Under The Hood – September 2014

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In this week's Weekly Insights:

– Under The Hood – September 2014
– Crude Oil And The Great Geopolitical Divide
– Dividends And The Art Of Looking Forward
– AUD Weakness: Winners & Losers
– BHP Billiton And Support At 4% Yield
– Buy-Backs Rule
– Rudi On TV: The Week Ahead
– Rudi On Tour

Under The Hood – September 2014

By Rudi Filapek-Vandyck, Editor FNArena

It's impolite to look a gift horse in the mouth, but when you're about to buy a second hand car, it's no less than common sense to first take a look under the hood.

The question whether equities are still attractive is more often than not a case of "value is in the eye of the beholder". Yet I cannot help but notice there's a growing number of reputable funds managers who have started to reduce their exposure to equities, lifting cash holdings for when better opportunities might arise.

The latest communique from today's superstars at Magellan clearly states:

"We are lifting our cash weighting to increase the defensiveness of our portfolio in response to the massive compression in risk premia across multiple asset classes over the last 18 months. We believe there is an elevated probability that this risk compression will unwind over the next 12 months or so as the US Federal Reserve ends Quantitative Easing (QE) and investors focus on a normalisation of US interest rates. An unwind of the compression of risk premia combined with rising long-term interest rates could lead to a material correction in credit and equity markets."

Another local celebrity in the sector, John Sevior, previously known as Deus at Perpetual and nowadays co-founder of Airlie Funds Management, has said the ASX200 would need to drop by at least 10% for him to feel confident about reinvesting a huge amount of cash into equities.

Having gone through the numbers here at FNArena myself, I can only guess these experienced share market participants have drawn a similar conclusion to mine: the local share market is more expensive than it seems at face value.

Before I move on to our proprietary FNArena calculations, let's focus on a recent event I haven't seen in quite a while: on Friday, market strategists at Macquarie reduced their ASX200 target for the next twelve months.

Admittedly, the reduction is only 2% and largely inspired by a weaker iron ore price, so maybe the real message from Macquarie's market update is that the gap between resources stocks and the industrials has widened further. This is also reflected in Macquarie's projections which, if correct, imply the broader market remains poised to deliver 10.8% in total investment return in the year ahead, of which 4.9% will come from dividends (franking not included).

Macquarie's September 2015 "fair value" ASX200 index target of 5876 (down from 5998 previously) also implies Industrials stand to deliver a total return of 14.2% while Resources stand to deliver a negative return of -2.5%. Both return projections are including dividends.

Strategists at CIMB also updated their views and recommendations, but included no targets for the index. CIMB broadly sings from the same song sheet as Macquarie: investors looking to reduce exposure to banks and REITs and other high yielding defensives, says CIMB, should look at buying cyclical industrial stocks, not resources.

Reports CIMB: "Cyclical stocks are trading below peak cycle PEs, and expectations of future earnings growth are being supported by cost-out. This is not unusual at this stage of the cycle."

CIMB likes Asciano ((AIO)) and Brambles ((BXB)) and building materials stocks Boral ((BLD)), James Hardie ((JHX)) and CSR ((CSR)) but most of all Fletcher Building ((FBU)). In terms of portfolio composition, CIMB prefers to be Underweight Technology stocks, Telecom, Utilities and Consumer Staples, Neutral Financials and Materials and Overweight Consumer Discretionary, Energy, Healthcare and Industrials.

The strategists acknowledge high quality growth stocks in the preferred sectors are not necessarily cheap, but in many cases growth looks solid and above-market and this means share prices should rise further in the years ahead.

A similar picture emerges when we dig deeper into Price/Earnings (PE) ratios and consensus profit projections post the recent August reporting season. Below are overviews as published by Macquarie on Friday. As one would expect, variations between calculations by different brokers are large due to the widening polarisation in the share market. I would therefore advise investors to not get too distracted by the exact multiples and percentages in the tables below.

In each and every case the underlying observation remains the same: earnings prospects for REITs, banks and mining stocks look fairly benign, if not tepid for the years ahead. Energy stocks (those that are about to deliver on gigantic LNG projects) and Industrials stocks, as a group, seem to offer the best growth prospects. Unfortunately for investors today, many of those Industrials stocks are well-known, they have a proven track record and their reputation and history are now reflected in not so cheap PE multiples.

This is why CIMB strategists emphasise that stocks like CSL ((CSL)), Ardent Leisure ((AAD)), Seek ((SEK)), Carsales.com ((CRZ)) and Flight Centre ((FLT)) do not look cheap, but meeting current profit forecasts will translate into higher share prices and thus these stocks are still worth buying.

It's been a while since I calculated and published average PE values for the Australian share market. There's one very good reason for this: the share market is so polarised, it makes an average PE equally as misleading as it is informative. FNArena compiles and calculates its own data and consensus estimates. This allows me to clean and deselect and to come up with calculations that offer a truer picture of what really is going on in the share market.

A few examples of what we are dealing with today. Atlas Iron's consensus EPS estimate is projected to drop by 100% this year (in other words: a healthy performance last year is to morph into a nasty loss this year). Alumina Ltd is presently trading on a PE ratio in excess of 1300 (not a typo). Macquarie Atlas Roads is expected to experience a drop in EPS of no less than 96.6%. On the other end of the ledger we find that Fairfax Media is projected to more than double its EPS this year (100%+) and the same goes for GUD Holdings, GWA Group, Greencross and Horizon Oil. And Iress. And Independence Group.

It's not easy to select and deselect and there's a whole wide and varied bunch somewhere in the middle, making their contribution to average calculations. Where does one draw the line? Where does the inclusion of outliers stop being representative for the broader market? There's no golden rule, but I would surmise that uncorrected numbers in this context are as useful as an umbrella during a heavy snow storm in Canada. Nevertheless, on Macquarie's calculations the market is positioned for high single digit growth in the two years ahead, carried by Industrials (see also above). The conundrum comes from an historically high average PE which, on Macquarie's calculations, currently sits at 14.9 and only falls to 14.00 on FY16 calculations.

The long term average is in between 14.0-14.5 but take a look at the second table above and you'll see that Industrials are trading well above these values. Resource stocks look cheapest but this is not by default an indication of better value (see also Macquarie's projections earlier).

On Deutsche Bank's calculations, the average market PE sits at 15 while Industrials excluding banks are on average trading on 17.5x times FY15 EPS estimates; well-above the rest of the market.

On FNArena's calculations, the present average PE, as of Monday after the market has closed, stands at 16.6 and it only falls to 14.7 on FY16 projections. Average dividend yields are 4.2% this year and 4.6% next year. Average EPS growth shows up as circa 12% for both years. In other words: this market is far from cheap and there's certainly no shortage in profit growth expectations, especially not if we exclude miners, banks and REITs.

In June, I published an overview of where the major index constituents sat vis-a-vis consensus price targets, but little has changed on that measure and I am sure you all can look up the latest details via Stock Analysis on the website. You instinctively know the underlying story: banks and discretionary retailers are near or past targets, Industrials and Financials like CSL, Suncorp ((SUN)) and Telstra ((TLS)) are equally in the vicinity of targets, unless they come from a dark place, like QBE Insurance ((QBE)) does, while resources stocks look cheap and they have been for a while.

Probably the biggest threat for the local share market stems from the fact that current growth projections might prove too high. This is precisely the crux of an update on the local share market published by Goldman Sachs on Monday. Goldman strategists predict the Australian economy is losing the favourable tailwinds that allowed corporate Australia to post an unusually strong financial performance in FY14. Expect downgrades to forecasts is essentially what Goldman is suggesting.

The good news is that Goldman Sachs still has an ASX200 target of 5900 in twelve months time, so the upside trend should remain intact. The twist in the Goldman Sachs report concerns defensive yield stocks that are considered by many as a logical "short" given that bond yields are expected to rise next year.

Goldman Sachs disagrees and points at the fact there's essentially only a patchy transformation happening into growth in Australia and this, predict the strategists, means high quality yield stocks are best kept in portfolio.

As such, Goldman Sachs suggest investment portfolios should retain a defensive bias. The strategists are Neutral on Domestic Cyclicals but reduced Building Materials to Underweight and they move to Neutral on Consumer Discretionary stocks. They cut Telcos to Underweight on the basis of valuation, while moving Overweight on Non-Bank Financials (preferences are Henderson Group ((HGG)), QBE Insurance, Suncorp and Challenger ((CGF)), as well as Neutral on the Energy sector.

All in all, what all these strategists have in common is they don't advocate investors give up their cautious, nimble approach. Quality stocks are well-priced. Cheap stocks are not as cheap as they appear and in many cases they are cheap for a good reason. CIMB, for example, reiterates the view that mining services providers still have to endure two more years of sector downturn.

In the meantime, moderate your expectations, advocates Macquarie. In light of today's valuations, the changing perceptions about US interest rates and the many challenges that lay ahead for the Australian economy, this seems but apt advice.

Crude Oil And The Great Geopolitical Divide

Crude oil is part of the group of four commodities which, I predicted last year, should not participate in this year's price upswing for the sector in general. The other three are copper, gold and iron ore. So far so good and even the mandatory bounce (there always is one) is not going to wreck my track record in this matter.

That's not to say I am not surprised to see Brent trading below US$100/bbl, given geopolitical fragility. Soon, I suspect, market watchers will again turn focus to Venezuela and wonder: how long before sustained oil price weakness will reveal more cracks in this ever so fragile dictatorial wasteland?

The main question, however, remains unanswered: how come crude oil is not above US$110/bbl? History suggests that would be more logical inside today's context. The answer, a recent report by BA-Merrill Lynch suggests, lies firmly with the Kingdom of Saudi Arabia. BA-ML research previously showed how carefully managed output levels by Saudi Aramco, the country's sole, government owned oil and gas producer, have managed to keep the price of crude oil above US$100/bbl over the past five years. Until recently.

So what has changed? A clearer divide between Russia and the West, for starters. Plus the emergence of the Islamic State in Syria and in Iraq, right on the proverbial doorstep of the ultra-conservative Saudi Kingdom. BA-ML analysts now suggest the Saudis have changed strategic direction. Clearly, a cheaper oil price is going to hurt. It's because of this fact that the previous price-supporting strategy was deployed in the first place. But Islamic fundamentalism growing stronger on the back of high oil prices is going to hurt so much more. Call it a case of choosing the lesser of two evils.

It also gives the Saudis a chance to regain some of the former camaraderie with the Americans, as both Russia and Iran are but logical victims of oil priced below US$100/bbl. So despite all the talk about shale oil/gas and the new era of LNG, it appears it's still in the hands of the Saudis what the price of crude oil is going to be tomorrow.

The chart below shows BA-ML analysts might be onto something.

Dividends And The Art Of Looking Forward

I still love newspapers. Not like. Love. I dread the day that iconic mastheads such as the Sydney Morning Herald will no longer appear in print, but instead disappear behind a web address that offers 24/7 news bytes and stories. Newspapers still are the anchor, the benchmark and the main source for what goes around in terms of daily news in today's modern society. We all will rue the day when newspapers shall pass on that baton to.., erm, to…., yes, to whom?

There's one section in the news reporting that has never been the strongest feature of newspapers and it's finance. Newspaper journos are so much more comfortable when they operate inside the "business and economy" concept. The SMH's Money inlay magazine last week (Sep 10) provided yet another heartbreaking example. The main feature story, "Dividend fountain to keep on spouting", lists the Top 12 dividend payers in the Australian share market, starting with BC Iron (12.6% and 100% franked for a total pre-tax yield of 18%), followed by Arrium (11.46%, no franking) and Monadelphous (7.97%, 100% franked).

Strictly taken the info provided is not incorrect and it comes with the necessary caveats that yields will vary as share prices change and even that "future dividends may also vary". Problem is that once we start looking forward, only two out of the twelve stocks mentioned are not expected to cut their dividends in the year ahead. Yes, that's right: two out of twelve. And whoever genuinely thinks that stocks like BC Iron or Arrium are going to provide double digit dividend yields should either stop taking drugs or hand over their investment portfolio to someone with a clearer mindset.

FNArena has been educating investors since 2002 about the importance of looking forward, and I am personally proud of this fact today. Of course, looking forward is not an exact science but I'd be willing to take a bet -a BIG bet- that FNArena's consensus forecasts for the dividends of the twelve stocks mentioned in the SMH story will prove closer to the actual outcome than last year's payouts. And that, dare I say, is what investing is all about.

(Please see Stock Analysis on the website – as often as possible).

AUD Weakness: Winners & Losers

Up by the stairs, down by the elevator, as they say. One moment AUD/USD remains stubbornly close to 94c and one blink later it is threatening to sink below 90c.

This is probably as good as any moment to remind you all, you paying subscribers, FNArena published an eBooklet last year, titled "The AUD And The Share Market". It is free for those who have paid for their subscription (6 months or full year). Send us an email if you somehow missed out on your copy: info@fnarena.com

BHP Billiton And Support At 4% Yield

Ra-ra, why did BHP Billiton's ((BHP)) share price rise from below $31 to near $39 over the past 15 months? One of the contributors has been the weaker Aussie dollar. History suggests BHP shares find solid support whenever forward-looking dividend yield rises to 4%. In mid-2012, that 4% level was situated around $31. A weaker AUD pushed it up near $35.

Now BHP shares are again approaching that $35 price level and I suspect there won't be much downside left as the implied forward looking dividend yield is once again approaching the 4%, also thanks to a weakening Aussie. What makes the situation slightly different this time is that Rio Tinto ((RIO)) shares are now also at 4%. Both resources giants may find it difficult to grow profits without the extra-support from rising commodity prices, their cash flows throughout the remainder of this decade are to remain unusually high and this means one thing above anything else: those dividends remain super-solid.

Treat accordingly.

Buy-Backs Rule

I've labeled it the Americanisation of the Australian share market. Economic momentum might be patchy, and the Aussie dollar still very much too high. No real help can be expected from Canberra and top line growth is still a demanding target. But none of this stops boards rewarding shareholders, just like their corporate peers have done on Wall Street in years past. International research suggests a strong causation between companies who buy in their own capital and share price outperformance. At the very least, share buy-backs provide support to the downside in case of a defensive policy.

Here at FNArena, we've put together a list of companies that have announced buy backs:

Ansell ((ANN))
CSL ((CSL))
Donaco International ((DNA))
Helloworld ((HLO))
Karoon Gas ((KAR))
Telstra ((TLS))

Companies believed to potentially announce buy backs in the not too distant future:

Aurizon ((AZJ))
BHP Billiton ((BHP))
GWA Group ((GWA))
Rio Tinto ((RIO))

If you know of any more companies, do tell us and we'll investigate and add them to the list. Our address, as per usual, is info@fnarena.com

Rudi On TV: The Week Ahead

On request from readers and subscribers, from now onwards this Weekly Insights story will carry my scheduled TV appearances for the seven days ahead:

– Wednesday – Sky Business, Market Moves – 5.30-6pm
– Thursday – Sky Business, Lunch Money – noon-12.45pm
– Thursday, Sky Business – Switzer TV, between 7-8pm
– Monday – Sky Business – circa 11.20am (Broker Calls)

Rudi On Tour

I have accepted an invitation to present to the Sydney chapter of the ATAA, in Sydney, on November 17th.

(This story was written on Monday, 15 September 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

For paying subscribers only: we have an excel sheet overview with share price as at the end of August available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms