Sports Cars And Trucks

This story features FLEETWOOD LIMITED, and other companies. For more info SHARE ANALYSIS: FWD

By Rudi Filapek-Vandyck, Editor FNArena

The most important events last week, in my opinion, happened outside the scope of most investors across the globe. Firstly, US diversified foods company H.J. Heinz Co issued a profit warning which caused its share price to fall by three percent on the day. Secondly, the price differential between West Texas Intermediate (WTI) and Brent crude narrowed noticeably and thirdly, the world's largest resources company, BHP Billiton ((BHP)) issued rather cautious statements at its Annual General Meeting, while analysts' expectations continue to fall. Let's explore all three in more detail.

Pittsburgh-based Heinz, which produces frozen food, Weight Watchers meals and -of course- its namesake ketchup, is increasingly directing its sales efforts towards Emerging Markets while closing factories in the US. Consumers in developed countries are opting for smaller quantities and cheaper prices, forcing the company to increasingly launch new products in smaller sizes.

Heinz, it appears, is facing challenges and opportunities in different markets and the combination of these should keep a lid on too lofty market expectations. Not that one could draw such conclusion from Heinz's share price performance. Even after Friday's sell-off the shares are still up for the year and, equally important, they are higher than when equities peaked in late 2007. Two weeks ago I wrote a story on "fundamentally defensive" stocks ^(*). Heinz's share price amidst extreme market turmoil proves it is one such "fundamentally defensive" company.

Heinz is a truck, not a sports car. You need sunny weather and well-kept roads to fully enjoy a sports car. Trucks however, take you anywhere you want, regardless of the weather or the state of the road.

You see where I am getting at with this comparison, don't you? The bursting of the mass-credit bubble through the GFC in 2007/08 has turned roads into pools of mud while Europe is hiding the blue sky behind big, dark clouds. Stormy weather with short interruptions of sunshine have become the new climate.

Is it a surprise then that investors who've loaded up on trucks have performed so much better than those who couldn't let go of their sports cars?

Heinz's profit warning sends an important signal to investors, because it shows just how fragile earnings forecasts are in a global climate that is toughening the task of lifting rewards for shareholders, even for a truck such as Heinz. Note that prior to the warning, Heinz shares were trading on a forward looking Price-Earnings ratio of 16, which had pushed the dividend yield to circa 3.5%. Anyone familiar with PEs will immediately acknowledge such a high number for a steady single-digit grower that is Heinz sounds a bit topsy-turvy. Which then leads to the obvious question: how safe are these trucks when valuations become bloated and earnings don't appear immune from rising costs and changing consumer behaviour?

It is a question that will also in Australia increasingly come to the fore now that yesterday's outperformers are trading at sizeable premiums vis-a-vis the sports cars in the share market. Note, for example, many of the stocks I mentioned since the start of this calendar year, including Monadelphous ((MND)), Campbell Bros ((CPB)), Domino's Pizza ((DMP)), Reckon ((RKN)) and Coca-Cola Amatil ((CCL)), are now trading at or above consensus price targets. One of my personal favourites, Fleetwood Corp ((FWD)), has already started correcting since FNArena's Icarus Signal warned about too lofty expectations being priced in (see chart below).

I think the message from all this to investors is: be extra-extra careful when adding to "safe havens" at this point in time. You are arguably at the very end of the queue and chances are investors in front of you have already priced in most of the "safety" that was previously on offer, and then some more.

From a pure risk-reward point of view, one can argue this automatically makes the less safe, more volatile sports cars in the market a better proposition, even if it is still raining and it doesn't look like the sun will break through the clouds anytime soon. This is why I suspect strategists at various stockbrokerages recently started adding some more risk to their Model Portfolios and why others are pointing into the direction of gold miners' stocks. It is the relative pricing of "safety" and "risk" that makes the latter a less risky proposition.

However, this doesn't mean those sports cars don't have their own challenges to deal with. Against a lengthy AGM (more than five hours) during which cautious statements from CEO Marius Kloppers and others caught the attention of financial media and investors, commodity analysts at Citi updated their forecasts for industry heavyweights BHP Billiton and Rio Tinto ((RIO)) by removing all references to "growth" for the next two years.

Here's something to put into context: H.J. Heinz's profit warning on Friday implied the company might miss this year's consensus forecasts by as little as 0.6% ("no more than US$3.32 a share" compared with consensus at US$3.34 a share). BHP's earnings per share for the year to June this year lifted by 75%. Rio's rose by near 100% last year. And now… no growth for the next two years?

It goes without saying that Citi's forecasts will not necessarily prove accurate, and neither do they reflect all the various projections in the market right now, but they do illustrate the concept of "trucks" and "sports cars" at times of climate change. Earnings forecasts across the globe are still falling and they are falling more for sports cars such as BHP and RIO than they are for the other companies mentioned in this story (some like Monadelphous are enjoying rising forecasts).

Consensus forecasts were still anticipating double-digit growth for both BHP and RIO only a few weeks ago, but now these forecasts have fallen to single digits only for BHP and to one more year only of 20% for RIO (this year to December; to be released in February). Given the high leverage built-in these forecasts, it is not difficult to see how Citi's projections can turn out to be accurate, but then that same leverage also works to the upside (as we've seen in previous years).

Economists at National Australia Bank have calculated base metals prices are, in aggregate, around 18% lower today than where they were at the end of 2010. The down-cycle has been less severe for bulk commodities coal and iron ore, but if NAB's projections can be relied upon any upside in 2012 should be no more than single digits only. While all this does not remove the observation that most cyclical stocks today seem very cheaply priced, it does raise a question or two about how much sustainable upside there is exactly in the short to medium term.

(Some shareholders have already started to question whether Big Miners (full of cash) should not change their dividend policies and become more selective in their spending spree. It is clear from the preceding paragraphs as to why that is. No doubt, a change in dividend profile would benefit share prices, but that's a story for another time).

Last but not least, the price differential between West Texas Intermediate (WTI) and Brent crude oil has dropped to circa US$10 per barrel this month, after blowing out as high as nearly US$30 per barrel earlier this year. This pushed WTI up near US$100 and has already prompted some market commentators to express their worries about US consumer spending leading into 2012.

Better to ignore those warnings. Due to local transport issues, WTI long ago lost its role as a benchmark for the price of oil, be it inside the US or internationally. Brent crude was trading around US$120 per barrel earlier in the year and today it is no higher than US$107/bbl. This suggests struggling consumers in developed economies are still enjoying a small relief from previous petrol/diesel/heating oil price pains, instead of a renewed squeeze on their budget.

Talking about "noise".

(This story was written on Monday, 21st November 2011. It was published on that day in the form of an email to paying subscribers of FNArena).

^(*) See Rudi's View: The Big De-rating – A Guide Through The Minefields (3) published on November 9, 2011.

P.S.: I was asked by the Sydney Morning Herald to nominate three stocks for Long Term Investment portfolios. Within the context explained above, I nominated Ardent Leisure ((AAD)), McMillan Shakespeare ((MMS)) and Amcor ((AMC)). Here's the link to the story as appeared in the newspaper on Saturday: http://www.smh.com.au/money/a-tough-but-navigable-road-ahead-20111118-1nmyr.html

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)

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