ASX Hold-?Em

The benchmark ASX200 index is making record highs and starting to move into a new, higher trading range. However, institutional trading activity is unusually quiet, and there seems to be none of the usual "euphoria" that comes with record index highs. I can never remember another period in my career when institutional investors seemed so displeased about a rising market, record corporate earnings and dividend growth, heavy merger and acquisition (M&A) activity, and unprecedented corporate balance sheet strength. The single worst feeling in investing is being under-exposed to a rising market.

If feels as though we are at a poker table '” institutional investors are flush with cash and the stakes are rising, yet nobody seems to want to place a bet by committing cash to the market. That situation won't last, and we are on the brink of some "forced investment". When one bets, they'll all bet.

But there always needs to be a "catalyst" for forced investment, and I see five looming. The first is further large-scale M&A activity. The second is large-scale consensus earnings upgrades to global earners, as global growth/commodity prices surprise on the upside and the Australian dollar surprises on the downside. The third is large-scale dividend reinvestment, which will start from early next week. The fourth is the upscaling of buyback programs, starting with BHP Billiton in early April. The fifth will be when iron ore contracts settle 18.6% higher for 2005-06, which will convert the commodity cycle non-believers '” at least for another 12 months.

MATING DANCE

The latest rumoured M&A actions are Lafarge bidding for Adelaide Brighton Cement, HBOS bidding for St George Bank, and Xstrata bidding for Oxiana. Although these are just rumours, my personal view is they all make strategic sense (through time), and I would not be betting against them. (These mergers would follow two significant mergers announced in recent days: the $2.3-billion merger of the ASX and the Sydney Futures Exchange, along with the $520 million merger of Tattersall’s and UNiTAB,)

All of these stocks have the right price action to suggest there may be some truth to these rumours, and make no mistake: the corporate world will continue to take advantage of cheap equity market valuations.

There is no harder decision in investing than buying back into a stock you sold at a lower share price. Most people are in this situation in regards to Woolworths. It's very odd; most investors will tolerate chronic stock specific underperformance and "never sell", yet they can't bring themselves to buy back into a stock they sold at lower prices.

Two things set “great” investors apart from good investors: they know when to cut a loser; and they have the courage to buy back into a stock they sold previously for a lower price. Buying back in is much more difficult than it sounds, and does require courage of convictions.

That actually also has relevance to the market itself, and it does appear that many institutional investors are struggling to reinvest cash at current index levels, and are waiting for a better opportunity to present. Everyone is cashed-up waiting for a correction, but I just don't see what will trigger a correction that will provide the required liquidity that investors need.

I actually believe the greater risk is that the market as whole keeps advancing, due to the combination of increasing M&A activity; rising consensus earnings forecasts; retail reinvestment of dividends, etc; and a "sellers strike" from institutions who are on the brink of breaching cash limits. The sellers’ strike is on: it is difficult to find any willing institutional sellers of leading stocks, particularly those that delivered earnings and dividend surprise in the interim reporting season. There's always "trading" stock around, but there's a real lack of genuine institutional selling around.

I don't particularly like weight-of-money arguments; I like fundamental long-term, bottom up investing in high-return growth companies. However, in the shorter-term, weight of money clearly does play a big role in overall stock pricing and I think that's the angle too many people are forgetting. To put it very simply: if investors are prepared to pay the proprietors of Babcock & Brown a premium for $500 million of existing stock, then that shows you just how much excess cash underpins this market.

The key is working out where the money is headed, and that's where the fundamental analysis kicks in. In my opinion, those investors who have too much cash are more likely to buy "large cap laggards". The reason they have so much cash is because they believe stocks such as my "Magnificent Seven" (BHP Billiton, Rio Tinto, Woodside Petroleum, News Corporation, Cochlear, Brambles and Patrick) are overpriced. They must believe this, as to have large cash levels suggest you don't see value in the largest index weight stocks, particularly resources. It's still very hard to find an institutional investor who is actually overweight BHP shares (9.57% of the ASX200). I don’t agree, but that's what makes a market.

The money will go to industrial laggards, and you can see some of that occurring right now (Amcor, PaperlinX, Coca-Cola Amatil, Foster’s Group, etc), yet that is a pretty risky strategy because laggards are generally, but not always, laggards for a reason.

A couple of interim dividend cheques have turned up at the Aitken household, with BHP Billiton's interim 23¢ dividend arriving last week. Many thanks, Chip.

We've got $22 billion of interim dividends/capital returns/and buybacks to be reinvested over the next few months, and investors reinvesting will be competing with many companies themselves who are buying back their own scrip. Very few companies now have dividend reinvestment plans, due to the fact they don't need new capital and reinvestment is via on-market purchases.

I just can't see where the big-cap supply is going to come from to meet this demand, when no top 50 company is issuing new scrip. The only supply will be found when the market pushes a given stock to levels where investors are happy to take some profits. In my opinion, those levels are significantly above today's, particularly if the institutional sellers’ strike we are experiencing is any guide.

THE VIEW FROM RIO

Sam Walsh, chief executive of Rio Tinto's iron ore division, said recently in a speech: "It is far, far, too early to suggest that the current commodities cycle has peaked. Indications are that metals and minerals prices can be expected to remain well above trend for quite some time to come."

Let’s put this in context: Rio Tinto is the most conservative resource company in the world (8% gearing), and it is more bullish than every commodity forecaster and analyst.

Walsh said the iron ore market is extremely tight but there had been a recent shift by the Chinese to accepting a price increase. "If you look at that (the iron ore spot price) that is also strengthening," he said. "That, to me, indicates things are on the move and steel mills want to settle now, quickly, before the market gets tired of it."

He said he was not in any hurry to settle the benchmark price and couldn't be sure when that would eventuate. "People are starting to talk numbers and that is an encouraging sign that people have moved away from a decrease to actually recognising market fundamentals."

I'm with you, Sam. My best iron ore industry contacts suggest that iron ore contract prices, in their opinion, will settle up 18.6%, yet any outcome of 15% or higher will be welcomed by investors.

The main reason the Chinese are now beginning to accept the inevitability of iron ore price rises are the continuing strong fundamentals. The latest figures from the International Iron and Steel Institute reveal global steel production in February rose 4.9% to 88.95 million tonnes. China was responsible for the large part of the increase, with crude steel production in February up 17% to 29.5 million tonnes. The Chinese Iron and Steel Association expects steel production to rise 12% to 390 million tonnes in 2006.

I just find it so amazing that the world’s largest resource stocks still command price/earnings multiples of about 10 times underestimated earnings, while I now have to pay 15 times for an Australian Bank, or 20 times for the averaging contracting stock.