Australia Remains Hard Work

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

By Rudi Filapek-Vandyck, Editor FNArena

Prologue

Global financial markets are in a mild state of turmoil ever since the Federal Reserve flagged its unprecedented liquidity support for US financial assets is not going to last indefinitely.

Global investors have responded by repatriating funds back into homefront USA and Japan, the two largest carry-traders in the post-GFC era. The immediate impact has been noticeable around the world. In Australia, the domestic currency is now well below USD-parity while banks and high yielding stocks in general have suffered significant price falls as international funds flowed out of domestic assets.

Meanwhile, larger resources stocks have suffered far less with dividend support announcing itself, but also because international and institutional investors had already long gone underweight or they exited altogether.

The Big Frustration among local investors, both retail and institutional, is that the closing of the extreme valuation gap between banks and high yielders and the higher risk industrials and commodities stocks on the other side of the spectrum has merely narrowed through share price weakness for the first group and only a tepid recovery for the second group. It's as if the darker days for the Commodities Super Cycle are here to stay forever!

In response to emails from investors complaining that "fundamentals no longer seem to count" in the Australian share market I thus respond: don't complain, try to benefit from the departure of foreign money from Australian shores. How else can you ever buy some solid looking, long-term opportunities at much lower share prices? Special note: I do expect volatility and possibly more weakness to persist for longer.

Below are some observations from the research desk I wanted to share with you this week.

****

From the illustrious commodities research desk at Citi…

These analysts have been predicting the end of the Commodities Super Cycle since last year and last week they reversed their general sector call to Neutral. Citi's update on the sector did not contain a lot of encouraging news, however. The Neutral call is more a reflection of the view that most of the sector's weakness is now behind us, though Citi sees little, if any, catalysts on the horizon to propel all those beaten-down small and mid-cap mining and energy stocks into a strong, broadly carried rally.

The general view remains that investors should be wary of more bad news to come. Balance sheets are under pressure, especially in the mid-to-small tier segment. Cash flows have diminished. Costs are still a problem. Funds are hard to attract. If commodity prices remain where they are, there's more bad news to follow, suggests Citi.

As things stand right now, and assuming prices do not change materially, resources stocks could be in for a prolonged down-cycle in earnings forecasts. The key terms are now "sufficient cash (flow)", "low cost producer" and "dividends". Management teams still think they are building future growth companies while investors have already abandoned that prospect and prefer to focus on yield and dividend growth instead.

Since BHP Billiton ((BHP)) shares are, on Citi's calculations, trading near fair value, the logical conclusion is that dividend focus and support have already kicked in for the Big Australian. Most peers, including Rio Tinto ((RIO)), are still trading at sizeable discounts to what Citi analysts consider fair value, hence their prediction that other low cost producers with sustainable cash-flows will start falling into line with BHP. Both Rio Tinto and BHP Billiton are far better placed than any of their international peers in terms of sustainable cash-flows and dividends. This is not the first time, Citi, other analysts or myself are highlighting that particular point.

Having said so, the sector remains at risk of further sell-downs with Citi arguing a weakening RMB (to assist Beijing in supporting domestic growth) might have an adverse impact on China's commodities demand (as it makes USD-purchases relatively more expensive).

One argument put forward by Citi in particular caught my attention. Global institutions are currently underweight the sector and they have been underweight since at least the middle of last year. If these investors move back to Neutral, so one bullish argument goes, this change could have a significant impact on the sector. True, but Citi counters by observing the relative weight for the sector overall is in decline, so moving to a neutral sector allocation requires a lot less buying orders than would otherwise have been the case.

Meanwhile, Chinese authorities remain in no hurry to stimulate their economy other than at the fringes. Negative stories about Chinese debts are going to stick in investors' minds for a while longer too.

Rio Tinto, in the form of its UK equities, is one of few only in the sector Citi analysts would recommend -globally- without extra caveats or reservations.

Global investment strategists at UBS believe it is time to shift more exposure to growth equities; in the US share market, not necessarily in Emerging Markets or in Australia. The philosophy behind this advice is that the Federal Reserve will starting winding down its extreme stimulus only when the US economy truly is in better shape. This means growth stocks such as technology and banks will grow earnings and thus become more attractive.

There's no mention about resources stocks in the UBS assessment, except that global energy stocks were downgraded back to Neutral. The advice is to be significantly overweight US stocks, significantly underweight Europe plus the UK, and neutral everywhere else. If UBS's in-house view proves correct, QE tapering by the Fed probably will not start until early 2014, meaning we are going to have a long time preparing for it in advance!

Here in Australia, UBS economists have been doing some number-crunching on which domestic sectors have been running below historical earnings trends in the past three years when the Aussie dollar was strong. The implication is that, now AUD is anticipated to fall to much lower levels in the years ahead, those sectors should mean-revert back to their historical trends, at the very least.

UBS's data-conclusions, though simplistic (even on their own admission), are very encouraging indeed. No less than 15 out of 19 sectors have been running below average historical earnings growth over the past three years. One very straightforward and equally simplistic conclusion would thus be that a much weaker currency will translate into a massive boost for corporate Australia, and for the Australian economy in its entirety.

Domestic sectors likely to benefit the most from a return to a lower AUD environment are, on UBS's assessment, (in order) media, manufacturing, finance & insurance, retail trade, utilities, accommodation (tourism) and construction.

UBS also highlights both mining and mining services have been running above historical earnings trends over the past three years.

Things never are that simple, are they? BA-Merrill Lynch points out many domestic oriented companies may, in theory, receive some welcome relief from a weaker Aussie dollar, but most have many other demons to deal with, such as the ongoing deleveraging by Australian consumers. So BA-ML would strongly advise against stacking up on domestic oriented stocks. Many of them will prove toxic is the underlying suggestion as share prices might rise (on simplistic assumptions as suggested by UBS) but if risks of profit warnings materialise, those share prices are likely to respond accordingly.

BA-ML economist Saul Erslake is predicting two calendar years of sub-2% growth for the Australian economy. If this proves correct, even the banks will suffer, is his argument. His advice is to seek out domestic companies with less cyclical earnings, such as Ramsay Healthcare ((RHC)), Wesfarmers ((WES)), Carsales.com ((CRZ)), Mirvac ((MGR)), Echo Entertainment ((EGP)), Aurizon ((AZJ)) and Suncorp ((SUN)) plus, of course, industrials stocks with large offshore exposures. BA-ML likes James Hardie ((JHX)), Brambles ((BXB)), News Corp ((NWS)), Amcor ((AMC)) and Crown ((CWN)).

And -surprise, surprise!- BA-ML also likes (selected) resources stocks. Not because of a fundamentally different view on China and prices than Citi, but because share prices have fallen so far. Too far, thinks BA-ML. Hence why Rio Tinto, Iluka ((ILU)) and BHP Billiton have been selected to stay Overweight the sector.

Over at the energy desk, BA-ML analysts believe a slowing Australian economy is going to work in favour of local LNG players. Not only because of the widely anticipated spike in gas prices in the eastern states, but because of 1) reduced wage inflation and an end to the skills shortage; 2) likely improved productivity as capacity constraints wane; 3) a weaker AUD; and 4) increased government acceptance of cost saving technologies such as floating LNG.

The main beneficiaries, predicts BA-ML, should be Santos ((STO)) and Origin Energy ((ORG)).

All in all, I think the underlying message from all this is the Australian share market very much remains hard work. There's no such thing as an easy opportunity. Risks are a-plenty and best not to be ignored. Buying should be selective and measured, in line with the level of risk acceptance. This is not an environment wherein yield stocks and All-Weather Performers^(*) will be forgotten about any time soon.

(*) DO YOU HAVE YOUR COPY YET?

At the very least, my latest e-Booklet "Making Risk Your Friend. Finding All-Weather Performers", which was published in January this year, managed to accurately capture the Zeitgeist.

All three categories of stocks mentioned in the booklet are responsible for the index gains post 2009 and this remains the case throughout 2013.

This e-Booklet (58 pages) is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com

(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. All views are mine and not by association FNArena's – see disclaimer on the website)

****

Rudi On Tour in 2013

– I will present and contribute during the 2013 National Conference of the Australian Technical Analysts Association (ATAA) at the Novotel in Sydney's Brighton Beach, later this week, from June 21-23 – see also further below

– I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm

– I will also present at the upcoming Trading & Investment Expos in Melbourne and in Sydney (more info in weeks ahead)

****

ATAA National Conference – Success! Strategies For Profit & Capital Protection
June 21-23 Sydney
Novotel Brighton-le-Sands

With the registrations close to capacity, there is now less than a week to get your forms in. The conference will include 13 highly regarded speakers (both local & international) on a range of topics including:
Dr Alexander Elder, who will open with his presentation “Five Key Tools of a Pro Trader”.
Jay Gragnani (Tom Dorsey Associates) – Understanding Point & Figure Charts To Identify Opportunities In Global Markets
Colin Nicholson – A Sharper Focus on Chart Patterns
Manesh Patel – Understanding Ichimoku Charts
Sinan Koray – Discretion: The Silent Killer of Your Profits and Capital
Nick Radge – A portable Strategy Designed to Capture Momentum
Michael McCarthy – Which Is The Most Appropriate Indicator
Brent Penfold – The Benefits of Mechanical Index Trading During Both Bull & Bear Markets
Peter Pontikis – Intermarket Technical Analysis, Dynamic Asset Allocation and Capital Management In An Aging Secular Bear Market
Chris Weston – Global Currency Wars And The Impact On Australian Markets
Adam Sorab – Technical Analysis – A Global Perspective
Rudi Filapek-Vandyck – Where Fundamentals Meet Technicals (and Vice Versa)
Daryl Guppy – Follow My Trade (and Gala Dinner Presenter).

There are also Meet The Speaker sessions on Friday evening and a new, special event, ‘Dinner With the Speakers’, where presenters will host an intimate table of 8-10 guests as part of the Saturday evening Gala Dinner, with Daryl Guppy as the main after dinner speaker. ($140 per couple, including pre-dinner and dinner drinks).

To register please go to the ATAA website for registration details or click on the following links:

Conference Brochure: http://www.ataa.com.au/file/ATAA_Conf2013_Brochure.pdf
Registration form: http://www.ataa.com.au/file/ATAA_Conf2013_Registration_Form.pdf

Click to view our Glossary of Financial Terms