Data Diary » Earnings analysis

Relative sector value of Australian equities

Rohan Clarke — Tue, 01 Mar 2011 06:08:45 +0000

Every quarter we run our state of the art filter over the industry sectors that trade on the ASX. It relies pretty heavily on the art part, but anyway the objective is to contrast valuations with earnings expectations to get a sense of where the sectoral opportunities might lie. The following chart summarises the results:

By way of explanation, a lower number on the value ranking generally reflects a lower market valuation for that sector’s earnings. The ranking seeks to take into account the variations that occur within a given sector over time and across sectors – the question being ‘is the sector relatively cheap relative to it’s own historical performance and relative to other sectors’. The earnings outlook again takes a forced ranking approach where a higher number on the earnings outlook reflects a more favourable outlook for earnings for that sector relative to others.

The point of the exercise is to insert a little big picture analysis into our portfolio management. While it is clearly broad brush in its approach, it serves as a cross reference against existing positions and to potentially find new areas of interest. Given my value orientation, the sectors in green generally attract immediate interest. However, the prospect of buying into sectors in the red zone has appeal, where there is a strong argument that the stock or sector is still undervalued relative to its growth outlook. Note too that this approach says very little about individual stocks – it wouldn’t be a very macro if it did.

The following tables list the data for individual sectors.

Australian financials versus A-REITS

Rohan Clarke — Thu, 17 Jun 2010 02:16:02 +0000

What to make of the following charts that map out the relative performance of the ASX200 financials (XXJ) and ASX200 A-REITS (XPJ) across the last decade (as described by their respective 50 day and 200 day moving averages)?

Interesting. The two indices paced each other to the market top in 2007. From there, the financials fared better through the worst of the turmoil, and have outperformed on the rebound. Notably both had their 50 day moving averages drop back through the 200 day MA recently – which often foreshadows further price weakness.

Now apart from the usual caveats that must be observed when looking at indexes – particularly the performance distortion that comes with index stock selection – what to make of this relative outperformance by financials and what does it portend?

Outlook for financials

Australian financials have enjoyed the liquidity lead uplift in risk spreads as much as any of their global peers. But looking ahead, the key drivers of earnings growth in recent years – fee income and growing lending books – appear to be coming up against strong headwinds.

Whether Australia’s housing market bursts or simply leaks for the next decade, it’s pretty clear that the top is now in (for an argument as to why see here). Even if governments were to find further ways of propping up demand – the fact that current prices are at least partly the result of the last cash injection means that the limit to this subsidised demand is close. The odds are short – household driven credit expansion has peaked (see here for latest Australian credit data).

While lending growth can be expected to stall, bank funding costs are on the rise. Risk premiums are heading north led by the step-up in sovereign debt that is taking place globally. While our banks may be well capitalised, and the risk of default is small (see speech on bank stress testing by APRA’s John Laker here), our hitherto reliance on foreign debt means that we are directly impacted by rising global credit margins (see here and chart of bank funding costs here). It’s little wonder that the battle for deposits has been heating up – but even this has its limits as ultimately higher risk premiums will flow through to the domestic markets. In summary, expect banks funding costs to rise.

Up until now though, banks have been able to pass on higher funding costs to their borrowers. In fact as the RBA noted, net interest margins actually increased through the crisis (see chart here). Once again though, this good news is history. With mortgage rates already starting to bite into the performance of their loan books, there is a tradeoff between increasing margins on the one hand and worsening loan arrears on the other. My working assumption is that net interest margins are unlikely to widen from here.

Then we have the impending capital and liquidity requirements that are likely to flow from the crisis that will be another drag on our banks return on equity. From APRA’s Wayne Byre’s (here)

Nonetheless the clear message is that, as far as minimum capital requirements for banks are concerned, the only way is up (even from Australia’s more conservative starting position). Capital requirements – and in particular, equity requirements – for banks will be higher in future. That will be achieved via a range of measures, including higher minimum requirements, tighter eligibility definitions, capital conservation measures and counter-cyclical capital adjustments. And, since the G20 Leaders asked for it, we‟ll also have a (non-risk based) leverage ratio as part of the supervisory armoury.

Finally, our banks have had a well publicised growth in fee income in recent years. When times were good, people didn’t seem to mind. Now times aren’t so good, there is growing unrest. Witness the class action, being touted by FinancialRedress and funded by IMF Australia to recover ‘penalty fees’ (see here). While these types of activities are designed with the promoter’s self-interest firmly at the fore, it is indicative of a changing mood. The net result – bank fees are unlikely to achieve another 9% growth this calendar year (chart from the RBA’s annual survey on bank fees here).

Outlook for A-REITS

This post has already run on too long – so for the moment a couple dot points to consider:

The A-REITS have reduced gearing – over the last 18 months, the listed property sector have been serial issuers of new equity at historically discounted prices. With gearing now down to the mid-30′s on average, the sector is well placed to weather any downturn in the domestic economy. As a generalisation, the risk of default is remote for participants in the sector.
Risk spreads to continue to widen – while Australian non-residential property has undergone some repricing, the pricing of risk as embodied in capitalisation rates still lags the credit and equities markets. As risk spreads continue to widen globally, we can expect cap rates to follow – though with leverage reduced, the impact on equity prices will be similarly softened.
Question is – what environment are current A-REIT prices factoring in?

Conclusion

1) Earnings of financials are likely to struggle against a confluence of negative factors

2) On the face of it, A-REITS look to be well positioned for a downturn in the domestic economy. On the flip-side though, can’t think of any macro variable that might be a catalyst for a re-rating of the sector. Regardless. more work required to get a view on what sort of economic scenario is reflected in current prices.

3) Intuitively, A-REITS to outperform Financials – on the basis that financials have material earnings risk, while A-REITS have a good deal of bad news priced in.

A longer term log chart of the All Ordinaries – are we at fair value?

Rohan Clarke — Wed, 14 Apr 2010 02:51:00 +0000

Following on from our previous reflections on fair value for the All Ordinaries (find it here)…

Log charts are a misunderstood lot. For a start there’s a certain mystery just cause logarithm is a four syllable word. Also, they’re something of a party pooper – flattening the good-times exponential as they do.

Still, when looking at the longer term context they come into their own. Consider the following chart of the All Ordinaries since the peak of of 1987:

A couple of observations:

Looks like we are approaching something like fair value based on this slice of history. In the bigger picture, oscillations around the middle of the channel could reasonably be ascribed to changes in valuation multiples.
That the 50 day moving average would stall around these levels is pretty understandable. The post-87 sideways market is interesting in this regard – liquidity surged post the crash leading to a property bubble that was popped in the early 90′s – the equities market rallied hard from the 87 low before trading back down when the liquidity was removed. We similarly have entered a tightening phase.

Another way of viewing this longer term history is by overlaying the nominal price chart with an exponential growth curve:

Assuming earnings per share for the All Ords grew from around 60 cps in mid-1984 to 350 cps in mid-2010 (that’s being generous), then EPS grew by approximately 7% per annum. The green line illustrates what this would have looked like in planet Smooth – assuming all else is constant – which of course it wasn’t. Market multiples expanded across the period – P/E in mid-1984 was around 10.5x versus a current one closer to 15x (plus or minus a digit depending on what you consider ‘normalised earnings’). This would explain why the green curve rarely meets the index.

Conclusion

Fair value might be around here somewheres – if you assume that recent market multiples are appropriate and that earnings per share of 350 is sustainable. I’m not in that camp. We are heading into a higher interest rate world with household debt to disposable income some 4 times what it was in 1984. As we suggested the other day – a multiple closer to 12x is more appropriate (call it 4250 for XAO) – till then better steer towards the lower risk part of the curve.

Update on S&P500 EPS forecasts

Rohan Clarke — Mon, 15 Feb 2010 00:27:15 +0000

In October, we had a look at Goldman Sachs earnings forecasts for the S&P500 (Giving lemmings a bad name). Figured it was about time that we had an update:

The changes on 2010 forecasts – allowing for the fact that the numbers don’t add up (rounding errors presumably)?

Energy -$3
Information technology +$1
Health Care +$1
Financials Operating EPS -$2
Provisions & Writedowns -$1 (ie. less writedowns)

Net the assumed rounding effect, the change in S&P500 EPS ex-P&W was…nothing.

Turning to the 2011 forecasts, the numbers that stand out to me are Energy (+50%), Materials (+50%), and once again Financials (+58%). Higher commodity prices to drive earnings in the energy and materials sectors (go figure). And for the Financials? I thought the 2010 results had the risk revaluation trade to thank (or more correctly, QE) – certainly lending has become a side business as banks hoard cash as seen by the drop in credit and M3. Wonder then what is going to deliver the 2011 gains?

BHP and China’s overcapacity

Rohan Clarke — Sun, 29 Nov 2009 09:43:56 +0000

Two useful contributions to the global information glut last week. The first being the documentation coming out of BHP’s AGM. The second a report published by the European Chamber of Commerce on “Overcapacity in China“.

So to BHP, the world’s 11th largest company by market capitalisation (at least last Thursday). This is a company at the peak of its powers. The strategy is simple, if a bit of a mouthful, to own a – ‘portfolio of tier one, low-cost, long-life, expandable and export oriented assets, diversified by region and commodity”. Couple that with low financial risk (net gearing ~12%) and an EBIT margin of 40% and you are on a winner.

The one metric that keeps coming up is the 40% EBIT margin. I have discussed it before as something that should prove hard to maintain. BHP makes the claim that their strategy has delivered this margin and the resultant return on capital of 25%. This is only partially true of course. It takes two to tango. So while BHP operate a resources business that has the scale, reliability and a relatively low cost base - the other dimension to achieving such gratifying margins is demand.

And this is where, in the short term, China’s overcapacity comes in. In the longer term this slide, from a presentation by Don Argus, suggests the cost of carbon could be a problem.

Now don’t get me wrong – notwithstanding the inevitable managerial inertia that will set in – BHP is, and will continue to be, a great company. And I’m happy to accept a 2025 vision that has long term demand being underwritten by the urbanisation and industrialisation of China and India. It’s just that a lot can change in 15 years.

Again, the market wisdom that a company’s share price peaks with earnings momentum comes to mind. As I’ve suggested before, I just can’t see current commodity prices being sustained over the near term. At a P/E around 20 times BHP is trading expensive given these demand side risks.

Let’s come back to the European Chamber of Commerce report separately…

Steel as a proxy for BHP

Rohan Clarke — Thu, 03 Sep 2009 08:12:00 +0000

Getting back to my ruminations of a couple of days ago – want to explore the world of BHP a little more.

BHP – broker consensus has it a BUY?

While some naysayers in the broker community have deemed BHP a ‘Hold’, the majority of the professional pundits rate it a ‘Buy’. The investment thesis is broadly based on the principles that:

1) The developed world has turned the corner, and therefore will resume its demand for commodities,

2) China’s economy has gathered a ‘fresh head of steam’, and,

3) Medium to long-term commodity demand is underwritten by China’s industrialisation.

Simple enough, and certainly fits with the ‘recession is over’ theme.

While I’m not going to build a full-blown model for the mining behemoth, I think we can have a closer look at this consensually conceived thinking. Let’s take one analyst’s forecasts as a guide. Following is a summary of earnings (EBIT) by division:

Some quick observations on the three-year outlook:

- Petroleum remains a strong contributor on rising volumes

- Base metals make a resurgence with greater volumes

- Carbon steel remains the stand-out contributor, after a weaker 2010 reflecting lower prices/higher costs, volume and price picks up again into 2012

- Steaming coal takes a hit on lower prices in 2010 and kicks up again thereafter on rising volumes and prices

No sign of a global recession there – volumes just going to keep heading higher. And a similar story with the price assumptions behind these forecasts:

There you have it – volumes rise and so do prices. Couldn’t have asked for more. But before we boldly embrace the broker recommendation, let’s test the investment thesis using steel as the divining stick (particularly given it is so important to BHP’s earnings).

China’s insatiable demand for all things steel

Consider the following profile of world steel production since 2003 (from the World Steel Association):

First conclusion is that non-China production has fallen into a ditch. While it may be climbing from this lower base, it would be fanciful to assume that it is going to reclaim its pre-crash levels anytime in the near future. Just as construction activity in the developed world benefited from the debt inspired binge, it will struggle along with the chastened consumer in an extended period of fasting. On this basis, it’s probably not a great idea to hang your hat on the premise that the non-China world is going to drive growth in world steel production.

Not to worry though cause China has taken up the slack. As of July 2009, it accounts for approximately 50% of world steel production up from 5% in the early 1980’s. And while the 2008 year was a slow one by its usual standards (annual growth of only 1% in production volume), 2009 promises to be the harbinger of things to come with at least 10% annual growth seemingly in the bag.

So to support the broker assumptions of growing volume and prices, we only need to look to China’s steel production that will keep growing by 10% to 15% per annum for at least the next 10 years …right? (Small detail that is beyond my scope here – but the broker in question assumes BHP increases sale volumes of iron ore by more than 20% per annum from 2009 to 2012. Well, if the big Australian can’t grow its market share, who can?)

I reckon this scenario is a little optimistic for the following reasons:

1) China’s internal demand for steel has peaked – We have just witnessed an extraordinary capital injection from the government. With in excess of 60% of the fiscal package being directed towards infrastructure, and assuming an implied steel content of capital of around 15%, you can pretty quickly see how the recent surge in steel production has come about (and for that matter every other raw material that could be tucked away in a warehouse somewhere). Without a further impetus from the government (which is not out of the question), it will be a while before the level of internal demand is bettered.

2) China is an exporter of steel with no markets to export to – what the chart of world steel production doesn’t tell you, is the fact that until recently China has been a net exporter of steel (in fact the world’s largest). It’s conversion into a net importer wasn’t by choice, as the following chart from the Iron and Steel Statistics Bureau shows:

With the impact of the fiscal support fading, we are about to find out what the ‘real’ internal Chinese demand for steel is. The question then becomes what happens to the surplus capacity?

One answer may be that steel producers that would otherwise export product may get government assistance to reignite their export markets. Consider for example, the announcement on 8 June 2009 that the government will refund the 9% value-added tax rebate on exports of several high-end steel products. This is aimed at effectively undercutting the pricing of Posco in its own market (South Korea was the biggest importer of Chinese steel).

In short, I suspect that we are about to get a clearer picture about the real demand and supply of the Chinese steel industry (granted it will probably have vasoline smeared across the lense but at least the lense-cap will be off). On current indications, it looks less than supportive for an investment thesis that rests on double-digit growth in Chinese steel production over the next few of years.

3) China will gain pricing power – China’s steel industry struggles against persistent overcapacity (it produced 500mt in 2008 against a capacity at the time of around 600mt) that is spread across a plethora (72) of small and mid-sized producers. This creates an industry that is particularly vulnerable to demand and supply shocks. The flipside to the recent fiscally inspired boom is that once it is has passed, producers need to be weaned off the assistance. In an environment where export markets are particularly hard to find, it’s not surprising to hear reports of rapid stockpiling.

If you add into the mix that China’s producers operate on relatively thin average margins of around 5.5% (according to IMF working paper “Is China’s Export Oriented Export Growth Sustainable Aug-09) then there are all the ingredients for consolidation of the industry if it comes under stress. Hence, the statement from the China Mining Association that the industry lost money in the first four months of this year has special resonance. If you don’t believe me, have a look to the CISA for the direction that this is taking:

From China Steel and Iron Association on 31 July, 2009 – Secretary General of CISA suggested that steel makers accept a single ore price…to regulate excess ore shipments by small steel makers and intermediary traders, which have hampered negotiations by creating unnecessary demand.

(And for a little bit more colour on industry consolidation China style have a quick look at the state sponsored takeover of Rizhao Iron & Steel by Shandong Iron & Steel.)

It is highly likely that the likes of BHP can’t continue to make out like bandits, while the world’s steel industry struggles with excess capacity. Expect consolidation in China’s industry to deliver cohesive negotiating positions and pricing power – input prices will share in the pain of the ‘transition process’.

In summary, this doesn’t sound like a glowing endorsement of a financial model that suggests 20% per annum growth in volumes over the next 3 years as well as rising prices. As a litmus test for the investment thesis, it’s coming up red (or is it purple?).

What this discussion does throw into stark relief is the implicit reliance that world economic growth has on that red-lacquered flight-box China. The accepted wisdom is that we can rely on China to continue to grow at 8% per annum – cause without this there will be rioting and pillaging on its streets. There’s bound to be some truth in the myth, but as with all things, the truth is a whole lot more complicated. My take on it is that China may well continue to grow at 8% per annum, but in the current environment this may not translate to higher prices, perhaps not even higher volumes, for the likes of BHP.

I know this has been rather long but couldn’t leave the following out as I think steelprices-china.com summarises the current market with a certain panache…

The main reason of arousing price decline is that traders and speculators’ selling lead to low market expectation. Because of the overcapacity, once the downstream demand fluctuates, it will increase the stock. According to the present, the steel stock will still increase in few weeks.”

The report then goes on to point out how critical the recovery in the US is….

More and more professionals believe that market risk is increasing. Steel enterprises, traders and end users all think that it will have a big change on September in China’s steel market. There is an important mark is that the change of American economic data in third quarter as American economic recovery is the prerequisite of the global economic recovery. If American economic indicator of third quarter is improved, it will be a huge inspiration to Chinese economy even the whole world. Demand of steel and steel price will increase. Otherwise, the steel price will drop severely.