Smaller Cap Industrials: Re-Rating Or Bubble Threat?

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

In this week's Weekly Insights:

– Smaller Cap Industrials: Re-Rating Or Bubble Threat?
– China Threat Ongoing
– What If Lower Growth Is The Future?
– The Oil Search Valuation Tool
– Rudi On Tour
– Rudi On TV

Smaller Cap Industrials: Re-Rating Or Bubble Threat?

By Rudi Filapek-Vandyck, Editor FNArena

Give a man a number and strange things can and probably will happen.

In his 2011 master piece Thinking, Fast and Slow^(*) (a must-read), Daniel Kahneman showed how judges penalised less or more in court if they had been exposed to lower or higher numbers beforehand, even if the choice of those numbers was completely random.

But researchers of the human behaviour don't necessarily have to go through lengthy peer-reviewed research to prove the all-importance of numbers to the human mind. Keeping one close eye on the local share market could be sufficient.

CSL

In the run-in to the August reporting season -overall sentiment was still reasonably okay- investors' attention was once again piqued by the question: which stock is going through the $100 barrier first? Thus from the moment CSL ((CSL)) shares reached into the high $90s, it just had to be CSL. Had to be.

In a mad frenzy that lasted a few days only -no specific news to carry anything- the share price surged above $100… and then lost all momentum.

Sure, we can blame China, the US Fed and those nasty hedge funds turning negative on Emerging Markets and on Australian shares, but realistically, I think CSL shares would have dropped anyway.

I was watching the share price closely at the time (CSL is in the All-Weather Model Portfolio) and honestly there really was no other reason for CSL shares to jump higher in that first week of August, other than to get the share price on the other end of the $100 mark, answering the question: who will be the first?

The magic of numbers.

The magic applies even more when we're dealing with smaller cap stocks. Lesser research. Lower volumes. More traders looking at a price chart. You get the idea.

Blackmores

CSL might have been the first in 2015 to cross the $100 mark (both Incitec Pivot and Rio Tinto already did it years ago), But it didn't last. Enter food supplement manufacturer Blackmores ((BKL)).

A few weeks after CSL shares briefly captured everyone's attention, Blackmores became the next stock with a three digit share price on the ASX. Imagine the following scenario. Sharp retreat in global risk appetite pushes the Blackmores share price to $84 on August 25. The next day brings a bounce back so the share price rallies to $90.

Then JP Morgan comes out with a revised price target of $98. That very same day Blackmores shares close at $100. The next day it closed at $109. By then some funds managers had been quoted the share price could go as high as $150. Goldman Sachs also updated and introduced a share price target of $143.

Blackmores was always going to reach that $150 mark, I thought. And it did. As a matter of fact, the share price reached as high as $155 last week.

The magic of numbers.

Last week, when I pointed out smaller cap industrials have been the star-performers on the local share market this year, I also added some of the stocks I have been watching seem to be over-shooting to the upside. Blackmores is one such example.

After reaching $155 (twice – intraday on Wednesday and by opening on Thursday) momentum has shifted and the shares have quickly landed in a funk a la CSL. On Monday (today) the shares closed at $132.58, a whopping $22 below where the price was only two sessions ago.

One does not have to look back to 2007 or to tech stocks in 2000 to recognise a "bubble" – it happens in individual cases in the share market on a regular basis. Remember when everybody had to own a piece of mining services providers?

Re-Rating?

Investors like to herd and to cheer each other on. Right now, smaller cap industrials are the Go-To segment in the share market, as I explained last week. Probably the only thing preventing this from getting out of hand too much as yet is the fact that part of the investor and trader community is re-discovering the attraction of resources stocks. Contrary to most industrials, there still seems a lot of undervaluation for mining and energy stocks, and the stars have been aligning for a rally off multi-year lows.

I remain skeptical about the longevity of the rally in mining and energy stocks, so I'd be treating them as trading opportunities only. The present re-alignment of demand and supply will proceed slower than most anticipate, in my view. But every portfolio needs at least a few smaller cap industrials, unless they start reaching for the stars. Like in the case of Blackmores.

As said, there's far less research available for this market segment, but in many cases the research we have at our disposal can still be used to our advantage. What Blackmores has in common with the likes of iSentia ((ISD)), IPH Ltd ((IPH)) and APN Outdoor ((APO)) -to name but three out of many more such examples- is that share prices have rallied beyond consensus price targets, which can be easily checked on the FNArena website (go either to Stock Analysis or to Icarus Signal).

According to my thirteen years of local market observation, this makes these stocks susceptible to a sudden, downward correction, a la what Blackmores has been experiencing since Wednesday last week. In particular if the share market were to be hit by yet another wave of sudden risk aversion.

Below is the price chart of APN Outdoor which, as you can clearly see, is now acting purely on ongoing upward momentum, as if there were no fundamental limits to what the shares are actually worth. UBS downgraded last week and that seems to have had only a temporary impact.

For those not yet familiar with FNArena price charts: the greyish zone indicates the consensus price target. The share price respected this target as its upper limit, until this month arrived. Now the share price is well and truly above it.

One scenario wherein the market could be right, and analysts covering the stock wrong, is when investors as a collective decide that stocks such as APN Outdoor, growing at high pace and seemingly with the wind in the sails, deserve to trade on a sustainable higher Price-Earnings (PE) multiple, because they are rare to find in a market that is mostly "growth challenged".

In that case a PE ratio of 18.3x on 2016 forecasts plus a dividend yield of 3.3% on a payout ratio of 60% doesn't seem outrageous at all. But that is the open question that remains as yet unanswered for the super-stars of 2015.

Equally important is that FNArena shows all individual price targets that make up the consensus target in Stock Analysis on the website. The importance of this is it allows investors to remove the laggards and so correct the automated consensus which includes all. In some cases of strong momentum, such as Blackmores' until Thursday last week, I tend to simply focus on the highest targets available.

As per always, and in particular for these types of stocks, there are no universal truths, no rules or tools that work always & all the time. I did notice, for example, Bellamy's ((BAL)) shares never really made it to stockbroker Morgans' $8.50 target, but they have been on a slide downwards since, Blackmores-style.

I certainly will be keeping a close eye on further developments. There's plenty to watch too.

See also last week's "Small Cap Industrials In Focus"

Morgan Stanley's Favourites

After I published last week's special on smaller cap industrials stocks, analysts at Morgan Stanley released a report on Friday explaining why they believe investors should focus on mid-cap stocks showing "cycle-agnostic growth" and "defensive qualities".

While proclaiming "it is different this time", the analysts believe such stocks are likely to outperform the traditional blue chips (I like it when investment banking analysts support my own research).

Morgan Stanley's top picks are:

– Offering cycle-agnostic growth: Mantra Group ((MTR)), Domino's Pizza ((DMP)), Burson Group ((BAP)), Aconex ((ACX)) and Corporate Travel ((CTD))

– Offering defensive characteristics: Aveo Group ((AOG)), InvoCare ((IVC)), Japara Healthcare ((JHC)), TOX Free Solutions ((TOX)) and CSG Ltd ((CSV))

Citi's Favourites

Citi analysts updated their Big Ideas in Small Caps:

Top Calls amongst Industrials are Aconex, Charter Hall Group ((CHC)), Karoon Gas ((KAR)), McMillan Shakespeare ((MMS)), MYOB ((MYO)), News Corp ((NWS)), NextDC ((NXT)), Super Retail ((SUL)) and Tower ((TWR)).

Top Calls amongst Resources: Oz Minerals ((OZL))

(*) I once dedicated one Weekly Insights to Kahneman's career defining Thinking, Fast and Slow; FNArena Book Review: Thinking, Fast and Slow, March 2012.

China Threat Ongoing

Deutsche Bank analysts just returned from a trip to the USA and their conversations indicated one thing above anything else: US investors are far from convinced the world's second largest single-country economy has rescued itself, and other Emerging Markets, from the persistent growth slow down that continues weighing on forecasts for 2016.

To be fair, Deutsche Bank analysts also note the experience from past years shows US investors tend to be more bearish on China than peers elsewhere. That exact same sentiment was echoed by analysts at Macquarie, also back from a US visit. Macquarie analysts did pick up a switch in negative focus. "Unlike previous trips when clients were more concerned about structural issues like debt and property, this time questions are concentrated on short-term hard landing and RMB devaluation risks".

For good measure, Macquarie does think fears for a hard landing and capital outflows in China are overdone, even though the house forecast is that China's GDP growth will continue slowing to 7% GDP growth this year, to 6.5% in 2016, and to 6% in 2017. This is despite expectation for further stimulus. Put a gun against their heads and Macquarie analysts will tell you the biggest threat from China is not a short term "hard landing", but a reduction in China's growth pace over the medium to long term as capital is being misallocated to support short term policy outcomes.

Meanwhile, China experts on the ground for CLSA have issued a warning the Chinese authorities might go full throttle in trying to put a stop to capital outflows. This, warns CLSA, can lead to major consequences for Australian companies. Not only is James Packer's Crown Resorts ((CWN)) heavily invested in Macau, and Chinese success in limiting capital outflows should be gravely felt via lower money flows at Macau casinos, but also in Australian property markets as Chinese investors have become a force to be reckoned with in places such as Sydney and Melbourne.

At this stage, CLSA is only assuming relatively modest success in Chinese authorities' clampdown attempts, which should affect the apartment building cycle in Australian cities; an asset Chinese property investors have liked very much in years past. While any impact on companies such as Lend Lease ((LLC)), CSR ((CSR)) and Boral ((BLD)) is believed to be relatively modest for the next three years at least, CLSA has grabbed the opportunity to take a more bearish stance on Australian banks.

CLSA's resident banking specialist is sector veteran Brian Johnson, previously of JP Morgan fame, who points out approximately 38% ($565bn) of the $1.49tn Australian housing loan portfolio relates to investment property, "where speculators bear the brunt of a significant post-tax negative carry trade in anticipation of future capital gains – take away the expectation of a capital gain and correlated selling by this cohort could be problematic".

Johnson also points out CommBank ((CBA)) and Westpac ((WBC)) are the bigger housing banks in Australia, "and CBA is overexposed to WA".

Analysts at Morgan Stanley updated their own set of data and China insights and concluded, yes indeed, it appears things in China are stabilising, albeit at relatively subdued levels. Yet this might well be fantastic news for everyone who'd like to see a rally into year-end, with the analysts pointing out: "More financing is becoming available and the central government is pledging to take back funds for projects that have not yet been started by local governments. This suggests a late-year increase in infrastructure spending, which would be positive for materials and industrials".

The same sentiment was expressed by commodity specialists at Citi who are now anticipating mining stocks to put in a rally into year-end, but also that at some point in 2016, we'll be right back where we were last month. But that'll be a worry for next year.

Those speculating on yet another all-in, awe-inspiring stimulus program to put this trend of slowing growth to bed once and for all would not have liked to read the latest analysis by GaveKal which concludes "more of the same" is more likely to persist for much longer.

"This is not the disaster scenario that some fear, but neither is it hugely reassuring. Heavy industry is already in recession, and as business conditions stay weak, financial stress on a significant swathe of corporate China will intensify. Though the labor market is overall in good shape, conditions will still worsen and there are already layoffs in some regions and industries. As a result, “more of the same” looks unlikely to reverse the prevailing trend as growth takes another step down towards 6% in 2016."

What If Lower Growth Is The Future?

One of the key questions haunting today's politicians and investors is whether the world has now entered a prolonged new era of slower growth. If the answer is affirmative this will have major consequences for just about everything; from government policies to interest rates, to financial assets, to corporate investment hurdles, you name it.

But not everybody is on the same page on this. Far from it. Place four economists in an isolated room to discuss the thematic and you'll get four different views and predictions. Five if one of them studied at Harvard. (I had to use this old joke at least once in my life time).

As you would expect, I'll be mentioning a few things about it in my upcoming eBook (watch this space). One of the analysts who has no qualms about admitting he is on the side of the secular stagnation forecasters is Satyajit Das. He just published a whole new book about it: A Banquet of Consequences.

Even if you are rather skeptical about it, any self respecting investor should at least familiarise with the pros and cons, and potential consequences, for the years ahead.

Das's latest video on the theme: https://youtu.be/zHlbFh9QnEk

Direct link to his newest publication: http://www.booktopia.com.au/a-banquet-of-consequences-satyajit-das/prod9780670079056.html

The Oil Search Valuation Tool

I like it when analysts come up with an easy-to-apply tool that doesn't expire overnight. I like it twice as much when I am able to share it with subscribers and members at FNArena.

Last week, UBS analysts increased my happiness by releasing the chart below. It not only shows that, on their assessment, Oil Search ((OSH)) is incorporating a higher oil price in its share price (take-over premium), but also what the share price should be if investors want it to reflect a higher or lower USD price per barrel.

Analysis by the same analysts also revealed most share prices in Australia already suggest a price recovery next year is more or less "baked in" so to say with even "cheaper" priced sector minnows such as Drillsearch ((DLS)) suggesting an oil price above US$50/bbl will be the norm in 2016.

Rudi On Tour

– My next presentation will be to clients and contacts of Affinity Wealth (affinitywealth.com.au) on a boat in Sydney Harbour, Friday,October 16.

Rudi On TV

– on Thursday, Lunch Money, noon-1pm

(This story was written on Monday, 12 October 2015. 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.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via Editor Direct 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

Odd as it may seem, but today's share market is NOT only about dividend yield. Post-2008, less risky, reliable performers among industrials have significantly outperformed and my market research over the past six years has been focused on identifying which stocks, and why, are part of the chosen few; the All-Weather Performers.

The original eBooklet was released in early 2013, followed by a more recent general update in December 2014.

Making Risk Your Friend. Finding All-Weather Performers, in both eBooklet versions, 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 September available. Just send an email to the address above.

Click to view our Glossary of Financial Terms