REPEAT Rudi’s View: Looking Forward

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(This story was originally published on Wednesday, 16 March 2011. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).

– February revealed an extreme gap in earnings growth between "winners" and "losers"
– This gap is expected to narrow, if not close over the next 18 months
– This prospect is not priced in share prices for most industrial stocks

By Rudi Filapek-Vandyck, Editor FNArena

You wouldn't have noticed from the price action we have seen since mid-February, but the recent corporate reporting season in Australia had strengthened overall market confidence in that earnings growth should continue for those sectors performing well (miners, energy and pick and shovel service providers) while others were staring at or near the low point in their earnings cycle. Under different macro-economic circumstances this would have created the ideal platform to extend the share market rally that started in August last year, but this time around it simply isn't to be.

In Australia, major indices have now lost more than 9% since their peak in February. Despite many experts calling "value on offer" it is clear investor sentiment has been dented quite significantly over the past few weeks. The underlying message from the February reporting season, however, hasn't changed because of tighter liquidity in China, doubts about what will happen post QE2 in the US and a series of natural disasters. That message still is: there's value in the Australian share market if forecasts for FY11 and FY12 prove more or less accurate.

Confidence in these forecasts seems pretty high. Not only have analysts emphasised the point in their regular updates post February, market strategists at various stockbrokerages have done the same while retaining their projections for the Australian share market post the "correction" from the past four weeks. As an example, both Goldman Sachs and UBS maintain earlier estimates that put the ASX200 at around 5500 by year-end, while noting this includes further potentially small downward adjustments to FY12 forecasts between now and then. On Wednesday the ASX200 closed at 4558.

At face value, the February reporting period was one of the worst in a long time. One stand-out observation was that Australian companies seemed unable to outperform analyst forecasts, contrary to the preceding reporting season in the US, for example. A second observation was that earnings forecasts continued their downward trend, in place since May last year. Other negatives include an extreme gap in earnings growth between resources and industrials, low profit margins and cautious consumers, and a general reluctance to give specific guidance, let alone optimistic guidance.

There were some clear positives too. One of these involved further increases in dividends, consolidating Australia's position as the dividend capital of the world. Another positive was that, while earnings projections outside natural resources remained negative, the size of overall downgrades had become much smaller than in previous months and certainly than during the previous two reporting seasons. Above all, the most important positive characteristic from the February reporting season was that forecasts for FY12 had been left largely untouched. For a good reason it seems, as analysts would claim in many cases their confidence had been boosted in significant fashion, suggesting if there was a risk, it was likely to the upside.

All this translated into higher valuations and higher price targets for individual stocks. No wonder the balance between recommendation upgrades and downgrades had shifted in favour of the former.

However, there was more to all this than initially meets the eye. Behind the headlines on financial television and in newspapers, market observers had noted the valuation gap between the outperformers (miners, energy and pick and shovel service providers) and most of the rest of the market had blown out to such extremes, that the latter seemed to represent the better value – on the condition that the February reporting season would boost overall confidence in future earnings for these companies.

It is here that the February reporting season has played a key role. Because, just as every engineer and mining service provider had been re-rated since late 2010, investors had by now jumped on every laggard among industrials in the run up to the actual reporting season. As one would have expected, not all companies (or even sectors) lived up to expectations. Within this framework, the February reporting season has set a few new trends, and broken a few others.

First up are the mining and exploration companies. Their results were good, but merely as expected. Big drivers were ongoing strength for commodity prices and a near relentless bullish investor sentiment. The main problem with the sector was that the easy gains had been made. Small cap mining stocks in particular no longer looked cheap. Market strategists at the likes of UBS and Credit Suisse decided to go "Underweight" the sector and they have not regretted that decision since. Both stockbrokers stuck to their decision this week, even after the Japan disaster-inspired sell-down.

Second are the oil and gas companies which have a long history of failing to live up to market expectations. Santos ((STO)) did surprise, but few others matched its example. To make matters worse, few share prices across the sector have genuinely kept up with oil prices in the past two months. My favourite sector observation is that long term investors who bought Santos, Woodside ((WPL)), Oil Search ((OSH)) and many others in the sector five years ago, and held on to their shares since, are still waiting for a positive return today. The February reporting season was not particularly inspiring for the sector. If anything, it raised more questions about what exactly is going to be achieved by the likes of Woodside, Origin ((ORG)) et all in the months ahead.

Having said that, the sector is definitely on investors' radar with stockbrokers and others raising their oil price forecasts for this year and next and this has triggered higher valuations, targets and recommendations. The shut down of nuclear power plants in Japan has only further fueled speculation that LNG will remain in high demand from here onwards.

Third up are the pick and shovel service providers. This group has grown to a wide and varied bunch of companies in the Australian share market, comprising the likes of Leighton ((LEI)) and Transfield Services ((TSE)), but also WorleyParsons ((WOR)), Monadelphous ((MND)), Fleetwood ((FWD)), Ausdrill ((ASL)), Decmil ((DCG)), Sedgman ((SDM)), UGL ((UGL)), Neptune Marine ((NMS)), Norfolk ((NFK)) and Imdex ((IMD)); and that's still only a few of them. This sector had been re-rated since late 2010 and most share prices had rallied above broker price targets in anticipation of future earnings growth on the back of higher capex in 2011 and 2012.

February showed, however, that overall earnings growth across the sector is still modest, so the re-rating remains one based on "anticipation". Secondly, not all companies in this sector managed to live up to expectations, which led to severe price falls for the likes of Sedgman. Thirdly, those who proved they had the goods to warrant the re-rating (Monadelphous, WorleyParsons, Fleetwood, etc) found out that broker targets were being raised to where the share price already was. Nowhere to go but down? This certainly proved the case once oil and Japan put a big dent in investor optimism. Falls in share prices for companies such as Fleetwood and WorleyParsons have been much larger than for most other stocks during the past four weeks.

Two interesting developments for the sector came to the surface in February. One, there is a move towards placing more risks with the client (companies like Leighton, UGL and Downer EDI ((DOW)) have been burnt recently) and two, labour shortages have become a real problem and will lead to missed opportunities. Access to labour is thus becoming a key differentiator inside the sector.

Next up are the banks which mostly managed to beat analysts expectations by a small margin, but it was enough to excite journalists, commentators and investors. Alas, once share prices reached for consensus price targets, this positive news story came to an abrupt end. Most share prices for banks have outperformed the broader market to the downside since mid-February. Banks are mostly exposed to that particular part of the Australian economy which is still going through a rough patch and thus investors don't see any upside (right now). This has opened up the obvious valuation gap for longer term investors who can buy into the sector at seldom seen dividend yields (approaching 7% on FY12 estimates). The fact that most banking analysts in the country hold a high conviction regarding their estimates only adds further to the overall appeal.

Note the February reporting season once again widened the gap between the regionals (have-nots) and the majors (haves) in the sector.

Among industrials, February failed to bring the anticipated turnaround for building materials stocks, as well as for gaming and gambling and for media. Expectations for retail stocks were already low on the back of many a profit warning prior to the reporting season and the overall view remains that more pain is likely to precede a turnaround later for most companies in these sectors. What makes stocks in these sectors interesting is that if current market expectations for better results in FY12 prove correct, then today's graveyard valuations for the likes of Fairfax ((FXJ)) and Tatts ((TTS)) should open up excellent value-opportunities once the turnaround materialises. No wonder thus, the media sector is abuzz with one deal after the other – valuations are cheap.

The problem is that more pain first seems almost a given and then what if the awaited turnaround is pushed out further away? Complicating matters is that while analysts' conviction in their estimates is high, it certainly appears much lower for these sectors. Note for example Fletcher Building ((FBU)) had to issue a profit warning recently because the anticipated pick up in building activity post the Christchurch quake turned out weaker and later than expected.

Healthcare stocks equally failed to ignite share prices in February with earnings forecasts mostly falling post results and with questions being raised about valuations for the likes of CSL ((CSL)) and Cochlear ((COH)) which seem more based on past legacies than on what realistically lies ahead. Pathology stocks remain subdued because of uncertainty about what the Australian government will come up with, while distributors to pharmacies are going through a tough time as well. Most excitement in this sector came from the smaller end of town with biotech companies such as Mesoblast ((MSB)) recently regaining investor interest in a manner that throws up flash-backs from eight, nine years ago, when biotechs were too hot to handle.

The stand-out sector in February, however, were the Real Estate Investment Trusts (REITs), otherwise known as LPTs (Listed Property Trusts). The sector has gone through its own cleansing exercise post the financial engineering bubble turned into bust in 2007. Most experts will tell you prices are still at considerable discount to Net Tangible Assets (NTA). The problem is: once burnt, most investors have not paid any attention to the sector over the past three years. Fact remains though, if there was one sector for which overall confidence has risen, and significantly so, throughout February, it is the long forgotten about REITs.

Three observations further strengthen this conclusion. REITs have been outperforming the Australian share market in all three months of 2011 so far. CFS Retail Property Trust ((CFX)) has been featuring as a Buy-with-conviction at several stockbrokers. And last but not least, property analysts have been busy issuing sector reports featuring that same underlying theme: the worst is now behind the sector, how long before valuations will close the gap with NTAs?

All in all, the general mindset among analysts is that 2011 is likely to mark the peak, as far as earnings growth goes, for the outperformers of February — the miners. Higher oil forecasts should unleash a new dynamic for energy companies, while pick and shovel service providers will be biting each other's hands to get their slice of the big capex wave that is about to hit Australia (and the rest of the world). The extreme gap that has opened up between those companies and most industrials, however, is expected to narrow from the second half of this year onwards.

Even if not everyone is equally convinced about how strong exactly profit growth will be for today's laggards, virtually no-one is doubting industrial companies will see much better performances later this year and into 2012.

It is on this basis that several stockbrokers have recently come forward to point out stocks that have been, in their view, sold down too far. These stocks include Qantas ((QAN)), National Australia Bank ((NAB)), News Corp ((NWS)), ResMed ((RMD)), OneSteel ((OST)), APN News and Media ((APN)) and Pacific Brands ((PBG)). Many of these stocks can be found towards the top of the R-Factor on the FNArena website (which further strengthens the thesis).

Market strategists at BA-ML even published a whole report on Wednesday, titled "Stocks that have fallen too far". Names that stand out according to the research include Duet ((DUE)), Qantas, NAB, Tatts, Toll Holdings ((TOL)), Seek ((SEK)) and Bendigo and Adelaide Bank ((BEN)).

Maybe what investors should keep in mind post the February reporting season is that overall growth in earnings per share for industrials has been non-existent for the six months to December. This is expected to become low single digits for the six months to June, with more improvement anticipated for H2. In 2012 EPS growth for the sector should print double digits.

For most industrials stocks, this is not priced in the share price. Quite to the contrary.

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