REPEAT Rudi’s View: Where Are Australia’s Growth Stocks?

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(This story was originally published on Wednesday, 15th September, 2010. It has been re-published to make it available to non-paying members at FNArena and readers elsewhere).

By Rudi Filapek-Vandyck, Editor FNArena

BA-Merrill Lynch investment strategist Tim Rocks has initiated a public debate in the Australian financial sector that I think should attract the full attention of every share market investor in the country.

On Monday, Rocks and his team of market strategists published a market analysis that suggested the Australian share market is losing its share of growth stocks. The team argues many of the traditional growth stocks on the ASX are maturing, which leads to slower growth, while few new growth stocks have stepped into the public limelight as yet.

If BA-ML’s analysis proves correct, the consequences for investors could be significant, because:

– it would imply that many of the traditionally popular stocks on the ASX are due for a de-rating (lower multiples)
– it could also imply that the Australian share market as a whole could be due for a de-rating; meaning expectations of an average Price-Earnings ratio of 14-15 may prove to be too high for the years ahead

Note the team does not accept resources companies as being “growth companies” due to the extreme volatile nature of these businesses and the prices for their products. One look at the profit and loss figures across the sector over the past four years or so could serve as the perfect illustration.

Another way of illustrating BA-ML’s point is via earnings per share growth/loss figures for BHP Billiton ((BHP)), the market leader, over the period 2009-2012 (the next two years are consensus forecasts):

– 2009: minus 54%
– 2010: plus 112%
– 2011: plus 64%
– 2012: plus 15%

There’s another reason why BA-ML’s suggestion could be important. Thus far, the debate about commodities overpowering everything else in Australia has predominantly featured within the framework of a two-speed domestic economy and the appropriate level of the RBA’s cash rate.

Tim Rocks and his team are now suggesting resources are taking away opportunities for industrial companies to continue maximising growth opportunities. If there ever was a cause for concern that Australia will suffer from “Dutch disease”, and end up worse than before, surely this piece of analysis should be a key worry.

Note, for example, the steep deceleration in BHP’s projected growth pace in the overview above.

The debate that has been triggered this week is unlikely to be resolved anytime soon. As one would expect, various stockbrokers and fund managers with a vested interest in Australian growth stocks have already denied, dismissed or opposed BA-ML’s analysis (see for example “Where have the growth stocks gone” in the AFR on Tuesday).

I, however, think there is at the very least some merit to BA-ML’s market analysis, especially since some of my recent observations point into a similar direction.

Note, for example, the growth forecasts for Australia’s Major Four Banks:

– ANZ Bank ((ANZ)); 2009: minus 3%; 2010 plus 27%, 2011 plus 13%
– CommBank ((CAB)); 2010 plus 22%; 2011 plus 17%, 2012 plus 8%
– National ((NAB)); 2009 minus 17%; 2010 plus 6%; 2011 plus 17%
– Westpac ((WBC)); 2009 minus 18%; 2010 plus 17%; 2011 plus 9%

Note that CommBank has a different fiscal year than the others. Above all, however, this is as good as any time to point out the strategy team at BA-ML argues that growth stocks are effectively ex-growth from the moment annualised EPS growth falls to 12% or lower.

The above overview then suggests National Australia Bank appears to be the only one who should comfortably exceed the 12% growth level next year, but this comes after two very disappointing years. If we combine all three years and divide by three, there doesn’t seem to be much margin left for the banks to slide into ex-growth in the coming years, at least not on BA-ML’s metrics.

BA-ML’s report does not zoom in on Australian banks specifically, but I think the Big Four stand out as THE growth stocks in the Australia sharemarket since the mid-nineties (post the 90s recession). This, in combination with a very healthy dividend payout, is also the reason why bank shares dominated so many investment portfolios throughout the past fifteen years.

Let’s zoom in on the more traditional growth stocks, many of which in Australia operate in healthcare. Again, my personal analysis earlier this year has generated a similar conclusion as suggested by Rocks and his team of market strategists:

– many healthcare stocks are facing lower growth ahead compared with years past
– as these stocks traditionally enjoy high multiples, a de-rating process is taking place

In many ways, this de-rating process has largely already taken place, and not just in Australia. Healthcare stocks were prominent underperformers during and immediately after the interim results season in February this year. Stocks such as CSL ((CSL)), Cochlear ((COH)), Ramsay Healthcare ((RHC)) and Sigma Pharmaceuticals ((SIP)) have found it difficult to keep up with the market in general, even when the market itself has merely moved side-ways since August 2009.

For most of these companies former growth rates in excess of 20% have now been replaced with growth projections half the previous rate, if not lower (single digits). Of course, and this will be the litmus test for the years ahead: are market expectations now too low, or not?

If the answer is “not” then many shareholders will be disappointed by the returns that lay ahead.

The same applies, argues BA-ML, for many other “growth” stocks, including Billabong ((BBG)), Iress ((IRE)), JB Hi-Fi ((JBH)), Computershare ((CPU)), Flight Centre ((FLT)), Austar ((AUN)), Macquarie Group ((MQG)) and Woolworths ((WOW)).

Many of those stocks -think Billabong, Macquarie and Computershare, for example- have already gone through a de-rating process, but many have not.

Note, for example, that Iress is still expected to achieve EPS growth to the tune of 27% this year (ending in December), following 18.8% growth last year, but that consensus expectations for 2011 assume 9% growth only.

Also, there is a group of growth stocks that is still showing high growth numbers, but at a gradually slower pace, suggesting de-rating could be something for next year or 2012, instead of this year. Stocks that belong in this category, according to BA-ML, include Seek ((SEK)), Wotif.com ((WTF)) and ResMed ((RMD)).

Current consensus forecasts for Seek and ResMed are still very high, suggesting BA-ML’s call might be premature, but for a stock such as Wotif.com, which today is trading on a FY11 PE above 18, the danger of de-rating is clearly looming with consensus growth projections of 5% and 15% respectively for FY11 and FY12.

I could go on, but the underlying message should be clear: many companies that have enjoyed a growth pace of 20%-plus in the past are facing serious headwinds in keeping up with this legacy. If Tim Rocks and his team are correct, most of these companies will not succeed in keeping growth above 12% in the years ahead.

The suggestion that de-rating will inevitably follow is, in my view, correct. One only has to look at what has happened to share prices for the likes of Leighton Holdings ((LEI)), QBE Insurance ((QBE)) and CSL in recent years once investors adjust to the idea that past growth is no longer a given for the future.

The question whether this will prove to be the case for the Australian share market as a whole remains a big question mark at this stage. My own analysis has taught me that while FY11 average EPS growth for ASX200 companies sits at around 19%, the number is closer to 12% for industrial companies. Many of the above mentioned companies, including some of the banks, are either at or below this number.

BA-ML’s assertion that the Australian market seems to be lacking a new generation of growth stocks may well prove too harsh of a judgment, but only the next few years will tell.

I do note various stockbrokers have highlighted several promising companies in recent times for which the next few years should bring very high growth.

A few examples are:

– Molopo Energy ((MPO)) – Macquarie analysts this week put the focus on the company, labeling it as “unparalleled production growth on offer”
– QrxPharma ((QRX)) – Southern Cross Equities joined others with a Buy rating this week, predicting very strong growth ahead for years to come
– Many of the smaller players in the Australian telco sector are projected to enjoy high growth in the years ahead, including Macquarie Telecom ((MAQ)), iiNet ((IIN)), Amcom Telecom ((AMM)) and TPG Telecom ((TPM))

There are many more companies that should achieve above average growth this year and next, but admittedly, most are commodities-leveraged or recovering from past carnage, so there might be more to BA-ML’s assessment than initially meets the eye?

(Special Note: Yes, I do realise Molopo would strictly taken not qualify as “growth” as it is an emerging energy producer, but I thought I’d bring it to the general attention anyway).

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi’s View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of ‘Rudi’s View’. You will receive an email alert every time a new Rudi’s View story has been published on the website.

Rudi On Tour 2010

Your editor will be roaming the country in the coming weeks to give presentations to investors about his latest views on financial markets and about how to better use the info, data and tools on the FNArena website.

These presentations offer the unique opportunity to catch up with your editor in person and to ask questions directly.

Investors should note not all of these events are free, and they are all organised by one of FNArena’s commercial partners.

The first series of presentations will occur on invitation from MINC Trading, with your editor contributing personally to opening day sessions of multiple day seminars on the Gold Coast, in Brisbane, in Sydney, Melbourne, and Perth.

Your editor will also provide the closing presentation on the “BULLS VS BEARS” one-day seminar organised by the Australian Investors Association (AIA) on Friday, 12 November at the Tattersalls Club, 181 Elizabeth Street, Sydney. (Other speakers include Steve Keen, Robert Vagg and Shane Oliver).

Finally, your editor will fill 100 minutes presenting and answering questions about the theme “The Market Always Knows Best, Or Does It?” to members of the Australian Technical Analysis Association (ATAA) on Monday, 15 November, also in Sydney.

While the AIA and ATAA presentations are for members, access to both events is possible after paying fees to the organisers.

The schedule for the four day seminars organised by MINC Trading is as follows:

Day One – Taking the fear out of the Stock Market
Day Two – Introduction to Options as a Trading and Investment Tool
Day Three – Trading Strategies to Profit from an Uncertain or Trending Market
Day Four – Long Term, Low Risk Income Generation Strategies

The current roster is as follows:

Gold Coast – 27-30 Sept
Sydney – 4-7 Oct
Perth – 11-14 Oct
Melbourne – TBA Oct
Brisbane – 18-21 Oct

Important: your editor will only present during the first day’s session. All sessions start at 7pm. Fees to attend are $40 for one day, $100 for all four days.

To express your interest: send an email to info@fnarena.com

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