Rising Risk Of Downward Pressure

This story features MOUNT GIBSON IRON LIMITED, and other companies. For more info SHARE ANALYSIS: MGX

By Rudi Filapek-Vandyck, Editor FNArena

When you keep a close eye on what's happening in terms of stockbroking analysts' ratings and forecasts, as I do, the following prediction is a relatively easy one to make:

The Australian share market is about to be hit by a wave of downgrades.

First victims will be commodity stocks. Prices for copper and iron ore are now well below where most analysts thought they would be this early in calendar 2014. The longer these prices stay at current levels, the more confident analysts will be to reduce their short and medium term forecasts.

This process has already begun with both CIMB and BA-Merrill Lynch updating price forecasts last week and in both cases coal (both coking and thermal, but in particular coking) and iron ore have seen cuts to price estimates for the years ahead. CIMB remains more positive on the short term outlook for copper than BA-ML is, but even CIMB acknowledged:

"In the near term we expect copper prices to remain clouded by shadow financing related inventory movements in China".

It's not all bad news though as both teams of analysts also lifted price forecasts for gold, though CIMB remains bearish for the years ahead, while BA-ML predicts gold will bottom out this year and then gradually grind higher.

What both also have in common is that forecasts for most minerals and metals continue to show higher prices in the years ahead, in particular for nickel and zinc, but also for uranium, rutile and zircon, and for alumina and aluminium.

This then throws up an interesting dilemma for investors in resources stocks: do you sell because short term performances are likely to come under pressure, or do you buy more into weakness in anticipation of better times ahead in 2015?

In terms of direct share price impact, smaller, single commodity stocks, like Mount Gibson ((MGX)) or Whitehaven Coal ((WHC)), will be more pressured than sector heavyweights BHP Billiton ((BHP)) and Rio Tinto ((RIO)) as both are supported by dividends and upcoming capital management opportunities. On my observation, BHP shares continue to find solid support whenever forward dividend yield rises to 4% and I believe this will remain the case.

In the bigger scheme of things, it's not as if resources stocks have provided a lot of support to market indices so far this year, and most investment portfolios are probably underweight the risky end of the Australian sharemarket (further backed up by recent funds manager surveys) while major customer China has kept anxiety levels high in the first three months of the year through weaker than expected economic data and a worrying clamp down on shadow banking and liquidity.

In other words: it is possible that the direction of resources stocks' share prices will be determined by macro-factors such as expectations for another mini-stimulus program by the Chinese government or said belief that fortunes for most commodities other than iron ore, including coal would you believe, will markedly improve, if not later in 2014, then surely in 2015?

If correct, this means any correction to the downside must come from the industrials (apart from offshore, macro driven events).

Here the potential for major disappointment is unusually large, as pointed out by a few worried market analysts. According to John Woods and his team of market analysts at CLSA, this year the number of companies on the ASX that relies on a good second half to justify PE ratios and meet or exceed consensus expectations is much larger than in previous years with almost 60% of the ASX200 dependent on such acceleration in H2.

It goes without saying, this opens up all kinds of possibilities for downward adjustments in the weeks ahead, including corporate profit warnings. In the wake of last week's profit warning / corporate restructuring / heavy dividend cuts by troubled retailer Metcash ((MTS)) quant analysts at Macquarie remind investors:

"Stocks typically underperform for up to a month post a profit warning… The excess return after 20 days is typically -3.3%. This trend has continued into 2013 with stocks facing stronger downward pressure one month following the event."

Sectors that rely heavily on profit growth in H2 include retailers (both discretionary and staples), gaming, energy, healthcare, utilities and IT plus various "industrials" including GWA Group ((GWA)), GUD Holdings ((GUD)) and Transpacific ((TPI)), as well as a number of mining services providers.

For good measure: this does not automatically imply that all these companies are under threat of a de-rating between now and August, it simply means there's now a higher than usual risk for downgrades and downward adjustments, outside the miners and explorers that are already feeling the pain from falling forecasts.

Despite the elevated risks, CLSA reports in 2012 a similar situation had emerged and back then three-quarters of the so-called "Second Half Club" actually rose to the occasion and delivered, which underpinned the rally that took off from the middle of that year. But 2012, says CLSA, was merely the odd exception. Last year, 70% of the companies in the Second Half Cub were downgraded during the May confession season. Only a quarter was upgraded.

Even if 2014 proves better than last year, one would have to acknowledge the possibility of downward pressure between now and reporting season in August, depending on what scenario exactly is going to play out?

Investors are being reminded that negative adjustments in the short term do not necessarily mean the company hit will be out of favour or due a de-rating, it still very much depends on what happens to expectations for the year(s) ahead.

I also believe all of the above will keep demand high for proven All-Weather Performers, such as REA Group ((REA)), Domino's Pizza ((DMP)), Flight Centre ((FLT)) and G8 Education ((GEM)). As I stated in last week's Weekly Insights, the risk that any of these high PE companies issues a profit warning is much lower, hence the high demand and the premium PE.
 

Metcash: The Dividend Warning Story

Last year I returned to Chatswood for a presentation to members of the Australian Investors' Association (AIA). My very first presentation ever in the role of FNArena Editor was back in 2008, on invitation of the local AIA representative in Chatswood. During the closing Q&A part I received a question about Metcash ((MTS)). I declared anyone still in there for the dividends should re-consider because I felt pretty confident market dynamics were about to force management to cut the dividend.

At that time the share price had already come down from $4.60 and was bouncing in between $3.60 and $3.00, or so it appeared. Today, we know the future is all about stopping the squeeze from Aldi, Coles and Woolies, and about paying less to shareholders. The share price is now at $2.60 and dividends are likely to be cut in FY15 and again in 2016, after FY14 saw a cut already. It is my understanding the investor who asked the question sold his Metcash shares in the week after my presentation and he joined as a paying subscriber. Obviously, avoiding one sinking submarine is worth many times more than a measly $360 in subscription fees, and I agree wholeheartedly.

The underlying morale of this story is not to get blindsided because of dividend legacies from the past. A lesson that should have been learned from previous shipwrecks including Fleetwood Corp ((FWD)) and Transfield Services ((TSE)). In my view, Metcash also is yet another example that when it comes to assessing the outlook for equities, investors should spend more time on learning about market dynamics, instead of putting too much focus on PE ratios, dividend yield, past performances and management statements. As far as I am concerned, market dynamics trump just about everything else.

China: The Land Of Many More Defaults

There will be many more debt defaults from corporate China and it's just about anyone's guess as to how exactly this process of debt re-risking is going to unfold and play out in the months ahead, including the Chinese authorities. While a repeat of the 2008 Lehman Bros experience is utterly out of the question (for starters because China is not integrated into the global financial system), there will be consequences, of course, as there always are. Will commodity prices be affected? Probably, as more debt with commodities as collateral is likely to receive margin calls and hit the open market.

More worrisome would be an impact on investor confidence and on actual commodities demand, which could be the end result in case many more property developers go bankrupt and/or steel manufacturers shutting down operations. So far, China watchers remain of the view that Chinese authorities will jump to the rescue if their own domestic version of too big too fail ends up in trouble.

BHP: The Myth Of Diversification

When asked the question: "BHP Billiton or Rio Tinto?" most experts will choose BHP on the principle that BHP is "well diversified", while RIO has essentially become an iron ore play (90% of annual earnings). But how diversified is BHP really and how much of an advantage is this going to offer in the years ahead?

Circa 50% of all BHP profits come from iron ore, with coal, copper and oil and gas taking up the rest. Coal has been in a severe downtrend for a few years now and judging by the latest analysts' sector updates, a turnaround is not yet around the corner. Copper has finally succumbed to the fact that supplies have caught up and prospects for the years ahead, even after the Q1 slump, don't seem spectacular. Crude oil is still in a sideways pattern and has been for years now but the number of analysts predicting lower prices, in the absence of geopolitical unrest, is growing.

Bottom line: so-called diversified BHP will have to rely on production growth and cost cutting to create more shareholder value. Luckily, for shareholders, margins for producers of copper and iron ore remain high, in particular for low cost producers as is BHP. But most of the cash flows in the years ahead will still be generated via the iron ore division, which is why some analysts are preferring Rio Tinto instead. More cash flows from iron ore means more opportunities for capital management.

To be continued. (see also below)

Iron Ore: The Bear Case Scenario

For a long while it appeared the iron ore market had been visited by the ghost of Irish writer Samuel Beckett, for despite all predictions about a downtrend kicking in, it never seemed to actually happen. Until it did, of course, and with China's spot price Fe62% seemingly stabilising at around US$110/tonne we are now well and truly off the peak at US$180/t as well as off last year's peak of US$140/t. Most analysts still retain rather modest predictions for further price falls in the years ahead, believing high cost producers in China and elsewhere are going to keep the price above US$100/t for longer.

Not so at Goldman Sachs where Australian analysts maintain the view that US$80/t is on the cards for 2015 (but that would be the bottom). The analysts rightfully point out such a price fall will have dramatic consequences for just about everybody in the sector. Consider the projected margin contractions on Goldmans' calculations: RIO -49%; BHP -55%; Fortescue Metals ((FMG)) -68%; Arrium ((ARI)) -86%; Atlas Iron ((AGO)) -86%; and Mount Gibson ((MGX)) -86%.

Despite all of this, BHP retains its $40 price target at Goldman Sachs, as well as the sole Buy recommendation in the sector. Rio Tinto only enjoys a price target of $65 -in stark contrast to all those $80 targets elsewhere- and a Neutral rating. Only two iron ore producers are currently on Sell ratings: Fortescue and Mt Gibson. Goldman Sachs has a price target for Fortescue of $4.20, well below the rest of the market, and below the current share price.

(This story was written on Monday, 24 March 2014. 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)

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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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