Buy time, apparently

What is the reporting season saying about the stock market? Little surprise that brokers think that equities are cheap. Might be time to ring, well, a broker. The overall picture is certainly reasonably healthy, although that of course is historical and doesn’t say much about future price movements. According to Goldman Sachs sales were up 6.1%, EBITDA was up 9% and EBITDA margins were 11.3%. Most of this reflects strong cost control. Depreciation and amortisation were up 20%, although it is below its long term trend as a proportion of sales, reflecting falling investment levels. Net profit after tax rose 5% and dividends 10%.

The more important question is how this related to the forecasts, to what extent it was priced in. Share prices, of course, reflect expectations. Goldman is saying that forecast EBITDA margins have declined in this financial year, with downgrades across the industrial stocks. The two speed economy is (half) powering along. But this may be overly conservative, Goldman argues, given strong revenue growth expectations (7%) and GDP forecasts (3%). The conclusion is that there could be significant earnings potential in cyclical stocks that is not fully priced in already. The sectors to look at are: transportation, media, mining services, retail, materials, banks and services. Not too many sectors missed out there. But investing in underpriced cyclical stocks may be justified.

Perhaps the most significant thing to emerge is the dividend story. According to Goldman Sachs, the grossed up dividend yield is 6.6%, a positive spread of 163 basis points over the 90 day bank bill. That does suggest that equities are attractively priced, given that it is a strong return even if the market goes sideways. The number of stocks paying dividends increased from 127 to 139. Tellingly, metals and mining and gold were among the sectors to increase their dividends, sectors that are more usually principally capital gains plays.

This represents a pretty solid recovery from the GFC. Between 2008-2010 dividends fell by 30%, which was a better result than the 1990/91 recession when they fell by 42%. Mainly because Australia’s government guaranteed, nationalised banks were able to remain quite profitable and pay strong dividends. Even the A-REIT market is struggling back to life. The main cloud remains the residential property bubble and the effect that any weakness, or worse, could have on consumer sentiment and the banks. Investors worried about that (which seems to include a large proportion of readers) might like to look at the mining and agriculture stocks, whose value will not be determined by domestic considerations.

And stocks to pick? Macquarie has added: Boral, Santos, BHP Billiton, Lend Lease, Charter Hall, Beach Energy, Mermaid Marine, SAI Global to its conviction list. Crown, Rio Tinto and Resmed are being removed.

Goldman suggests:

• GS&PA forecast EBITDA margins for FY11 have declined over the last 12 months consistent with downgrades to our FY11 earnings forecasts across the Industrial stocks (ex Financials). Further reductions occurred during reporting season, albeit at a slower rate.

• GS&PA analysts are forecasting FY11 margins to be lower than FY10 (removing TLS from the sample results in a flat outcome). From a top- down perspective this appears conservative, particularly in light of our revenue growth (+7.0%) and GDP forecasts (~3%). Our analysts’ current FY11 margin assumptions remain well below historical averages.

• Large cap stocks with FY11 EBITDA margins (GS&PA forecasts) close to or below long-term averages (whose operating business mix has not changed significantly over that period and excluding banks) are:


• Conversely, large cap stocks with GS&PA FY11 EBITDA margins at, or close to, record highs (whose operating business mix has not changed significantly) are:

– DJS, QBE, WOW, CSL, MTS, ORI, COH, ASX, CCL, IPL, JBH, FGL. Investment View:

• Our margin analysis continues to highlight that significant earnings leverage potential remains in various cyclical stocks, assuming margins revert to long-term averages (or above) over time. Stocks that fall into this category and which we currently rate a BUY are: BSL, SGM, QAN, AMC, UGL, SUN, SEK, CWN, OKN, TEN, BLY and IRE.

• Our – Transportation (QAN, AIO) – Media (NWS) – Mining Volumes/Services (ORI, BKN, UGL) – Retail (WES, MYR) – Materials (AMC, OST, JHX) – Banks (NAB, CBA) – Services (CPU, BXB)

Macquarie – Thurs