Torn Between Major Obstacles: For How Much Longer?

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By Rudi Filapek-Vandyck, Editor FNArena

The two major drivers behind equity prices -sentiment and valuation- have been at war with each other in Australia ever since the rally from the bottom up in March 2009 ran out of breath by early 2010.

The main cause of this disconnect between the two has been earnings growth, or merely the lack of it, among Australian corporates in each of the three previous fiscal years. Surely, now that we have had three consecutive years of virtually no growth in Australia, and with central bankers around the world propping up general risk sentiment, it's about time we saw some earnings growth coming through in fiscal 2013? Especially with more RBA rate cuts on the horizon?!

Alas, for Australian investors, none of the experts who recently updated their outlook and views on the share market is anticipating a significant change from the earnings pattern that has been established since 2010. Expect subdued growth remains the underlying message, if any growth at all. This then raises the obvious question: what can we realistically expect from the share market when there's little or no growth on the immediate horizon?

Before we move into the nitty gritty behind the most recent market updates and projections, let's have a look first at where we stand right now in terms of growth expectations and valuations.

The most straightforward way to assess the market's valuation is by calculating how many times today's share prices are incorporating this year's anticipated earnings per share. We can do this on the basis of analysts' consensus estimates and by calculating a rough average for the market as a whole.

On FNArena's calculations (corrected for disruptive, non-representative outliers) the Australian share market is currently trading on a forward looking Price Earnings Ratio of 13.2. This is below the 14.5 average established in the two decades before 2008, but above the 12.5 average established post-GFC. This immediately raises the question "cheap or expensive" in a different framework. If you happen to believe that we are in the early stage of the next bull market then Australian PEs still have some potential left to catch up. If, however, you remain of the view that low growth in profits and in global GDP, combined with elevated risk for calamities due to sovereign debt, impotent politicians and the need for austerity in developed countries, deserves a natural risk discount, then 13.2 is probably a bit on the excessive side.

Not everyone works off FNArena's calculations. Macquarie recently estimated the Australian share market is trading on a PE of 13.6, which makes it even more expensive (or less cheap, if you like to see it the other way) but the more bullish UBS has a PE of 12.5. All in all, none of these calculations is suggesting the share market is extremely undervalued as was the case back in early 2009.

Of course, a substantial part of the question "value or not" will be answered through what Australian companies can achieve in terms of earnings growth for their shareholders. But as said earlier, here the signs are not utterly promising, at least not for the current fiscal year.

On FNArena's consensus calculations, average profit growth for ASX200 companies this year won't exceed 5% and, equally ominous, the general trend in forecasts remains negative. Only six months ago, consensus estimates implied some 15% growth for the present fiscal year. The main contributions to the downgrades in forecasts have come from miners and energy companies.

Note, for example, both index heavyweights BHP Billiton ((BHP)) and Rio Tinto ((RIO)) yet again saw consensus forecasts drop by a few extra percentages last week. As a result, market consensus is not only signalling that BHP will report a second year of negative growth -an event last seen in 2002 and 2003- but also that this year's fall will be even larger than last year's 18% drop in earnings per share (current estimate -19%). For Rio Tinto, the market is now expecting a drop in earnings per share of no less than 36% for the year to December.

Needless to say, if we only judge both stocks on market forecasts for FY13 and 2012 respectively, "cheap" is not the term that immediately comes to mind. BHP shares are now trading on a PE of 13.2 while Rio's PE is 11.

Last week, see Weekly Insights "Investing Under Challenging Circumstances", I suggested one way to get around the fact that many stocks in Australia don't look particularly attractive on present year dynamics is to shift focus to FY14. FNArena calculations show consensus forecasts are for 14.7% EPS growth in FY14. If correct, this instantly reduces the average market PE to 11.8, which seems a lot more attractive than 13.2. The problem is, however, that we've read this script before. What guarantee do investors have that what looks like solid double-digit profit growth in less than a year's time, won't evaporate to low single digits for a few companies only, just as has happened in the four previous years (including FY13)?

Exactly that question will be hanging over the Australian share market in the months ahead. Experts with a positive bias will argue the difference this time is the RBA is cutting interest rates with the goal of helping the Australian economy to re-balance away from too much dependence on capital investments by resources companies. Other experts with a less buoyant outlook will counter-argue that lower interest rates will take more time to show up via increased activity levels and that the past will prove a flawed guidance for the future. The Australian consumer will remain cautious. The baby boomers are forced to stay in retreat. The Australian dollar is still above USD-parity and has to date shown no intention for settling into the low 0.90s again.

Somewhere in between both views lays the actual performance for the Australian share market. Similar to the three years since early 2010 (give or take), it'll remain a war between general sentiment and the general wish to enjoy a better performing share market on one hand and the lack of earnings growth on the other side of the ledger, which holds up a big question mark for what can be expected in terms of total investment returns.

No surprise, the more positively-minded UBS believes that market sentiment will side-step the issue (for now) with the ASX200 projected to reach 4600 by year-end. That's around 2.5% on top of the double-digits achieved this year so far. Note that UBS has taken a more constructive view on miners and energy producers, while acknowledging that successful investment themes to date centred around "low debt", "quality of the business/balance sheet", "cash flows" and "yield" are far from outdated. These themes may well remain with us for much, much longer, admit UBS strategists.

Experts at BA-Merrill Lynch (BAML) and Macquarie hold a more subdued view than UBS. That's because they focus more on earnings growth potential and, as stated above, the signs are not that promising in Australia for the short term.

On Merrills' assessment, the projected 5% growth in EPS will be reduced to zero by June next year, which implies the Australian share market will continue to suffer from cuts and downgrades in the weeks and months ahead. The light in the tunnel, as Merrills sees it, is that downgrades to forecasts will moderate (there's only 5% left to reduce). For resources stocks, the worst is probably past us, but not so for the banks. Merrills' strategists seem genuinely concerned what'll happen to banks share prices if the unemployment rate spikes to 6% and bad loans will jump on the back of further deterioration in the domestic economy.

No surprise thus, BAML suggests the Australian share market is probably about fairly valued, but with no growth prospects and risks in particular high for domestic oriented businesses. The strategists single out Seek ((SEK)), Asciano ((AIO)), QR National ((QRN)), Toll Holdings ((TOL)), JB Hi-Fi ((JBH)), Harvey Norman ((HVN)), Wesfarmers ((WES)) and Telstra ((TLS)) for whom market expectations will likely prove too optimistic this year.

Macquarie strategists have adopted a slightly more optimistic view, though their conclusion is pretty similar to Merrills'. Macquarie suggests there will be some (low) growth in earnings per share this year, but current share prices already reflect this. So on a twelve months view, Macquarie sees no more than 6.3% in investment returns ahead, of which 5% will come from dividends. Equally remarkable is that Macquarie suspects the year ahead will yet again prove devastating for resources stocks with a projected total investment return of minus -9.3% for the sector against a positive 11.6% for the rest of the market.

Apart from taking a rather negative view on resources, Macquarie strategists are also of the view that lower interest rates will have a more limited impact on the Australian economy, lower than what used to be achieved under similar circumstances pre-GFC.

I remain of the view that the key to Australia's share market outlook lies with FY14 from here onwards. Under a positive scenario whereby US companies will resume growth and obstacles such as the US fiscal cliff, European debt and recession and the new growth pace for China can be overcome, I believe investors looking to re-enter the Australian share market will increasingly ignore FY13 and focus on FY14 instead. The main impediments to this shift in focus today are the fact that these obstacles are still very much in place and FY14 still seems such a long way into the future.

All these factors can look very different in six months' time.

Of course, the next question to appear on investors' radar will be how solid and trustworthy are these FY14 projections? By then, investors will seek confidence from changes and updated market signals, including:

– where is AUD/USD?
– what is the growth rate in China?
– is the RBA still on a loosening path?
– where are prices for commodities?

The trouble today is there are no watertight guarantees, not with regards to the major obstacles and not with regards to growth estimates for FY14. Which is why I believe all predictions about the death of the safety culture in the share market are premature and heavily exaggerated. Quality, safety and yield are here to stay much longer with us (also because FY14 forecasts for the quality and yield outperformers come arguably with less risks today).

To those who like to play around with numbers: on current consensus projections for FY14, and applying the current PE of 13.2, the ASX200 is projected to reach… wait for it… 4989. Alas, still not enough to beat the 5000 mark and that's on the assumption today's projections can be relied upon (which seems rather unlikely). In terms of investment returns this would translate into 11% capital appreciation plus 5.5% in dividends.

(This story was originally written on Monday, 15th October 2012. It was published on that day in the form of an email to paying subscribers).

Good news for FNArena subscribers: colleague Greg Peel has just finished an in-depth market update on rare earths elements (REE) which will soon be published in e-booklet format, for FNArena subscribers only.

I will soon be writing my follow-up on All-Weather Performers which will also be made available to all paying subscribers in e-booklet format.

(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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