We have reached the end of perhaps the most difficult financial year on record, but as Simon Bonouvrie explains, at Platypus Asset Management, the outlook for the Australian market remains positive. 
It seems probable that the market established a major cyclical low in March 2009 and, from the way it has traded since then, it is unlikely to enter a major consolidation phase until we reach the mid-4000s level on the All Ordinaries index.
The mid 4,000s index level is an appropriate short-term target for the market from a number of perspectives. It represents approximately 15 to 16 times forward consensus earnings, a number which represents the historic median PE multiple for the market, and is also the level where the market was trading around the time of the Lehman Brothers collapse. If one considers we are trading on trough cyclical earnings, then the current PE multiple may understate the value inherent in today’s stock prices. In the mid 4,000s we expect the market will track sideways for a while until the economic fundamentals become clearer.
Furthermore, there is no longer justification for investors to be pricing in another systemic financial collapse of the same magnitude as Lehman. We believe that prices below levels seen last October (mid 4,000s) are pricing in a worsening systemic risk situation, which may not eventuate. Central Banks and Governments appear to have done enough to stabilise the financial system, and this is starting to be reflected in improving economic data.
In Australia, this data is suggesting we are closer to the end of recession than the beginning. The parts of the economy that would be expected to respond to massive monetary and fiscal stimulus (housing, retail) are responding, and should make up for continued weakness in business investment and the inevitable weakness in net exports. In addition, investor sentiment is turning more positive, as evidenced by the resumption of inflows into equity funds and the strong participation in the many equity capital raisings since March. "Leading" economic indicators such as consumer sentiment, business confidence and retail sales are showing signs of improvement, while credit market indicators such as LIBOR and TED Spread have also improved, which should give confidence that the financial system has reached a sustainable level of stability.
Investors are still displaying a "buy the dips" mentality; hence we believe corrections will be shallow. The most recent pullback at the start of May, both here in Australia and in the United States, has been more of a sideways pattern than a fierce correction. The general feeling is that investors do not want to “miss the rally”, therefore at Platypus we believe that any market pullbacks will be well supported with buying. From a technical perspective, the market looks to be breaking out of a basing pattern, so this could add further momentum to buying support.
As investors – both professional and retail – start to return to the sharemarket, the lessons of the last financial year shouldn’t be forgotten. These include:
- Companies with excessive amounts of leverage should be avoided e.g. Allco, Babcock and Brown, MFS, Centro etc
- Stock prices can fall much further than you think, particularly when sentiment takes hold of a market and drives stock prices well below their fundamental value. This occurred in many of the mining services stocks, where solid companies with strong balance sheets were trading on one or two times earnings. There was a "fear" that the end of the mining boom would mean the end of these businesses.
- Understanding the consequences of counterparty risk, especially for over-the-counter (OTC) derivatives. Lehman Brothers was the counterparty to many OTC transactions and some investors didn’t properly consider or understand the risk involved in selecting and accepting counterparties to derivative transactions.
If these lessons are kept in mind, there are now a number of tempting opportunities for investors. As stated above, we believe that corrections will be shallow and, as such, buying during the pullbacks should be a good strategy. Stocks that are showing technical strength or leadership are worth keeping an eye on. However, to be considered as an investment opportunity, a company must have a strong balance sheet and the ability to grow earnings strongly once the economic cycle begins to properly recover.
A major theme in the market will be rotation in and out of specific sectors/stocks to make money. For example, Banks and Resources led the start of the market rally, whilst Industrial stocks initially lagged. After their strong start, banks have tracked sideways for the past two months. Resources have continued to remain strong and Industrial stocks have caught up from their initial underperformance. It is probably time to start taking profits in the sectors that have outperformed and adding exposure to the lagging sectors, such as Financials.
We believe that the market is underestimating the potential earnings recovery for certain banks, based on our view that the bad-debt cycle will peak during financial year 2010. The bad debt situation, so far, has been contained to large corporate collapses.
We think middle market corporates and retail consumers will hold up better than some commentators suggest. CBA and WBC are attracting the largest percentage volume growth in new business and have strong provisioning levels relative to risk weighted assets. Technically, these banks have shown leadership, bottoming in January compared to the overall market bottoming in March.
On a twelve-month forward P/E, CBA and WBC are trading on about 12 times earnings (PE), on what we consider to be trough cyclical earnings. During a bear market we think it is appropriate to analyse bank stocks from a price-to-book basis, and banks do not look overly cheap on this basis. However, as it becomes clearer that the stock market recovery will be sustained, we think that the market will shift focus to the earnings power of these banks and accordingly value and benchmark the banks on a price-to-earnings basis.
Toll Holdings is another interesting proposition for investors. It has a strong balance sheet, a good appetite for acquisitions, and has performed well through this economic downturn. Its ambition is to consolidate the freight forwarding market in Asia and Australia, with the goal of moving more volume through their network. It is highly leveraged to any pick-up in global GDP and will benefit from inventory restocking. Toll is trading on 14.5 times forward earnings, which is cheaper than the international peer group average of 17 times forward earnings. Global freight sector stocks such as UPS and Panalpina trade on approximately 22 times earnings, which adds valuation support to Toll at current levels.
Another company to investigate on a stock price pullback is David Jones. Sales fell by about 10 percent at the bottom of the cycle; however their profit growth was still positive. This comes down to management's ability to control costs and prepare for a downturn, in which David Jones did well. It also has a strong balance sheet in the retail space, which has helped them to weather the difficult trading conditions. Anecdotal evidence suggests a strong rebound in department store sales occurred during the months of April and May 2009. Recently, David Jones’ major competitor, Myer, upgraded sales and profit growth forecasts for the year end to July 2009. This forecast should help contribute to more positive sentiment towards the sector.
Simon Bonouvrie is portfolio manager at Platypus Asset Management, an Australian equities joint venture partner of Australian Unity Investment
JULY 2009