Value In Equities Even As Earnings Revised Lower

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This story features RESMED INC.
For more info SHARE ANALYSIS: RMD
The company is included in ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Chris Shaw

Global equity markets are down 16% from their peak in late April, a fall that followed a gain of about 80% from the lows of March 2009. In Australia the numbers are relatively similar, the recent decline coming in at 15% after an almost 60% rally from the lows of last year.

AS UBS notes, the recent correction has been sparked by sovereign debt concerns in Europe and has been further fuelled by softer economic data out of the US. This has triggered fears of a double-dip recession, though the broker sees this as unlikely.

UBS points out there has never been a double-dip recession without some policy inducement, while it also notes a steep yield curve as is currently the case has never preceded any recession. As well, while policy elsewhere is tightening, the broker expects US policy settings should remain at accommodating levels for some time.

This suggests to UBS a more likely outcome is a period of sub-par economic growth, with global growth of 2.5-3.0% in both 2010 and 2011 possible. The downside in the broker's view is a deceleration to growth of 1.5-2.0%.

National Australia Bank agrees a double dip recession is unlikely, the bank's head of research in Australia, Peter Jolly, suggesting a reasonable global recovery is in fact likely on the back of a modest cyclical recovery in Europe, business investment led growth in the US and ongoing strength in Asia.

In Australia UBS notes the domestic economy is going through a soft patch, something that reflects concerns over a possible slowing of growth in China. But the broker's estimates are for Chinese growth of 10% this year and 8.7% in 2011, which suggests Australia's terms of trade should remain high and the current structural uptrend in capital spending will continue.

With the global economy slowing down there are implications for corporate earnings forecasts, particularly as UBS notes earnings revisions have generally been positive for several quarters. This leads the broker to suggest while earnings should continue to grow in year-on-year terms, actual forecasts are likely to start (and in many cases have already started) being revised lower.

But as equity market valuations are currently trading close to 20-year lows in Price to Earnings (P/E) terms, UBS suggests markets are pricing in significant earnings downgrades. This implies as long as earnings growth remains positive, equity prices should in fact be able to move higher even in the face of moderate downgrades to earnings estimates.

Moderate changes to forecasts have been the trend in the US, Jolly noting in early May earnings per share (EPS) growth forecasts for S&P 500 ex Financial stocks stood at 22.1% this year and 15.4% in 2011. These numbers have since changed to forecasts of 23.8% this year and 14.8% next year.

For Australian companies UBS also expects a trimming in earnings estimates, something that has not really gotten underway yet given over the last two months aggregate, cap-weighted estimates for FY11 have fallen just 0.8%. A weaker Australian dollar should help support earnings for Australian corporations but UBS suggests there is a relatively normal downside risk of around 5% to current 2011 earnings estimates. A key swing factor in this regard will be commodity prices.

The Australian market looks cheap in UBS's view, as the overall market valuation is around 11 times earnings at present. The broker suggests this makes Australian equities attractive relative to government bonds and corporate bond yields.

From a sector perspective, as long as earnings growth doesn't collapse UBS suggests cyclicals will outperform as risk aversion normalises. To reflect this the broker remains overweight Mining and domestic cyclical plays, while being strategically neutral on the banking sector.

Strongest growth/defensive ideas in the market at present according to UBS are Resmed ((RMD)), AGL Energy ((AGK)) and Crown Limited ((CWN)). The FNArena database shows Sentiment Indicator readings for all three stocks of 0.7.

In terms of targets for the Australian market, UBS has trimmed its year-end estimate for the ASX 200 Index to 5,250 from 5,500 previously. This new target still suggests a substantial re-rating for the market as it implies a year-end P/E of 13.5 times compares to 11.0 times currently.

Citi has gone one-step further and reviewed its stock market country selection model. The top five countries in order based on the broker's attractiveness score measures are the Netherlands, Korea, Spain, Canada and the United Kingdom. Germany, France, Australia, Italy and Singapore round out Citi's list of countries with positive attractiveness scores.

In contrast, the worst markets in terms of attractiveness at present based on Citi's model are, in order, Japan, Mexico, Malaysia, Belgium and Austria. Switzerland, the US, Brazil, South Africa, Hong Kong, Taiwan and Sweden follow in order, with all registering negative attractiveness scores.

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