It’s A Stock Pickers’ Challenge

This story features BORAL LIMITED, and other companies. For more info SHARE ANALYSIS: BLD

By Rudi Filapek-Vandyck, Editor FNArena

Probably the most important feature of the Australian share market, as the local reporting season (large cap) moves through its final week, is that the forward looking average Price-Earnings (PE) ratio is around 14 on prospective FY14 earnings per share (EPS) estimates.

Those among you with a good memory (or an easily accessible archive) will know by now the average for the past two decades is around 14.2x, suggesting "value" is an increasingly rare phenomenon in the local share market, even with only 30% of all listed stocks doing most of the hard work over the years past. ("Hard work" is making profits grow and achieving net gains for shareholders).

Add to this observation the fact that most equity market strategists in Australia remain of the view that profit forecasts for FY14 must fall in the year ahead, similar to the pattern that has occurred in previous years, and the key message for investors is as simple as it is straightforward: cautious stock picking remains but appropriate.

Meanwhile a few key conclusions can be drawn from the present reporting season:

– Corporate cost cutting is finally coming through (this should underpin margins and corporate growth for the years ahead)

– A weaker AUD is yet to make its influence felt (this feeds into market optimism for the year ahead)

– Growth in dividends continues to outpace growth in profits (this is not sustainable, of course)

– Resources stocks are no longer by definition synonymous with "disappointing" and "cuts to earnings estimates"; some miners and energy companies are actually enjoying upgrades

– Stockbrokers continue to issue far more downgrades to ratings and to price targets than they issue upgrades (see also the balance for the week past)

– Cracks have seemingly started to appear in the outlook for some of the best performers in the share market

– Hope is growing that (finally) consumer spending might make a turn for the better on the back of rising household wealth due to improving house prices in Australia

The latter conclusion is currently drawing attention from stockbrokers, funds managers and the like. With forward indicators and weekly auction clearance rates suggesting boom times are back for Australian property values, the logical knee-jerk response is to start looking for companies which stand to benefit from rising property prices and a general uptick in overall building activity. The problem with this is that investors have already been too eager in bidding up the share prices for many stocks that instantaneously come to mind.

Note that Boral's ((BLD)) share price topped out above $5.20 in March this year. The share price has since fallen to $4 and now sits around $4.25, but this still -believe it or not- represents a FY14 PE of more than 20. James Hardie's ((JHX)) share price (also down significantly from May) is now indicating a PE above 19. Others, like Fletcher Building ((FBU)) and Adelaide Brighton ((ABC)), have come off far less, and are trading on less elevated PEs (and better looking dividend yield) but they too require robust growth to (finally) come through in the years ahead to make an investment today worthwhile.

Note also that these companies will be on the receiving side when prices for natural gas in NSW and Victoria spike from next year onwards^(*).

One important observation was made by analysts at Goldman Sachs who noted the average dividend payout ratio in Australia is now approaching historical peaks previously seen in 1992, 1997 and in 2004. This suggests the Australian story about dividend growth outpacing growth in profits might be running on its final legs.

Analysts at Goldman Sachs seem to support that suggestion, judging by their following comment: "The index is currently yielding 4.7% on consensus expectations of 7.5% DPS growth in FY14. Historically, when the payout ratio has been above 65%, dividend growth has averaged only 1.5%"
 

On my own assessment, the story about dividends in Australia has received yet another big push with banks and resources paying out more than was expected this year (FY13), even though some still disappointed the market by withholding a speculated bonus pay-out (think CBA). As I have been predicting for a while now: the likes of Rio Tinto ((RIO)) and BHP Billiton ((BHP)) will increasingly start re-allocating more of their future cash flows to shareholders as the mining cycle moves beyond the heavy investment phase, and that's not to mention companies including Oil Search ((OSH)) and Santos ((STO)) turning into cash cows from next year onwards.

Woodside Petroleum ((WPL)) has already shown investors the sector can, and will, pay out more when circumstances change and cash flows remain abundant. Next year it will be the turn for Oil Search and for Santos to follow suit.

Maybe the underlying message here is that growth in dividends is likely to shift away from the usual suspects (banks, REITs, consumer discretionary stocks, et cetera) to less traditional dividend plays, including the big diversified resources and larger oil and gas producers.

Note also that Telstra ((TLS)) has been noticeably absent from any dividend growth stories for many years as the telco's board has promised 28c each year and that's exactly what shareholders have received since 2005, the occasional bonus payout not included. Telstra is now expected to lift its dividends both this year (FY14) and next to 29c and 30c respectively based on the NBN cash payments coming in from the Australian government.

Talking about dividends, isn't it ironic that the Greens are now becoming the parliamentary defenders of franking credits in Australia?

As per usual, picking stocks is all about what kind of growth lies ahead and what exactly is already priced in today's share price. One factor to add during reporting season is whether a company's financial report disappointed to the point that analysts had to revise downwards expectations and valuation. History shows these stocks are likely to underperform in the months ahead. So far, disappointers include Computershare ((CPU)), Brambles ((BXB)), Boral, Coca-Cola Amatil ((CCL)), BlueScope Steel ((BSL)), Invocare ((IVC)), QBE Insurance ((QBE)), Cabcharge ((CAB)), Leighton Holdings ((LEI)) and SMS Management and Technology ((SMX)).

Plus, of course, a whole slew of mining services providers. Any generalised number for earnings growth or valuations regarding industrials stocks in Australia should now be taken with a big pinch of salt as mining services providers effectively distort everything (cheap valuations, high implied yields, high growth potential, etcetera).

My personal view on this sector hasn't changed: in years to come investors will look back and discover that some of the stocks at today's prices have proved to be a bargain. The problem is that many in the sector will continue to churn out ongoing negative news in the year ahead and possibly even in 2015 still.

Investors willing to take the punt should consider the personal experience of a professional funds manager who stopped me in the street recently and told me he'd bought some cheap looking mining services providers stocks. Some of those stocks had rallied from their lows, but others had fallen even further. All in all, this funds manager told me, on balance there had been no net gains.

I believe anyone suggesting this sector has seen its lows must be a blind optimist and share prices will still reveal their risks and vulnerabilities in the year ahead. To be treated with caution and the appropriate risk appetite only.

For the record (and returning to the first theme in this week's story), UBS economists are anticipating a rather modest upswing for the Australian housing sector only, with property prices projected to increase 10% this calendar year and by a further 5% in 2014 as rising unemployment is somewhat tempering historically low interest rates. Housing credit growth should recover modestly to 5% ahead, say those same UBS economists.

This means that banks' prospects are also improving, albeit not spectacularly so (in line with market consensus forecasts).

Note some of the better performers to date seem to be running into valuation constraints this reporting season with price action for the likes of Amcor ((AMC)), CSL ((CSL)) and ARB Corp ((ARP)) lacking their usual vibrancy while momentum remains intact for the likes of Wesfarmers ((WES)) and REA Group ((REA)), where already lofty looking valuations are arguably inviting the arrival -at some point- of a downward spiral from investors taking profits and selling. All of these stocks are trading above consensus target and FY14 has only just begun.

Last week, I reported Citi strategists had reiterated their positive projections for the Australian share market. This week, strategists at UBS did exactly the same. UBS believes projections for FY14 profits are too high but a weaker AUD and stringent cost cutting should underpin profit growth for the year ahead.

UBS continues to target 5250 on the ASX200 by year end and 5400 by June 30 next year. AUD/USD is projected to fall to 85c by June 30th next year.

Here's how UBS believes investors should position themselves to capture most of the projected upside:

– Overweight beneficiaries of a weak AUD
– Overweight Energy
– Neutral Mining
– Underweight Yield
– Underweight Consumer Staples
– Neutral Domestic Cyclicals

(This story was written on Monday, 26 August 2013. It was published in the form of an email to paying subscribers on that day).

(*) See Are Rising East Coast Gas Prices On Your Radar?

(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)

***

THE AUD AND THE AUSTRALIAN SHARE MARKET

I have been researching and writing an eBooklet titled "The AUD and the Australian Share Market". From late July onwards this eBooklet has become part of the bonus package that comes with a 6 or 12 months paid subscription to FNArena. If you are not as yet a paying subscriber, maybe now's the time to consider joining?

My previous eBooklet (see below) is also still included.

****

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

****

Rudi On Tour

– A special thank you to all subscribers and readers who visited the FNArena stand or attended my presentation at the Trading & Investing Expo in Melbourne on Friday and Saturday.

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

– I have also accepted an invitation to present to ATAA members in Canberra in late November

– I might give my final presentation for the year at the ASA's Sydney Investor Hour in December

Click to view our Glossary of Financial Terms