How Much Upside Is There?

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This story was first published two days ago in the form of an email sent to paying members.

By Rudi Filapek-Vandyck, Editor FNArena

Ask any technical chartist about global equities and the answer is a resolute "pure strength". Ask any equity strategist and the answer is "surprised about how easily and how quickly global equities have distanced themselves from the troubled macro-picture", which is in essence another way of stating the same thing: "pure strength".

As major indices in Australia are once again rapidly approaching that magical 5000 level, many of those chartists are telling investors if the market manages to surge past technical resistance, located a little above 5000, Australian equities will have landed in blue sky territory and much larger gains should lie ahead. The same prediction comes from strategists with a positive outlook: get ready for much larger gains.

At the end of last year, most experts set their target for the ASX200 index for calendar 2011 at 5,500-5,600. Most of these experts have left their targets unchanged, post economic disasters in Queensland and in Japan, and despite higher oil prices, which suggests the benign share market gains thus far over the first three months of the year (less than 2% in Australia) should see at least another 12% (without dividends) being added over the next nine months.

There are some, however, who question the validity of these forecasts, myself included. I thought in late 2010 the above mentioned projections will probably turn out too optimistic. Thanks to FNArena subscriber Tim Moffat, those who share my view now have an extra argument in support of their scepticism: FNArena's consensus price targets.

Tim Moffat, who works as a market trader for Minc Stockbroking, recently took the effort of translating all consensus target prices for the 200 stocks that make up the ASX200 to see how far this would take the index. Importantly, the calculation was done in line with respective index weightings so it should give all of us a reasonably good insight into how much upside there is left for the main index in Australia. This is, if we take guidance from target prices set by stockbrokers for individual stocks. The answer that came out of Moffat's calculations is 5335. 2.5 weeks ago, when these calculations were made, this suggested the Australian share market still had some 15% in potential upside left (dividends not included). After the rally we've experienced since then this potential has shrunk to a little less than 9% (plus dividends).

The gap is, give or take, some 250 points with the upper range of expert forecasts (circa 5%), large enough to make a difference.

This raises a few obvious questions. The first one is: how valid are these targets to start with?

As readers of my regular market analyses know, I am a close follower of gaps between share prices and consensus price targets. More often than not, these targets put an iron-clad ceiling above the share price, as again proven by all major banks in February. But banks are certainly not the only ones who meet stiff resistance once share prices converge with consensus price targets. Witness, for example, how CSL's ((CSL)) share price tried to push boundaries in January and February and then, despite a rise in price targets, got hammered to lower price levels, where it has remained since (the grey coloured area on the chart below shows the level for the consensus price target).

This suggests these consensus price targets can be used as a reasonable reliable guide and my own analyses and observations from the years past certainly would support such a view. However, to reach maximum potential would mean all 200 stocks in the ASX200 reaching their consensus targets by year end. That seems a bit rich. A far more sensible approach would be to apply a 5-7% safety buffer, but this instantly reduces further potential upside to 2-4% (plus dividends) – a lot less then the above suggested high double digit returns.

In index terms, this would reduce this year's potential to circa 5100, about 200 points higher than where the ASX200 is in the first week of April.

There is one important factor we haven't mentioned as yet: those targets are not set in stone. What are the chances they can rise between now and year-end?

I would take it as a given that today's target prices will mostly have changed between now and late December. Stockbrokers update their models on an ongoing basis. Most changes occur during reporting season, so August will be key, as will be the upcoming interim reports by most banks. However, to expect an average rise in price targets of 10% -which would add the missing 400-500 points- simply doesn't look realistic. That would have been possible, and more likely, in the pre-2007 era when earnings growth was abundant and forecasts constantly needed to be adjusted upwards.

Right now we are staring at an Australian share market wherein a minority -predominantly resources and energy- is enjoying ongoing strong growth and upward revisions to forecasts, while the majority continues doing it tough. Companies outside natural resources have on balance suffered downgrades to forecasts since May last year, and this process is still ongoing. So while targets continue rising for a minority, and they may retain certain non-tapped potential for the nine months ahead, there's also potential for other targets to fall. One such good example is Qantas ((QAN)) whose consensus price target has fallen nearly 2% over the past week and only a brave man would predict there won't be any more downgrades from here on. (The good news is that Qantas's share price is still some 39% below the consensus target price).

The downside represented by airlines and other industrial companies is more than compensated by ongoing upside stimulus for energy companies and materials stocks, including Woodside Petroleum ((WPL)), Santos ((STO)), BHP Billiton ((BHP)) and Rio Tinto ((RIO)). BA-Merrill Lynch and Deutsche Bank recently further raised their price forecasts for natural resources and for crude oil and the result was for across the board upgrades to earnings forecasts and valuations. While individual adjustments were as high as 20%, average increases to price targets in both cases did not exceed 5%.

The message here seems to be that, unless we continue to see further increases to oil and commodity prices, it doesn't look like these increased inputs will be sufficient to add another 400-500 points to our implied ceiling of 5100 for the ASX200.

We should also keep in mind that commodity prices cannot rise indefinitely without triggering side-effects. Russell Investments' chief investment strategist for Asia Pacific, Andrew Pease stated in a conference call on Monday that if crude oil prices rise above US$125/bbl and stay there, Russell Investments would start lowering forecasts for economic growth and company profits across the board, across most geographical markets.

Also, don't forget that even if stockbrokers raise their targets by an extra 10% on average for the 200 members of the ASX200, and share prices in accordance rise by an extra 10%, this would raise the same question by late December about what is left for calendar 2012?

Within this context I found it remarkable that one of the rising stars among equity strategists in Australia, Macquarie's Tanya Branwhite, recently updated her market projections which generated a fair value calculation for the ASX200 of 5185 by March next year. I don't want to quibble about 85 points here or there (with three extra months), but Branwhite's projections would seem very much in line with the 5100 I suggested earlier for December this year on the basis of today's consensus price targets.

Branwhite, and her team at Macquarie I must add, made two important points in the recent Macquarie market update. One is that earnings upside potential for industrials seems limited due to ongoing margin pressures. This suggests the downtrend in earnings forecasts is to last a while longer and this will automatically also keep a lid on further upside for price targets. The second point is that on Macquarie's assessment, large cap industrial stocks should outperform resources over the next twelve months.

Investors should note that even if consensus price targets and Macquarie's projections prove correct, there still seems to be plenty of potential left as many stocks are still trading well below consensus price targets, including BHP Billiton (circa 14%), Rio Tinto (26%), ANZ Bank ((ANZ)) (10%) and Woolworths ((WOW)) (12%), to name but a few.

The underlying message thus seems: keeping an eye on valuations and understanding the art of stock picking will become ever so important for the remainder of calendar 2011.

Which leaves us with the question as to how many an expert can be so far off the mark with their projections (assuming targets/Branwhite are correct)?

I have a very simple explanation for this. Most of the time equity strategists will calculate an average EPS number for the market as a whole and then multiply this by what is believed to be the average PE multiple for the market. In Australia this average multiple is somewhere in between 14 and 15 (depending on how far we go back in time to calculate the average). Such an approach omits the fact that PE ratios for major resources stocks tend to contract to 10-11x at times of super-natural profits (like we are experiencing now) while another important sector for the share market, banks, have been derated into the 9-12x PE range due to rather subdued industry conditions.

Below average PE ratios for two such important segments of the ASX200 index probably means the average PE for the market as a whole is going to remain below historical norm for a long time. Prepare for continuously repeated mantras that the share market remains cheap in comparison with overseas peers and with historical averages. I would also expect that by year end most experts will use the term "disappointing performance", just like they did at the end of last year.

My bet is on Tanya Branwhite and FNArena's consensus price targets, suggesting there's still upside for the astute and alert investor, just not as much as many would like us to believe.

(This story was originally written and published on Monday, 4th April, 2011. It was sent in the form of an email to paying subscribers at FNArena).

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