Big Banks And Big Resources

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

By Rudi Filapek-Vandyck, Editor FNArena

This one is for those readers who have been on board the Weekly Insights email for many years.

Last Friday, I caught up with a funds manager in Sydney to talk about prospects for the local equities market. At some point he asked me: explain your banking stocks indicator. I replied: Easy! Bank stocks above consensus target signals market sentiment is probably a little too hot and share prices are temporarily overbought.

As FNArena reported on Thursday: that day ANZ Bank ((ANZ)), the laggard amongst the Big Four, rallied above consensus target. It remains too early to draw any definitive conclusions, but I would not be surprised to see weakness popping up for the days and possibly weeks ahead.

It never is a good idea to use one single indicator as a stand-alone signal, but this time around technical analysts are talking about "short term overbought" signals, which is exactly what my personal market indicator is pointing out.

Having said this, it's probably not a good idea for long term investors to spend too much time on this. The future for the banks looks -if anything- to be improving and there's plenty of talk about extra dividends from the sector.

My best guess is share prices will quickly recover from any weakness, as well as that upcoming financial results will look OK and price targets are more likely to increase than not in about a month's time.

But, and this is in line with what I reported earlier, the normalisation of share price valuations on the ASX has also revived my Never Fail Personal Market Indicator and last Thursday, in my view, has put banks share prices versus targets back in focus.

(For more info on this indicator, see below)

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The warning signal from the banks comes at a time when share prices for the large diversifieds in the resources space have also found the going getting tougher. BHP Billiton ((BHP)) shares don't seem able to decisively move away from the $35-$36 region while Rio Tinto ((RIO)) has managed to rise above $60 (it has traded below that since March) but sustainability of these levels still remains an open question mark.

This despite commodity analysts at both Macquarie and Citi issuing some very interesting in-depth analysis on both resources companies this month. Long term investors in particular should take note.

The first conclusion drawn by both teams of analysts is that neither BHP nor RIO has been able to genuinely benefit from rising commodity prices in the last decade, even though the period included probably the heftiest upturn for the sector in modern history. The problem is that rising commodity prices were only one side of the story, admittedly the one that attracted most of the attention as that is how financial markets operate, but on the other side of the ledger rising costs and currency movements eroded a big chunk of the price rise benefits.

Because production volume increases were rather tepid through the period, the past few years has seen virtually no profit increases for both companies (on a net basis). No surprise thus, shareholders haven't really seen much in terms of benefits either since 2006, apart from dividends and bottom-up rallies (for those who had their timing right).

Note that amongst all the hullabaloo about equities being in a long-lasting bull market the Resources sector index in Australia is still in the negative to date for calendar 2013!

Most analysts are not expecting much in terms of price rises for commodities in the years ahead, so it would be easy to assume both BHP and RIO will prove poor investments for the years ahead.

It is here that this story receives an interesting twist: not so, suggest both teams of commodity specialists.

For starters, what has been lacking thus far -sizeable increases in production volumes- is finally starting to happen, including for iron ore and for copper. While this should keep a lid on prices, and thus on profits for smaller players, both BHP and RIO should be able to generate benefits for their shareholders.

Macquarie makes the salient point that during commodity bull markets, both share prices cannot keep up with price rises but during bear markets both shares  tend to outperform deflating commodity prices. I think this is where investor sentiment comes in. I have made the connection multiple times in the past and Macquarie sort of confirms my market observation by concluding that share prices of BHP and RIO tend to move in line with equities in general during austere times, largely ignoring any assumed correlation with commodity prices (which thus remains very low).

The underlying message here is that investment returns from owning BHP and RIO shares in the years ahead are likely to outperform returns from the years past, even without any sizeable increases in prices for commodities. Indeed, even with projected price falls for the one commodity that remains key for both juggernauts: iron ore.

The secret, so to speak, lies in the reversal of the drivers during the commodities bull market: prices are lower, and not likely to revisit the highs from the past, but costs are being lowered, volumes will crank up, investments will trend lower, capital management will come to the fore (think rising dividends) and there should be Australian dollar support instead of currency headwinds.

Citi, whose team of commodity specialists had the audacity late last year/earlier this year to call the End of the Super Cycle, believes BHP and RIO will be able to grow profits by between 57-63% over the coming five years; this despite forecasts for further weakening commodity prices.

Note that Rio Tinto will largely remain a derivative of iron ore, while Australia's most important bulk commodity is of lesser importance to BHP, but still iron ore is to remain the group's largest contributor to cash and profits.

The most important conclusion for investors, no doubt, is that both Citi and Macquarie suggest BHP and RIO are likely to transform into share market outperformers between now and 2020. Macquarie calculates that, including reinvestment of dividends, both stocks should generate on average some 15% over the seven years ahead.

This is where the irony starts as Rio Tinto's return during 2001-2012 was lower on the back of a troubled Alcan acquisition. Apparently, these kinds of returns were also achieved during the bear market of 1990-2001 when RIO outperformed because BHP had a disastrous acquisition called Magma Copper. Again, all these calculations assume received dividends were reinvested in new shares.

Interestingly, Macquarie's historic analysis suggests overall performances for both stocks are heavily influenced by the fact that investors refuse to accept troughs and peaks as permanent features. In practice, this translates into higher PE multiples when times are tough and to PE contraction when times are good.

Putting bull and bear markets together, and assuming dividends are reinvested, BHP and RIO shares have on average generated returns of 13.1% and of 13.4% respectively between 1990-2012. On a net basis, commodity prices have only been responsible for 30% of total shareholder returns over the period.

The remaining 70%, points out Macquarie, relates to a combination of volume growth, movements in operating margins, capital management and changes in valuation multiples.

Because the AUD moves in line with commodity prices (or at least that's the theory) it doesn't get a mention with Macquarie stating the AUD is what helps both companies keeping operating margins relatively stable throughout both times of the cycle.

Macquarie, by the way, is slightly more optimistic on the outlook for commodity prices than is Citi, with Macquarie analysts suggesting we are near or past the trough for most metals and basic resources.

Macquarie has now shifted its preference away from the energy sector towards BHP and RIO instead.

Below are the projected earnings drivers for both juggernauts for the five years ahead, according to Citi. Note also that most of the projected gains are expected to occur in the three years ahead. In practice this means 2014 and 2015 should be strong years for both.

And here are the prospective volume growth drivers for both in the three years ahead.

(This story was written on Monday, 23 September 2013. It was published in the form of an email to paying subscribers on that day).

(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 two charts. If you are reading this through a third party channel and you cannot see the charts, we apologise but technical limitations are to blame.

Of potential interest:

– BHP At $25?

– Diversified Resources Turning Into… Banks!?

– Investing In Commodities: A Mini-Guide

– Investing In Commodities: A Mini-Guide (vol 2)

And for those who are as yet not familiar with my personal market indicator (banks share prices versus consensus targets):

– Banks Now Overpriced – What Does That Mean?

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July this year forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

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

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

Ignore at your own peril.

This eBooklet was released in January this year and is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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Rudi On Tour

– I have 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