Brokers Urge Caution But Still Value Out There

This story features MACQUARIE GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: MQG

-Is consensus too optimistic?
-Still some value to be found
-Foreign earners attractive
-Further M&A activity ahead
 

By Eva Brocklehurst

Sell in May and go away. Or should it be the reverse? May is considered a significant month for warnings as companies become more confident of how their earnings for the financial year are shaping up, or not shaping up.

Goldman Sachs observes, since 2007 over 20% of the ASX 100 industrial stocks have endured a consensus earnings change greater than 5.0% during the month, in either direction. Historically, revisions have been skewed to the downside with 12.0% of stocks downgraded and 8.0% upgraded.

The broker suspects, this time, consensus expectations for a stronger second half are too optimistic, as there is little evidence of a broad-based recovery in activity. The solitary official rate cut so far from the Reserve Bank of Australia appears to have done little to offset falling commodity prices and a weak outlook for investment. Goldman Sachs observes the positive momentum in housing and retail seems to have stalled.

The broker estimates geographic exposures will matter in the second half and its highest conviction idea is to be long those stocks which have offshore earnings, given their valuation premia have fallen in recent weeks, while conviction in a lower Australian dollar has grown.Goldman Sachs' highest conviction underweight sectors are the banks and resources.

Citi believes the common problem for investors at present is finding stocks where the valuation is still reasonable. The average price/earnings ratio across the ASX 200 is near its highest in two decades. Pointedly, Citi observes analysts are at the most bearish they have been for a long time. Naturally, most of the downgrading that has occurred has been in resource sector earnings, particularly in Australia's case.

Citi finds a few stocks that have performed well that are still reasonable value, including Macquarie Group ((MQG)), Lend Lease ((LLC)), Stockland ((SGP)), Mirvac ((MGR)) and Harvey Norman ((HVN)). Potential recovery stocks are QBE Insurance ((QBE)), Woolworths ((WOW)), Coca-Cola Amatil ((CCL)), Orica ((ORI)) and Fletcher Building ((FBU)). Those looking expensive are Commonwealth Bank ((CBA)), Telstra ((TLS)), Insurance Australia ((IAG)) Qantas ((QAN)) and health care stocks, in Citi's view.

Morgan Stanley is cautious about the outlook as well and finds foreign earnings still attractive. Key holdings in this regard are Macquarie Group, ResMed ((RMD)), Ansell ((ANN)) and James Hardie ((JHX)). The broker accepts investors will pay higher multiples whilst rates are low and liquidity abundant but, ultimately, earnings matter and more so this month as the focus turns to what FY15 reports will reveal. Multiples are considered extremely full versus history and, with earnings trending negatively, the broker believes the risk/reward for the market is skewed to the downside.

The broker forecasts Australian GDP should be around 2.1% in 2015 with unemployment peaking at 6.8%. Australian official interest rates are expected to trough in the second half at 1.75%, with two further 25 basis point reductions from the current rate. Housing continues to strengthen but Morgan Stanley asks whether it is enough. The infrastructure agenda, outside of NSW, has been disappointing and public demand remains a drag on the growth outlook. Meanwhile, the terms of trade have deteriorated further. Morgan Stanley notes, nonetheless, the lower Australia dollar is starting to help support tourism and trade-exposed industries.

Investors may feel the market is fully valued but Credit Suisse has noticed some analysts are adjusting down their weighted average cost of capital (WACC) which, in turn, supports higher discounted cash flow valuations and target prices. The broker accepts cynics will say that this is simply the case of analysts chasing share prices to maintain recommendations, which means a heightened risk for a correction.

Still, the Australian 10-year government bond yield remains at an historical low of 2.6%, which is feeding into the cost of equity and debt. Hence, it can be argued, in the broker's view, that this cycle is different and there is some fundamental support for lower WACC, higher valuations and further equity market strength.

Australia is in the midsts of its fourth mergers & acquisitions cycle in 20 years and history suggests to Credit Suisse further deal activity is still on the cards. This should be underscored by sluggish top line growth, strong corporate balance sheets and the low cost of debt.

Four strategies are set out by the broker, including being overweight small caps versus large caps, buying deal facilitators such as Macquarie Group and targeting potential targets such as APN News & Media ((APN)) (by News Corp), Caltex ((CTX)) (by private equity) and Myer ((MYR)) (by Premier Investments ((PMV)) or international co). Caltex is also on the other side of the deal barrier as an accretive acquirer, as the CEO has an M&A track record and NZ service stations could be targets. Acquiring potential acquirers is the fourth arm of the broker's strategy and includes Boral ((BLD)), Nine Entertainment ((NEC)) and News Corp ((NWS)).

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