REPEAT Rudi’s View: Australia, (not) The Lucky Country?

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This story was originally written and published on October 13, 2010. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere.

By Rudi Filapek-Vandyck, Editor FNArena

Don't be fooled by all the positive commentary about the immediate outlook for the Australian share market and the Australian economy this year and next, this country has some serious issues and while investors and market commentators might ignore these issues in the short term, they won't be able to do so for long.

In the boom years prior to the bear market of late 2007-2008, the outside-the-box thinkers at GaveKal published a memorable analysis about how it had become increasingly difficult for the world's wealthy citizens to live a wealthy lifestyle, because everything the global rich desired was becoming rapidly more expensive.

To put it simply: being wealthy was increasingly becoming more and more expensive, while being poor was becoming cheaper by the day (thanks to China exporting deflation).

I think Australia, as a country, is suffering from a similar phenomenon. I also think we are only at the early stages of this process, so things will get worse.

Let's start with some easy conclusions: Australia's resilient economy has stood out on a global comparison with just about everyone else bar the likes of China, India and Brazil. Yet, the Australian share market continues to underperform most equity markets around the world, though not so much these three countries.

As it happens, some of the world's weakest and most troubled economies have still allowed their local equity markets to perform much better than Australia's since March 2009, and especially since January this year.

Does this sound like the world upside down, or what?

This theme is not new. For months I have witnessed market commentators and stockbrokers on finance television, and read them in newspapers and elsewhere (as I am sure you have too), bemoaning the fact that Australia's World Beating Economy is not translating into a first class return for investors.

Earlier in the year, I countered this was because Australian companies did not have that same economic trough to climb out of, so earnings growth was pretty dismal in FY10. Add the fact that all those capital raisings had diluted shareholders to the hilt in 2009, so it really shouldn't have been a surprise to anyone who cared to look below the share market's surface.

Average growth in earnings per share terms for Australia's top 200 companies did not exceed low single digits for the year to June 2010 while companies in Europe and the US were reporting 40-50-60% growth, and more.

To make things even worse: Australia's low single digit growth rate was still supported by strong growth in the resources sector. Just think about, for example, BHP Billiton ((BHP)) pretty much doubling its EPS from the previous year.

As far as share market returns are concerned, this wide gap in EPS growth could serve as the perfect reason as to why the Australian share market was unable to keep up with Wall Street and others.

FY11, however, was supposed to be different with average EPS growth in Australia anticipated to jump to around 20% and with growth in the US and in Europe to drop closer to 15%. Alas, it should be clear by now this scenario is not going to materialise.

Instead, what we have is rising earnings forecasts in the US and in Asia, but persistent declines in forecasts for Australia. As I have pointed out repeatedly over the weeks past, stockbrokers continue issuing more recommendation downgrades than upgrades (for three months uninterrupted now) and where stocks do receive an upgrade it is almost without exception an upgrade to Neutral.

Behind this ongoing trend in downgrades is an ongoing downward trend in earnings forecasts. After a brief pause between mid-August and mid-September, this downtrend in earnings estimates is now once again in acceleration.

Stockbrokers are still talking about 20% growth for Australian companies this financial year, but on FNArena's adjusted and cleaned calculations the underlying EPS growth number is now closer to 15%, from around 16% at the beginning of October (down from 20% in late August).

Given the somewhat slow process whereby stockbrokers update their models for the latest currency movements, I would expect this underlying number to drop further in the days and weeks ahead. This is not something investors should casually ignore. On FNArena's calculations (again: cleaned and adjusted for outliers) the Australian share market is already trading on an average Price-Earnings ratio of 14.5.

This is above the market's long term average of 14.3.

What is effectively taking place is that high PE rated stocks (think Woolworths ((WOW)), Cochlear ((COH)) and Coca-Cola Amatil ((CCL)) are giving up some of their “over-value” in favour of low PE rated stocks such as BHP Billiton, Qantas ((QAN)) and National Australia Bank ((NAB)).

Meanwhile, others such as Hastie Group ((HST)), McPherson's ((MCP)), Telstra ((TLS)) and OM Holdings ((OMH)) are largely being ignored.

Add the gold and uranium miners (and prospectors) and it is easy to see why this market hasn't necessarily maxed out its full potential just yet. But the diverging dynamics also show this is not a time to be complacent nor to ignore the weakening domestic fundamentals.

To put it simply: falling earnings forecasts and rising share prices is not a combination that can remain in place for too long. I think the fact that recommendation downgrades by stockbrokers persistently continue outnumbering upgrades is a direct reflection of this. (Made even worse by the fact that almost all upgrades are to Neutral only).

Taking a more detailed look into current market forecasts reveals a rather disturbing trend with only resources, consumer staples and capital goods sectors anticipated to achieve double digit growth this financial year. The first two of these three sectors are effectively holding up the average growth forecast for this year.

Growth projections for IT services and for telecommunication are both negative, while other sectors such as consumer discretionary, energy, financials, healthcare and utilities seem poised to only enjoy low single digits growth. Repeat: market expectations are still falling.

As to why Australia continues to excel in below peer growth and falling projections, I am sure most commentators would (by now) point into the direction of the Australian dollar. As reported by myself, and by others at FNArena over the past weeks, most downgrades in September and October are inspired by the ever surging AUD.

However, I suspect that what we are witnessing is of a deeper, fundamental nature. Similar to GaveKal's argument prior to 2007 that the world was changing, making it more expensive to be wealthy, and to continue to be wealthy, I think Australia is paying the price for being the World's Greatest Economy.

And I mean literally paying for it.

I just returned from Perth where I paid $4 for a large take-away cappuccino. I could have paid even more as a coffee shop on St George's Terrace, near where stockbrokers have offices, charges $4.50 and I spotted one coffee shop at the airport charging $4.90.

According to recent market research, the average price in Australia for a large take-away coffee is $3.20, with cities such as Sydney charging above average prices of up to $3.50. However, when questioned about this stark price differential, coffee shop owners in Western Australia argue their profit margins are not larger than elsewhere.

They simply have higher costs to deal with through utility bills, rent, wages and such.

I do not have at present all the details and data at hand, but I have a strong suspicion that my coffee observation is symbolic for the underlying dynamics in the Australian economy. Australia is paying for the privilege of being the Lucky Country of the Twenty First Century and it is translating into disappointing, below peer comparison earnings growth for ASX-listed companies.

Other elements that reinforce my suspicion include:

– the fact that Australians continue moving overseas in their travels and holidays (effectively moving part of consumer spending outside the country)
– the fact that a whole generation of teenagers and tweens is learning the benefits from shopping online (big discounts are available, again this shifts part of consumer spending outside the country)
– recent analysis has revealed Australian consumers pay near the highest price in the world for an iPod; this is very interesting because it clearly shows the different dynamic in the world right now where US company Apple manages to tap into consumer wealth in Australia, but where can Australian companies go to if they want to tap into similar wealth offshore?
– Re Apple: Australia's exporters are currently receiving cuts and downgrades instead (see above)
– Gerry Harvey, founder and chairman of Australia's iconic retailer Harvey Norman, this week declared the current environment for audio-video retailers “worse than during the GFC”
– Apparently, the star amongst Australia's retailers, JB Hi-Fi ((JBH)) issued similarly cautious statements at the annual shareholders meeting this morning, which is likely to prompt downgrades to stockbroker forecasts in the days ahead

On Wednesday retail analysts at BA-Merrill Lynch downgraded their profit growth projections for market darling Woolworths to… mid single digits. Not just for the current financial year, but for multiple years ahead.

Because Woolworths is buying in some of its own shares, growth in earnings per share should still remain in between 6-8% between now and 2014, but I wholeheartedly agree with BA-ML analysts that such growth pace is insufficient to sustain a PE ratio higher than 16.

Australian investors have over the past year witnessed the de-rating of stocks such as QBE Insurance ((QBE)) and CSL ((CSL)) for the same reason that PE ratios were too high and EPS growth was simply no longer there to sustain such high PE multiples.

In more recent times, and as forecast by myself, shares in Cochlear ((COH)) and Wotif ((WTF)) have similarly (and for similar reasons) started de-rating. Is Woolworths next? If BA-ML projections prove correct, I can almost guarantee that Woolworths will be next.

Let's take a small, but important, step back: Woolworths is part of consumer staples in Australia. Does BA-ML's assessment imply the immediate outlook for investors is for resources, and for resources only?

The Australian share market risks becoming a one trick pony whereby anything that is not leveraged to resources seems poised to disappoint investors in the year ahead (at the very least). Even more reason, I would argue, for investors looking for opportunities outside the mining sector to seek out solid dividend payers among industrials.

One stock that caught my attention this week is beauty and healthcare products producer McPherson's ((MCP)). Growth is likely going to be moderate this year (see all of the above) and the share price jumped by 2% today (we did publish a story earlier), but investors buying today and holding on for minimum two years should see near 8% in dividend return by then, on current consensus estimates. That, by the way, is 100% franked.

Resources and dividends. I cannot think of a better summary for the Australian share market's outlook right now. But be careful for high multiple stocks that are about to be de-rated.

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.

Meet Your Editor

Your editor will be traveling to Queensland this weekend to explain, educate and present the ins and outs of The Australian Broker Call Report, Stock Analysis and R-Factor through seminars on the Gold Coast and in Brisbane.

Feedback post similar seminars in Sydney and Perth the past two weeks have ranged from positive to very positive. Needless to say, you are all encouraged to attend.

The following events are scheduled (in cooperation with Minc Trading):

Sunday, 17 October (Gold Coast)
Monday, 18 October (Brisbane)
Saturday, 6 November (Melbourne)

If you are interested, or have questions, send an email to info@fnarena.com

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