Australia Offering Value
By Chris Shaw
A major lesson of the last few years according to Deutsche Bank is to not be complacent about risk, so the current European debt crisis must be considered given the potential it develops into a problem for the global economy.
As Deutsche notes, inter-linkages in the global economy mean troubles in one part of the global financial system now tend to have more far reaching impacts, as the sub-prime debt crisis showed.
As well, Deutsche points out if the current issues in Europe do spread there is less scope for an appropriate policy response given governments have generally been on the stimulatory side with respect to policy settings over the past year or so.
Applying the current risks to the global economy to what is being priced into markets leads Deutsche to suggest the Australian market may now be factoring in too much risk. Australian equities have fallen 15% over the past month, which follows earlier sluggish performance.
On Deutsche's estimates, this means the market's price to earnings ratio on year ahead earnings forecasts has fallen from a normal level of around 15 times to 11.5 times currently. This compares to a low of around eight times when the Global Financial Crisis was at its peak in October of 2008 and amounts to a downgrading of growth in FY11 from 26% to more or less flat.
At that time markets were pricing in a severe global recession, so according to Deutsche the recent de-rating seems to be factoring in either a major slowdown or a stalling in global growth. Even allowing for the these risks the broker suggests current prices imply potential for a recovery, especially in those sectors hit the hardest of late.
These include the banks and mining stocks, construction contractors, wealth managers and some selected industrial stocks, the falls again creating value in Deutsche's view. To reflect this it suggests lifting or sustaining positions in these sectors to take advantage of any market rebound, rather than adopting a more defensive approach.
On the back of the value on offer, Deutsche has lifted its rating on the banks from underweight to index weight, this change being implemented by adding ANZ Banking Group ((ANZ)) to its recommended portfolio at the expense of Boral ((BLD)).
Deutsche retains its overweight positions in the mining, contractors, wealth managers and diversified financials sectors, while it continues to be underweight in defensive sectors. Deutsche is market weight Energy stocks in its recommended portfolio, pointing out the sector continues to trade at around an average price to earnings multiple despite the recent sell-off in the market.
According to Deutsche, the fact the Australian equity market and the Aussie dollar have both fallen significantly suggests foreign investors have been active in withdrawing from the market. This leads it to suggest at current levels the Australian market should again be looking reasonable value to foreigners, which has the potential to bring inflows again.
This is especially possible as US growth prospects continue to be upgraded, as this implies greater resilience in global growth than markets are currently estimating. The other point Deutsche makes is the de-rating of the Australian market reflects concerns over Chinese growth and the potential for policy tightening to prevent an overheating.
But if the sovereign debt crisis acts to dampen activity levels in China it would lower the pressure to tighten policy, which could also ease the market's sense of nervousness on the outlook for Chinese growth.
What supports Deutsche's positive view on mining stocks in particular is that commodity prices are still on average above the level it has built into its forecasts, with spot prices in particular still at elevated levels.
If spot prices were assumed to continue at current levels and this was factored into earnings, Deutsche notes price to earnings multiples for the likes of BHP Billiton ((BHP)) and Rio Tinto ((RIO)) would be down around the low multiples seen at the height of the global financial crisis. Such a multiple allows for significant falls in commodity prices in coming months.
Citi suggests such significant price falls are unlikely, as while a slowdown in China remains a risk underlying demand indicators ex-China have been recovering. This makes it unlikely in the broker's view average commodity prices in 2010/11 fall below the levels experienced in 2009.
Given this assumption, Citi suggests value on a 12-month basis is emerging in the Australian metals and mining sector. This view is reinforced as Citi notes its long-run commodity assumptions are very conservative, so when share prices breach its net present value estimates for companies good value is on offer.
Citi has taken a floor level net present value approach, which assumes 2009 average commodity prices until 2015 when long-term price forecasts kick in. This approach implies around 10-30% downside to base net present values, so the fact the likes of BHP, Rio Tinto, Whitehaven Coal ((WHC)), Fortescue ((FMG)), Energy Resources of Australia ((ERA)) and Paladin ((PDN)) are trading below these floor net present values suggests value is evident excluding any catastrophic market shock.
The proposed resources super tax has also been factored into Citi's analysis and it notes adding this to its model shows ERA, Paladin and Rio Tinto are still trading below the broker's "floor" scenario for net present value. Fortescue and BHP are trading broadly in line with net present value under such a scenario.
In terms of core picks, Citi continues to recommend Rio Tinto in preference to BHP Billiton given greater value and more leverage to a price recovery thanks to its aluminium and iron ore divisions. PanAust ((PNA)) remains Citi's core metal pick as the company should double production growth over the next five years and offers strong leverage to copper.
In coal Whitehaven is Citi's top pick as aside from value at current levels it offers good volume growth and exposure to tight coal markets, while Paladin is also viewed as attractive given an expected significant increase in production and merger and acquisition potential.
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