What If The Past Is Not An Accurate Guide?

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

By Rudi Filapek-Vandyck, Editor FNArena

The Australian share market is posting five year highs on improving sentiment, thin volumes and no tangible earnings recovery just yet.

This shouldn't be a problem, according to bullish market experts, as this is how the share market recovery story typically unfolds: share prices rally first, earnings momentum comes next.

Indeed, the latest market strategy update by Deutsche Bank is a typical reflection of such view: Australian strategist Tim Baker sees positive signals and green shoots everywhere, from resilient analyst forecasts to domestic indicators such as consumer confidence, house prices and labour market data.

Deutsche Bank, reports Baker, is typically positioned for a re-stocking cycle, through Toll Holdings ((TOL)) and Asciano ((AIO)), and a housing recovery, through Boral ((BLD)), BlueScope ((BSL)), Stockland ((SGP)) and Lend Lease ((LLC)), while favouring cheap cyclicals, including Downer EDI ((DOW)) and Myer ((MYR)).

Deutsche Bank's strategy falls in line with recent market movements and is backed up by historical precedents. Those long enough in the market know cyclical stocks start rallying well before there's any signal of improvement available, and then these cyclical stocks rally a lot further as earnings momentum follows through.

But what if history doesn't repeat exactly as investors are pricing in?

After all, Boral ((BLD)) shares are now on a forward Price-Earnings (PE) multiple of more than 25. JB Hi-Fi ((JBH)) shares are trading on a PE above 17 (and no less than 18% above consensus price target). GWA ((GWA)) shares are up more than 40% since June, currently reflecting a PE multiple of 20 and a share price some 17% above consensus target. The implied forward dividend yield, usually the prime reason for owning GWA shares, has collapsed to 4.3%.

And therein lies the conundrum for investors who are still looking to join this share market rally.

It's OK for pumped-up, enthusiastic market bulls to predict further gains for equities (and only few will contest such views with conviction), but what exactly does one buy when nothing appears to be genuinely undervalued?

Those Boral shares everybody seems to be constantly talking about rallied to $5.20 in March, when there was but hope and anticipation, but no earnings growth, and then swiftly dropped to $4 in a few weeks only. That drop of 23% can serve as an indication of what might happen when future growth won't keep up with today's expectations.

Admittedly, Boral shares have by now rallied back above $5 and that too can serve as a firm signal about the market's willingness to price in the inevitable recovery.

We still don't know to what extent Boral's profits will recover, but current consensus forecasts anticipate a big switch into the positive this year, followed by a 50% jump in FY15. On that basis, there could still be more upside for the share price, but any further upside potential certainly doesn't come risk free.

Market strategists at Macquarie and at Morgan Stanley recently published in-depth strategy analyses that were both characterised by the same underlying concern: what if the share market too easily assumes that everything will unfold in line with priced-in expectations from here onwards?

Both Macquarie and Morgan Stanley concluded there's likely a mismatch between current market expectations and what is yet to unfold next, in both cases with strong suggestions growth in profits will not match present expectations.

However, both teams of strategists also believe the share market will be higher in twelve months' time, offering double digit returns.

It is Macquarie's view that things really are different this time around and the coming recovery won't be as strong as during past precedents. Macquarie is projecting a milder, more gradual recovery in key pillars such as construction activity and consumer spending. It goes without saying this opens up a gamut of possibilities that the likes of Boral, JB Hi-Fi and GWA are pricing in too much, too soon.

Morgan Stanley has formed the view that expecting a solid jump in profits this financial year (FY14) will simply prove too optimistic. Hence why investors receive the advice to largely ignore FY14 and concentrate on FY15 instead.

Investors should note both strategy teams hold rather subdued expectations for commodity prices in the year ahead, so no run-away share prices in the mining sector should be on the agenda either (at least not in a sustainable fashion).

Macquarie has labeled the current recovery in Australia as the "long, grinding cycle". The underlying theme is: yes, the earnings cycle is turning, but don't expect a swift bounce higher in profits as last happened in 2002. This implies that cyclicals carry a lot more risk than in the past. The strategists have taken a detailed look into cyclical sectors discretionary retail, building materials, media, transport and diversified financials.

Their conclusion is investors are better off with companies that rely less on top line growth and more on margin recovery to meet market expectations for profit growth.

In concrete terms this means, among other things, that JB Hi-Fi looks a much better bet than Harvey Norman ((HVN)), David Jones ((DJS)) or Myer ((MYR)).

Fletcher Building ((FBU)) seems the best bet in the building materials sector, while Boral's margins might well surprise to the upside.

Seek ((SEK)) appears to be good value in the media sector, while Fairfax ((FXJ)) is likely to remain in a down cycle for at least the next two years.

Perpetual ((PPT)) looks like good value among wealth managers.

Remarkable, on Macquarie's analysis, is the fact that many of the solid outperformers from years past are still less dependent on higher sales and revenues to deliver continued earnings growth for shareholders, including companies such as REA Group ((REA)), Amcom Telecom ((AMM)), ResMed ((RMD)), Brambles ((BXB)) and Navitas ((NVT)).

Equally important is that Macquarie's analysis shows many companies are 100% dependent on top line growth to finally come through, or else there will be disappointment.

This is not exactly music to the ears of strategists at Morgan Stanley who have come to the conclusion that FY14 will simply morph into yet another year of sub-par earnings growth, like just about every year in Australia since 2008. But FY15 should finally start delivering on expectations.

Morgan Stanley has selected the sectors that are poised to represent the best value on that basis:

– Insurance
– Diversified Financials
– Energy
– Companies linked to housing construction
– Industrials and Transport
– Consumer Discretionary (best sector among all, according to MS)

Note Morgan Stanley is Neutral on yesteryear's outperformers the banks, real estate and healthcare, but negative on miners, staples, telcos, IT and utilities, and very negative on capital goods (which includes mining services providers).

In terms of individual companies, MS has selected AMP ((AMP)), Perpetual, Goodman Group ((GMG)), Lend Lease, Stockland, Fortescue Metals ((FMG)), Oil Search ((OSH)), WorleyParsons ((WOR)), DuluxGroup ((DLX)), REA Group, Brambles, Mineral Resources ((MIN)), 21 Century Fox ((FOX)), Domino's Pizza ((DMP)), Flight Centre ((FLT)), Navitas, Super Retail Group ((SUL)), Treasury Wine Estates ((TWE)), ResMed ((RMD)) and Sonic Healthcare ((SHL)).

Note that Morgan Stanley has broader interpretations of sectors, with 21 Century Fox, Domino's Pizza, Flight Centre, Navitas and Super Retail Group all selected from the "Consumer Discretionary" basket, instead of usual suspects such as David Jones, Harvey Norman and Myer.

Investors should also consider with AUDUSD back above 0.96, Australian companies are not enjoying the long awaited FX relief.

(This story was written on Monday, 21 October, 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)

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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.

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 on November 19, which shall be my final presentation for calendar 2013.

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