Causes For Caution

This story features SUPER RETAIL GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: SUL

By Rudi Filapek-Vandyck, Editor FNArena

Are you concerned that equities offer more risk than reward, at least in the short term?

You are far from the only one. Equities, both local and overseas, have so far struggled to make any meaningful advance in 2014 and investors worry about rising risks in the Ukraine, in China, in Europe and even in the US.

Domestically, it should come as no surprise the trend in earnings estimates has now turned negative on the back of the first Abbott-Hockey-Cormann government budget, the seemingly endless slide in iron ore prices (with analysts now adjusting forecasts lower) and a stubborn AUD that remains close to US94c despite most forecasters calling for a return to sub-US90c.

Even then, it should be clear from recent company updates from the likes of Super Retail ((SUL)), Salmat ((SLM)), Boart Longyear ((BLY)) and Bradken ((BKL)), as well as from out of season financial results releases by the likes of CSR ((CSR)), Incitec Pivot ((IPL)) and Orica ((ORI)), that there's still a gap between what analysts think how Australian companies should be performing and what many companies are actually achieving.

Each of these events has forced consensus forecasts lower. Combine with reduced forecasts for iron ore, given (much) lower price levels than widely expected this month, and we now have a trend that has turned negative.

On Monday, Macquarie added more pain by declaring economists and analysts are underestimating the resilience of the local currency. Macquarie essentially forecasts AUD/USD won't go lower than 88c between now and 2017 (as an annual average) and this means, of course, a fair amount of earnings growth that had been assumed on the back of lower currency projections, has now been removed from Macquarie models.

On FNArena's calculation, AUD/USD has averaged a little above 90c so far this calendar year, but it sits at just under 92c on a three-month average and above 93c for the past four weeks, so it appears there's further downside potential from the stubborn Aussie battler, even on Macquarie's contary-to-consensus view.

Time to take another look at the eBooklet FNArena released in 2013, "The AUD and the Australian Share Market"? (see also bottom of this story) Making matters more confusing is Macquarie's preference for exactly those stocks that are now suffering from reduced profit growth expectations because of a stronger-for-longer AUD; the industrial exporters and multinationals with access to higher growth potential in foreign markets. Think CSL ((CSL)), Macquarie Group ((MQG)), Amcor ((AMC)) and Computershare ((CPU)).

The table below reveals exactly as to why Macquarie sticks to industrials with access to offshore growth, despite a negative impact from AUD. Banks, property trusts and resources are all facing a downward trend in profit growth, with less momentum projected in FY15 compared to FY14 and with no big bounce expected in FY16.

What is not evident from the table's generalised numbers, is that many domestically oriented companies such as Telstra ((TLS)) and Woolworths ((WOW)) are projected to only contribute to general growth in a rather modest fashion, so the pressure is on for the likes of ResMed ((RMD)), Brambles ((BXB)), James Hardie ((JHX)), Ardent Leisure ((AAD)) and the aforementioned names to tilt the average EPS growth number to a higher level next year, and the year thereafter.

(Source: Macquarie Research)

One other important feature to keep in mind is that, while projected growth for "resources" continues to look reasonable for the years ahead, there's some explaining to do for this category as well. As things stand right now, 2014 is widely anticipated to mark the high note for just about every producer of iron ore, regardless of scheduled production increases, with the sole exception of Rio Tinto ((RIO)). What is carrying those elevated growth numbers are the major gas producers whose multi-billion LNG projects are (finally) moving out of the construction phase and into planned production.

Consider, for example, Santos' EPS growth numbers (market consensus) are currently 22% and 50% for this year and next year respectively. For Oil Search, the corresponding numbers look even more impressive: 85% and 134%. The fact average growth projections for "resources" beyond the current year look rather timid against such growth numbers can serve as an indication as to what "mining" is expected to contribute, especially with nickel stocks on a high since late last year.

Strategists David Cassidy and Dean Dusanic at UBS make a point to highlight this diversion in their latest market update for Australian equities. An opportunity they seize to highlight the many headwinds that are building for corporate profits in Australia. UBS is working off different numbers than does Macquarie, but the underlying trend remains the same: both banks and mining stocks are expected to grow below market average in FY15.

As to exactly what this means for the outlook of the ASX200, I'll leave to everybody's imagination, but personally I'd be surprised if dividend yield won't prove yet again an important factor for total investment return by the end of this year, with the extra comment that both BHP Billiton and Rio Tinto's future are now more about capital management, dividends and the sale of non-core assets than about growth in profits.

Both price charts below, accessible via Stock Analysis on the FNArena website from today onwards, tell the story of most mining stocks in the Australian share market over what has been, overall, a generally disappointing period since mid last year.

First up is the chart for BHP Billiton. The top part shows that, apart from a major dip in the Northern Hemisphere's summer period last year, the share price has essentially traded sideways, offering more joy for traders who can play momentum each way than for pure play investors (unless they managed to pick the bottom).

The bottom part of the chart (which is what we've added) shows how consensus forecasts made a turn in February, around the release of BHP's interim financials, with EPS estimate for year two (purple) crossing over and remaining below the estimate for year one (yellow). Currently consensus is expecting a robust performance for FY14 (22% growth) to be followed by negative growth to the tune of minus 4.7%.

For Fortescue Metals ((FMG)), continued progress in production expansion and analysts' confidence in management's schedule have led to continuous increases for consensus expectations, albeit with a negative skew for next year since October last year when purple crossed yellow in the bottom part of the price chart. Since this month, projections for both years have now started to decline as analysts are reducing their price projections for iron ore.

Note: paying subscribers can now keep an eye on market expectations for around 400 ASX-listed stocks through the graphic display of EPS estimates at the bottom of each price chart via Stock Analysis on the FNArena website.

While the overall trend in Australia has now turned negative, there's no reason for investors to panic with most downward adjustments to EPS estimates confined to single digit percentage cuts, including for the major iron ore producers, would you believe.

Both the strategy teams at Macquarie and at UBS acknowledge the headwinds, and the downside risks, but both also remain confident their favourites, the above mentioned industrials with exposure to offshore markets, will continue to perform. The pity, from an investors' perspective, is that access to offshore growth is not a new theme, to put it mildly. It does raise the question as to when exactly the buyers will jump in as many of these stocks have lost some of their momentum in recent weeks.

This question becomes even more pertinent when one considers that, according to this week's update by quant analysts at BA-Merrill Lynch, the trend in earnings estimates is now negative on a global scale, affecting developing markets such as the US and Europe, as well as emerging markets in China and elsewhere in Asia.

On BA-ML's observation, "the scarcity of EPS growth remains close to recession levels in Europe, Asia and Emerging Markets. In Europe, only 45% of stocks have been able to grow EPS more than 10% in the last 12 months, a figure only lower in the recessions of 1991, 2001, and 2008. The numbers are similar in Asia and EM."

The general picture, and outlook, for profits in Australia certainly seems to fit inside this global framework (note the absence of the US).

BA-ML remains of the view that companies offering reliable, strong growth (even if most of these have sold off in recent weeks) will prove an excellent investment in the years to come, but nevertheless advises investors should consider rotating from "expensive Quality" to "inexpensive Risk" and from "Defensive Yield" to "Cyclical Yield". This advice remains based on the belief that global economic growth will follow through in the quarters ahead.

Too high expectations, however, should be tempered. Taking guidance from global price targets for individual stocks, BA-ML reports global equities remain poised for a 9% return in the year ahead, noting the gap between share prices and targets has remained within a 8-10% range for the last fifteen months.

In the short term, rising investor concerns and a negative trend in corporate profits -globally- suggest equities are looking towards more volatility and possibly more weakness. This in itself is likely to feed into investor anxiety. A recent study by Credit Suisse concludes the Australian share market seems poised to remain inside a low volume environment for years to come with the domestic economy poised to grow below trend, regardless of any more political shenanigans from Canberra, and not just in 2014 only.

However, data-analysis by BTIG supports underlying sentiment as expressed by Macquarie, UBS and BA-ML in that pull-backs and corrections ("Sell in May") should prove buying opportunities for investors prepared to look beyond short term uncertainty.

BTIG has done some data mining going back to the 1980s to try to determine what today's context actually means for equity investors. The analysis has zoomed in on this month's key characteristics for US equities: what does history show for full months in which both the S&P 500 and Russell 2000 were lower, as were 10 year note yields while oil prices and the USD were higher?

BTIG acknowledges its data-study only provides a rough reference, as it doesn't take into account valuations and a variety of other factors that can, at any given point in time, play an important role. Sticking to the core premise of the five factors mentioned above, only eight months have previously generated a picture as we are currently experiencing this month; Jan 1984, Sept 1984, Aug 1985, Oct 2000, July 2002, July 2004, Jan 2005 and Nov 2011.

Some of the conclusions drawn are:

– If these eight observations are any indication, one month forward performance risk is decidedly skewed to the downside, justifying the present cautious stance by many

– By three months out, returns balance out somewhat and then by six months out, returns are skewed considerably to the upside

– Only one instance — October 2000 — was a full blown bear market underway or imminently beginning

For specific data and calculations from BTIG's data-analysis, see below.

(This story was written on Monday, 19 May 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(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 2013 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 last 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 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 from the Australian Shareholders' Association (ASA) to present to members (and others) in Wollongong on June 10. Title of my presentation: The Share Market: Always The Same, Always Different.

Click to view our Glossary of Financial Terms