be employed to crunch numbers.

UBS is nevertheless now looking more favourably upon stocks in the Australian utilities sector given perceived undervaluation. The bottom line is that utilities tend to underperform when the index is moving up – which they should as defensive, yield stocks – but also underperform when the index is moving down, which is counterintuitive.

UBS polled a bunch of fund managers recently and asked what sort of return on equity level would make them more interested in buying utility stocks, to which the answers averaged out to around 13%. Given the average total market return over the past twenty years has been only 10%, and that utilities are defensive stocks, UBS effectively implies there's a lot of idiots out there.

Utilities typically run close to the wire on return on capital invested, notes UBS, so investors should not so much focus on whether share prices have improved but what premium over the benchmark government bond rate would the market price “regulated equity”. Utilities are considered “regulated equity” because governments, state and federal, set prices for electricity, gas , water etc and this forms the utilities' revenue streams.

Using recent price settings, UBS determines the current premium over bond to be 5.3%, which the team believes is “adequate”. Therefore, the recommendation is that utilities are undervalued because foolish fund managers won't buy them despite reasonable returns being offered.

I think.

UBS asked fund managers specifically about utility stocks Australian Pipeline Trust ((APA)), Spark Infrastructure ((SKI)), SPN Ausnet ((SPN)) and DUET Group ((DUE)). Among that selection, the team sees Spark as 15% undervalued at one end with APA about correctly valued at the other.

There is never any equivocation from the GSJB Were equity strategy team, nevertheless, when it comes to the famous Conviction List. This is the list of those stocks being afforded a Buy rating by respective Weres analysts but which the team is really, really convinced about.

There's no point in making jokes about it however, given the Conviction List portfolio has outperformed the ASX 200 Accumulation index by 16.7% over 12 months and by 32% since its inception in 2006.

Today Weres has upgraded its 2010 average copper price forecast from US$3.20/lb to US$3.52/lb with similar increases in latter years. The analysts already had Buy ratings on copper producers PanAust ((PNA)), Equinox Minerals ((EQN)) and OZ Minerals ((OZL)) but today they have added both PanAust and Equinox to the Conviction List.

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