Required: A Leap Of Faith

This story features TELSTRA GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: TLS

By Rudi Filapek-Vandyck, Editor FNArena

It is not an item that receives regular attention here at FNArena, but we do pride ourselves we are providing investors in Australia with (on our own observations) the most accurate and up-to-date data and calculations for the Australian share market.

This may not necessarily help many among you in booking an extra financial gain each month, but at least you're not jumping on BHP Billiton ((BHP)) with the incorrect assumption the shares are trading on a single digit Price-Earnings (PE) ratio following the relentless trend in earnings downgrades that has characterised analysts' updates throughout calendar 2012.

Before we move on to what is happening with individual stocks in the Australian share market, it is my personal observation that quotations about the current Price-Earnings Ratio (PE) for the Australian share market are all over the shop. According to one expert the share market is currently trading on an average PE of 11, suggesting extreme undervaluation even after the circa 6% in gains booked thus far this calendar year. According to another expert the average PE is currently 12.5, which is still well below the average 14.5 since the eighties as well as the post-GFC average of 13.5.

However, having just updated data and calculations post the August reporting season, I can report the actual PE for the Australian share market for the year ahead currently stands at 13.5; in line with the average post the bursting of the global debt and leverage bubble in 2007-2008.

I don't know how or why FNArena's calculation differs so much from what is being published elsewhere, but I suspect the difference lies in the extra market intelligence we apply when making those calculations.

As I explained before, there's little use in trying to calculate a representative (and useful) PE average for the Australian share market when an ASX200 member such as biotech Acrux ((ACR)) is trading on a PE above 60, while Alumina Ltd ((AWC)) is on a negative -34.

In the same vein, what good is it to calculate an average growth in earnings per share (EPS) when it includes outliers such as APN News & Media ((APN)) which is forecast to see its EPS dwindle by no less than 81% this year? For the same reason, forecasts for companies including Atlas Iron ((AGO)), Billabong ((BBG)) and BlueScope Steel ((BSL)) can hardly be called "representative" when growth is expected to exceed 100% this year.

Removing such "noise" from the data provides us with the following stats:

Price Earnings ratio for FY13 (including December-2012 companies): 13.5
Average growth in EPS: 5.3%
Average dividend: 4.95%

While we're at it, here are the numbers for FY14 (including December-2013 companies):

Price Earnings ratio for FY14: 11.4
Average growth in EPS: 14.4%
Average dividend: 5.5%

What these numbers suggest is that the share market looks relatively fully valued in light of the rather slim looking immediate growth prospects, while expectations are high for the following year, but that's still a long way off right now.

What these generalisations don't reveal, however, is the large gap in valuations between the less risky, solid business models and the more risky, more fragile, growth-leveraged stocks in the market. The first group comprises of outperformers including Domino's Pizza ((DMP)), Coca-Cola Amatil ((CCL)), Ramsay Healthcare ((RHC)), CSL ((CSL)) and Breville ((BRG)). The second group includes sold-down ex-market favourites such as BHP Billiton ((BHP)), Santos ((STO)), Lynas ((LYC)), Newcrest ((NCM)) and MacMahon Holdings ((MAH)).

The first group mostly trades on PEs close to, or even above 20. The second group in most cases sits on single digit PEs. Dividend plays such as the major banks and Telstra ((TLS)) have performed strongly over the past year or so and while their PEs look like they could still have some extra-stretch left, it has to be noted current growth prospects look far from fantastic (note the 1% growth forecast for Telstra in FY14). Some caution seems but warranted as it's not like these companies carry no risk at all. Special note: there appears to be little risk when it comes to the dividends and that explains why investors jumped on board earlier this year.

All in all, the combination between these three groups is what makes up the 13.5 in average PE and the single digit EPS growth forecast. Clearly, the largest potential for positive returns lies with the growth stocks that are unloved, underowned, shorted, downgraded, abandoned and in many cases without growth. History shows strong investment returns more often than not start with a cheap valuation, but until recently there simply was no catalyst around for these stocks as global economic growth went through yet another broad-based downturn.

Immediate prospects are still looking ugly on the global economic front and the latest data from the US, China, Japan and Europe suggest there is no bottom in sight as yet. But we do have support from central banks and both the ECB in Europe and the Federal Reserve in the US are expected to support risk appetite and the price of risk assets. It should thus come as little surprise those beaten-down risk assets have once again started moving upwards.

Shares in BHP Billiton are back near $32.50 (PE of 12) after bouncing off $30 only weeks ago, while Santos is at $11.50 after threatening to break below $10 in August. Newcrest is back near $27 (from below $22), Rio Tinto is back above $54 after sinking below $50 and Beach Petroleum ((BPT)) is trading at $1.30 after falling below $0.90 in June and again in July.

The problem with most of these companies is that growth has all but evaporated (at least for the short term) while economies in Europe, the US, Japan and China continue showing signs of ongoing weakness. Central bank support, and more accommodative policies in China, is pretty much everything these stocks have going for themselves, on top of cheap looking valuations and negative investor positioning. The latter refers to the fact most funds managers are now underweight these stocks while traders and hedge funds are in large numbers short.

Ironically, it is from such barren stuck-in-the-mud situations that strong rallies have emerged in the past and recent analysis conducted by analysts at Standard Chartered confirms just that. The last time resources stocks found themselves in a similar position was in late 2008-early 2009 and Standard Chartered points out what followed next was a 16-month rally that pushed up miners' share prices by some 200%. Before that we have to go back to April 2003 when, in the midst of a recession in Europe and the US, a 12-month rally started that pushed up share prices by 60%. The Asian crisis in 1998-1999 resulted in a 115% gain over 15 months.

Taking guidance from history, Standard Chartered analysts conclude it is far better to buy resources when times are desperate and to sell the shares when times are good as history shows mining stocks perform at their best when the world is in recession. They are far from the only ones that have taken a more positive view on the sector lately. On Monday, commodities analysts at UBS moved to Overweight resources stocks in Australia on the expectation that Friday's dismal labour market update in the US will trigger yet another round of Quantitative Easing by the Federal Reserve.

Completing the picture, technical chartists are now increasingly turning more positive on prospects for this year's laggards. Technical market analysts at Barclays reported they had been "forced" (by price action and momentum indicators) to abandon their bearish bias for industrial metals. It would appear the likes of copper and aluminium have started to grind their way higher again, while spot iron ore might have seen the bottom (on the fall-out from a major producer in India).

Positioning for an upswing in miners, industrial cyclicals and energy stocks seems but the logical thing to do given the extreme outperformance of defensives, dividend payers and less vulnerable business models ("All-Weather Performers") over the past 18 months, in particular with central banks about to throw their support in the mix. However, at the danger of being overly sceptical, I don't think this year's slump in global demand/momentum is likely to be followed by the usual strong global economic growth recovery like we saw post the economic tipping points in 2009, 2003, 1998 or 1991.

As most market participants are now adopting a shorter time-frame approach, I don't think many will genuinely care. They will ride the momentum for as long as it lasts and jump off board as soon as price action stalls. As the experience post late-2008 has shown, resources stocks are fun to own and to play with while optimism is young and the sun starts showing itself from behind the clouds, but one should never stick around for too long. In Wall Street parlance this becomes: date them, but don't get married.

Those investors who are not willing to take that leap of faith will be keeping their fingers crossed the long anticipated rally in commodity stocks will arrive sooner than later and last long enough to draw money out of dividend stocks and "All-Weather Performers" so that new and extra shares can be bought in these lower risk companies at more attractive prices.

(This story was largely written on Monday, 10th September 2012. It was sent out in the form of an email on Tuesday, 11th September 2012).

The following stories might be of interest too:

– How The GFC Morphed Into A GFZ

– Investment Returns: What Does The Future Hold?

– Invest Like A Woman, Trade Like A Man

– A Silent Revolution

– Wear Two Hats. Don't Mix

P.S. Paying subscribers receive two e-booklets written by myself in 2010 and 2011. The concept of "All-Weather Performers" is explained in the second one, titled "The Big De-Rating. A Guide Through The Minefields". If you are a paying subscriber and you haven't received your copies, send us an email at info@fnarena.com

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