So, We’re Becoming ‘Normal’ Again?

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

By Rudi Filapek-Vandyck, Editor FNArena

If we take a broader, macro view on what has been happening in the Australian share market over the past twelve months, then one conclusion stands out: valuations for equities have normalised from depressed, bear market valuations.

Last year's first round of normalisation was all about attractive, and reliable, yield plays and solid, sustainable and equally reliable growth achievers whose Price Earnings ratios were brought back to what can be regarded as the usual, bull market type valuations. (I use the term "bull market" here as the flipside alternative to "bear market", not suggesting we are about to return to the dynamics of 2004-2007).

Unfortunately, for Australian investors, stocks that fell into either of both categories only represent about 30% of all listed entities and so it was that the index normalised to its long-running average PE by April-May this year but most diversified investors didn't immediately see those gains reflected in their portfolio, with whole sectors such as mining services providers and resources stocks seriously lagging the broader market performance.

Those laggards have now (finally) started to catch up and certainly recommendation downgrades by stockbrokers in majority have that one factor in common: normalising valuations means short term valuations in general are no longer by definition "cheap".

Most brokers will tell you the share market's average PE on forward looking FY14 earnings estimates today starts with a 14, implying the market is valued at or near its long term average. On FNArena's adjusted calculations (we take out the nasty outliers) the average PE is around 15 while fiscal 2014 has only just commenced and most strategists remain of the view that profit forecasts retain a negative bias.

Forget about quibbling whether the share market is fair value, slightly expensive or overvalued, at a time when confidence seems to be rising about the prospects for equities in the year ahead, the underlying message should be loud and clear: not everything listed on the ASX is by default a screaming buy and many stocks that are moving up today, carried by post federal election relief and a tempering in Fed tapering projections, may not necessarily offer investors with an attractive return in the year ahead.

In a simplistic set-up this becomes: general market optimism versus stock specific valuations.

Assuming nobody's banking on exuberant stock market valuations once again (or: just yet), it would appear that "timing", "stock picking" and "valuations" should once again be high on investors' watch lists.

A normalisation in valuations for ASX-listed stocks also implies the return of consensus price targets as a tool for investors and, in extension of these targets, the return of my personal market valuation gauge; banks' share prices versus targets.

Those among you who have been long enough on the mailing list for FNArena's Weekly Insights will no doubt remember the close correlation in the past between banks share price exuberance and the share market's tendency to subsequently correct to lower levels. However, if investors all of a sudden start pricing bank shares on dividend yields, and no longer on growth and PEs, then price targets become pretty meaningless too.

Which leads us to the key question: where are we in terms of banks and targets?

A few obvious observations stand out:

– CommBank ((CBA)) remains by far the most expensive of the lot in Australia. The implied forward dividend yield, with prospects for reduced franking under the new Abbott government, is only a tad above 5%.

– ANZ Bank ((ANZ)) has become the new laggard among the Big Four as investors have caught up by now that investing via minority stakes throughout Asia does not automatically add to short term growth. Plus, of course, Emerging Markets have been turned into the world's financial laggards this year and this has lifted the risk profile and thus also ANZ's discount.

– The previous sector laggard, National Australia Bank ((NAB)), has been receiving support from stockbrokers predicting FY14 might finally become the year that NAB catches up and achieves the highest growth pace in the sector in Australia. The share price has already moved in anticipation. (Not that it is the first time such predictions have coloured market sentiment towards NAB).

– Including Monday's share price improvements, three of the Big Four are now at or above consensus price targets, but ANZ Bank shares are still some 5% below.
 

Based upon my historical observations and experiences with this market indicator, it is probably fair to say the banks are telling investors the same story as does the share market's PE: it's getting a bit pricey but that doesn't necessarily mean share prices cannot move higher in the short term. The easy gains are gone. There's no obvious exuberance that makes a share market correction inevitable.

In the meantime, a non-specific, non-detailed stroll through price targets and share prices on the FNArena website (see Icarus Signal) shows many share prices have started to behave in a manner that looks a lot like pre-2008. See, for example, how the CSL share price has now been rejected three times in the past three months every time the price approaches the $70 level. Consensus target sits at $68.62 and there are quite a few analysts around who question whether slower growth ahead won't translate into a lower PE for the stock. You can include me on this as well.
 

Similar questions surrounding Insurance Australia Group ((IAG)) have now pulled the share price back below consensus target. The same has happened to Telstra ((TLS)) shares. And the same applies to M2 Telecom ((MTU)), Coca-Cola Amatil ((CCL)), Primary Healthcare ((PRY)) and to ARB Corp ((ARP)), to name but a few others.

Having said so, it's also obvious this normalisation process still has some way to go. FNArena's Icarus Signal shows no less than 112 names that are all trading above consensus target. This group is an amalgamation of growth recoveries being priced in in advance, to beaten down trading stocks, to mining services providers that have enjoyed strong rallies on the back of short covering, to defensives, All-Weather Performers and yield stocks that remain popular today.

Mining and Energy stocks have experienced a market-beating run since the dip in June, but most are still trading below targets, albeit those large looking gaps from earlier in the year have now narrowed considerably. See, for example, Santos ((STO)) below.
 

Quant analysts at Macquarie have also made some interesting market observations and they too fall in line with the idea that the share market is returning to its usual valuation constraints and dynamics. Only this time it meant that outperformers during reporting season in August have turned into share market laggards as far as their share price performance goes, while many of the disappointers last month have outperformed the broader market (and thus also those companies who delivered a better-than-expected financial result).

Usually it works the other way around, note the Macquarie analysts (and I can confirm their observations).

This then suggests some of the better performers in terms of financial reports in August are starting to look a lot better from an investors' perspective.  Macquarie's Quant team has nominated JB Hi-Fi ((JBH)), ResMed ((RMD)), Skilled Group ((SKE)), Transurban  ((TCL)), Arrium ((ARI)) and CommBank.

On FNArena's tally (see Reporting Season Monitor) no less than 61 companies delivered a clear beat with their financial performance in August, but some of them, like REA Group ((REA)) and Woolworths ((WOW)), are also trading well above target. As is CBA from Macquarie's list, of course.

This again confirms the danger of following "momentum" in a share market that no longer looks cheap. Long term investment returns tend to be more closely correlated with the valuation at the time of purchase. This is why I don't believe dividend stocks will genuinely fall out of favour in Australia. As a matter of fact, the dividend theme is about to make some decisive inroads into the mining and energy sectors here in Australia. Has anyone checked what the yield is on iron ore producer BC Iron ((BCI)) lately? (Coincidentally, BC Iron's share price has also been pulled back below consensus price target these past few days).

We are less than one year away before investors can start looking forward to the likes of Santos, Oil Search ((OSH)) and, potentially, Origin Energy ((ORG)) turning themselves into cash rich dividend plays too. Woodside made the first transitionary step earlier this year. Its share price is now offering 6% dividend yield and has just moved above consensus target. Investors looking to accumulate more shares might be better off waiting for the pullback. Unless, of course, global energy markets are poised to deliver an upside surprise, or Woodside is.
 

(This story was written on Monday, 9 September 2013. It was published on that day in the form of an email to paying subscribers).

(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)

This story contains no less than five price charts. If you are reading this through a third party channel and you cannot see them, we apologise but technical limitations are to blame.

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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.

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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

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Rudi On Tour

– This week, 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