Un-normal analysis

Broker analysis relies heavily on looking at the fundamentals: assessing earnings forecasts, the validity of future earnings multiples, and discounting back to the present from the future. That tends to be highly normative. That is, it works best when markets revert to the norm: normal consumer demand, normal economic activity, normal price earnings ratios and so on.

Of course, that does not always happen, and picking when it will not happen is the key to getting above average returns. We have just seen one such non-normal shift. The market is down about 10% from its recent highs, despite the fundamentals mostly looking good. That is partly because of sentiment, but mainly because what is happening in Australia is anything but normal. A once in a lifetime mining boom, a once in a lifetime property boom, post-float highs for the $A, the gradual end of the property wealth effect on consumer demand, a possible reprise of the GFC courtesy of Greece, the possible end of America’s economic hegemony and China’s extraordinary rise.

It all adds up to a need to be sceptical about fundamental analysis, even when they look pretty good. But habits die hard and brokers are persisting in the usual methods. Which is not to say they are necessarily wrong, it is just to say that the analyses they offer are very partial. This is especially so for investors with a more short term orientation. Long term investors can afford to invest on fundamentals because there is a reasonable chance of them playing out over a longer period. But the global financial markets at the moment are perilous and eventually Australia may not escape unscathed. Plus there is the small problem of a probable recession in the non-mining sector.

Deutsche sees good value in the market, arguing any earnings downgrades are priced in:

In common with equity markets globally, Australia had a severe downgrade cycle during the global recession. However, Australia uniquely had another downgrade cycle in late 2010, which led to market underperformance. While early 2011 looked better, the last 2 months have seen a third cycle begin.

Over the past month, earnings forecasts have been downgraded for 119 ASX200 companies, vs 56 upgrades (previous month 120/60). For industrials, the ratio of downgrades vs upgrades was 75/27 (68/36), resources 38/29 (49/21), & banks 6/0 (3/3).

Further downgrades likely, but the market overall looks well priced for this.

Despite the past couple of months of downgrades, earnings forecasts have yet to change materially (FY11F & FY12F earnings growth ~1ppt lower). The ramp-up in net downgrades has coincided with a strong AUD and a hawkish RBA, and seems likely to continue. Still, with the market PE below 111⁄2x, a fair amount of weakness is in the price. Equities globally have slid over the past 6-7 weeks, in line with negative data surprises in the US and elsewhere. But with economists responding to this data flow by reducing forecasts, the capacity for further disappointments has lessened, which could support equities. Accordingly, we see upside in 2H11.

O/W resources – expecting stronger commodity prices across the spectrum

(i) Despite a recent softening, PMIs globally still point to solid growth, (ii) Chinese lead indicators point to a soft landing, (iii) oil is still vulnerable to supply-side issues, (iv) gold is supported by negative real rates, EUR/US debt concerns.

O/W banks – earnings risk limited (recently reported, & low AUD exposure)

While credit growth is moderate, the banks can grow earnings in high single digits through cost control and bad debt roll-off. Wholesale funding is less of an issue than in the past, given strong deposit growth & only moderate asset growth.

U/W industrials – AUD could rise further, affecting cyclicals

The AUD is constraining many industrials, directly in the case of offshore-focused stocks, and indirectly for domestic cyclicals. Further, the RBA is expected to increase rates in 2H11, in an environment of only average business sentiment, and pessimistic households when it comes to their own finances. We prefer: (i) resource capex exposure (TSE, WOR, NWH, ABC), (ii) stocks that are defensive, operate in oligopolies and/or can return cash (eg, WOW, SUN, AGK, AMC).

Southern Cross believes there is some contrarian value, especially between now and the end of the financial year: ( my emphasis )

I also want to go bottom fishing because I see such compelling contrarian value in so many industrial stocks and sectors. Combine that with the fact that the Bell Potter private client network tell me there has been heavy tax loss selling this season and I can’t come to any other conclusion than it is the right time to go very high conviction and bottom up in our ideas, with a focus on beaten up (heavily shorted + tax loss selling) industrial cyclicals and financials.

One of the reasons I went tactical bearish at 4900pts in April was because I had a conversation with a good client. We both came to the conclusion that we couldn’t find anything to buy that was ‘compelling value’, or the true test, ‘that we would buy personally’. However, yesterday I had a conversation with the same client, roughly 500 ASX200 points lower, and we came up with a long list of industrials that were considered compelling value and would buy personally. That’s a good enough indication for me that being outright bearish will add little or no value from here.

While everyone tells me “it’s about getting timing right”, I somewhat disagree with that. When there is blatant and compelling value, driven by shorting and tax loss selling, you simply have to shut your eyes and take advantage of it. In markets like these sentiment can swing very quickly and time is rarely on an investors side.

I have been encouraging our analysts to be brave (yet recommending stocks at low prices is hardly brave, its commonsense). I want them to draw lines in the sand where they see fundamental value. I am encouraging contrarianism, particulalry after the FGL takeover offer which reminds you that its never the pretty girls who get taken over.

Today our excellent diversified financials analyst, Laf Sotiriou, initiates coverage on the downtrodden, market linked offshore and local earner, Computershare (CPU). This is about as contrarian as we can get, with the five main drivers of CPU’s earnings at cyclical low points in our view. I urge you to read Laf’s initiation note, remembering he as made great contrarin calls on CGF, ILF, KAM, ASX and PPT over the last few years. In my view he is the no.1 analyst in the diversified financial sector by a mile.

Both these analyses would be compelling during normal times. But we are not in anything like normal times.



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