Bears' Comeuppance

This is one of the more aggressive notes I have ever written. It is designed to make readers consider a "what if" scenario. It's not a forecast; it's a scenario analysis that I want you to consider the ramifications of for your portfolio.

Let me set the scene. Here is a chart of News Corporation's share price performance in absolute terms between 1997 and 2001. News was the largest index weight in the All Ordinaries index at the time, and was the only stock you really had to get right to beat the benchmark index.

You can see NWS was happy trading along in a steady uptrend, and was occasionally subject to three-month periods of profit taking. However, when the stock bounced off the long-term uptrend, and also broke the short-term trading downtrend, the share price ramifications were enormous.

This all occurred in the lead up to, and peak of, the "tech boom" and News was Australia's largest stock in index-weight terms. You can basically see the point on the chart where institutional investors capitulated on their bearish views, and News rallied from $20 to a high of $56 in less than six months.

It was a monumental event, and many investors who were under-exposed to News ended up losing their jobs, while the funds they worked for lost their mandates.

Have a look at the chart below; it's scarily similar to the News chart before the fun really started. There are two other similarities between News and BHP Billiton. One is that they were the largest index weight in the market. The second is that an underlying "boom" was occurring in their sector.

The other unnerving similarity is that the smaller, more leveraged companies have sharply outperformed. In the lead-up to the News spike, a plethora of small and new stocks in the TMT (technology, media and telecommunications sector) led the market. That then made the "Goliath" '” News '” look "cheap on comparisons", which enabled underweight fund managers to "justify" buying into News at record highs.

That is happening right now in relation to BHP shares. The small end of the resource sector is performing so strongly it is making BHP (and Rio Tinto) look ridiculously cheap in comparison, particularly when you look at the diversity of their asset bases and diversity of commodity exposure. Obviously, balance sheets and cash flows aren't even comparable.

But it's not just small and emerging resources that are making BHP (and Rio) shares look ridiculously cheap; it's also the price the market is prepared to pay for large and mid-cap industrial stocks. As I mentioned last week, I have to pay a multiple of 15 times price/earnings (P/E) for the average Australian bank, up to 20 times for a contractor, and 30 times for a healthcare stock. Even poor old Telstra costs me 15 times. None of these stocks have the investment attributes of BHP, in terms of earnings per share growth, net tangible assets growth, free cashflow growth, barriers to entry, pricing power, management, asset quality, asset life, or return on equity growth. None are even close in index weight terms either.

Here's what I really think. My gut feeling is that the mother of all capitulations is coming from resource sector bears. They will not be able to fight the earnings and share price momentum any longer, or the merger and acquisition cycle any longer, and will be forced to invest.

I don't think you'll see BHP trade at $56 in six months’ time, but I believe very strongly that you are all going to be shocked by how quickly BHP (and Rio) move into a new, significantly higher trading range.

You can see how this is going to work. The big brokers will give up with their pathetically woeful attempts to forecast commodity prices, and will start basing their earnings forecasts and valuations off long-term futures curves. The divergence between commodity prices and the Australian dollar will be the last straw for forecasters.

Short, medium, and long-term earnings forecasts will be raised dramatically; by up to 40% for BHP and Rio in 2006-07 (remember, production growth is also kicking in), and valuations will be raised to significantly above current share prices. Yes, I do think consensus forecasts for 2006-07 for BHP and Rio will be revised up by more than 40%. We are on the brink of a "seminal change" in how analysts value resource stocks.

The capitulation by analysts will drive a capitulation by bearish investors, and at the same time the big resource stocks will have 5% less scrip on issue after completing buy-back programs.

Post these large upgrades to earnings and valuations; the big stocks will fit again into all investment-style categories. Everyone from Quant funds through to value funds will be able to justify owning these stocks. There will be a lot of traffic going down a small street.

I don't run money, so I can have crazy thoughts. But are the thoughts above really that crazy? I think we are still in the infancy of the biggest fundamental investing event of the decade, yet P/E multiples of 10 times underestimated consensus earnings suggest to me that nobody truly believes in the sustainability of the commodity cycle. The TMT (technology) boom was speculative and based on "new valuations". The commodity boom is fundamental, visible, and leading to increased returns to shareholders in terms of dividends and capital returns. The commodity cycle is real, and tangible; that's the biggest difference between it and the TMT boom.

There's one chart that BHP published last year that I simply can't get out of my head. It made me think this will be a 20-year event, not just a 12-month event as the consensus view remains. I saw this chart after I visited China last year, and I reckon it's the only chart you need to look at.

I just feel we are going to wake up one day very soon, and investors will have decided to truly commit to the major resource stocks. We haven't seen commitment yet, all we have seen are share prices begrudgingly rising in line with consensus earnings forecasts, and in the case of BHP and Rio, share prices haven't risen at the same pace as earnings revisions, and we have seen some P/E contraction.

The above is not meant to frighten readers. It's simply meant to make you think, and consider what could be about to happen. This could be very violent, and I believe there is a much larger chance of an "upside correction" in major resource stocks, than the widely anticipated "downside correction".

There is a precedent: News Corporation in 2000. When haven't yet seen any “speculative premium” in BHP shares.

Ask yourself one key question: Is your portfolio positioned for the "what if" scenario above? If it isn't, I strongly believe you should take out some upside protection in leading resource stocks by buying out-of-the-money call options, or just biting the bullet and buying BHP and Rio on market before 40% upgrades to 2006-07 consensus earnings come through.

Anyway, this is all just my own gut feeling combined with historical precedent. However, gut feeling comes from experience, and I have seen this before in 2000. I can smell the same fear, and I can see BHP in a $32–35 trading range later this year.

Just remember, BHP and Rio (and Woodside Petroleum) are still trading slightly below their record share price highs set in January, yet Australian dollar commodity prices are averaging 16% higher than late January. I really smell something big coming, and it will make what we have seen so far in the resource sector look like a dress rehearsal. Strap yourselves in, and remember: "Denial is not a river in Egypt."

Southern Cross Equities analyst David Radclyffe has had the highest earnings estimates and share price target on BHP for two years now. He first issued a $30 price target when the stock was about $15. Now he has revised his price target to $35, and has also revised up his 2006-07 earnings estimates to levels up to 40% above our non-believing competitors.

David argues that BHP will generate $US30 billion of excess capital over the next five years, which equates to $A4.50 a share. One way or another, BHP shareholders will benefit from that huge excess capital position.

Here's my view on what BHP will do with its $US30 billion of excess capital.

First, as I've written previously, I would expect the company to increase the current off-market buyback in the Australian listing, possibly doubled, to distribute excess franking credits to investors and improve earnings per share and returns on equity, etc. But that only takes care of a couple of billion dollars of excess capital. What about the other $US28 billion?

Take out the Poms. While all and sundry run with rumours that BHP will buy Alcoa, Inco, or even Woodside, I don't think a massive acquisition is the way forward for BHP. Investment bankers will hate me, but I think the best plan for BHP is actually investing in itself. There is no better investment in the entire resources world than its own shares, and its executives know more than anyone about their own company. That is the strategy that will deliver the best returns on equity.

If I sat on the BHP board I would be planning to buy back the entire British dual-listing over a period of three years. Buying back the entire British listing would improve earnings per share and returns on equity dramatically, and the Poms will kindly sell you British scrip at an 8% discount to the Australian listing. The dual-listing had a purpose, but in my opinion that is no longer the case. The dual listing, via the consistent discount the British listing commands, is actually increasing BHP's effective cost of equity capital.

Buying back the entire British listing in no way affects your ASX200 index weighting of 9.57%, yet by cancelling more than 30% of the entire capital base, the effect on earnings per share and return on equity will be dramatic, and almost certainly lead to our long-awaited P/E expansion.

After I'd taken out the Poms, and watched my P/E expand to 14 times in Australia, I'd use my world-leading scrip to make significant acquisitions as the commodity cycle slows, about five years from now.

There is a precedent in all this: Brambles. Although the BIL dual-listing was easier to unwind, in terms of tax structures, etc, the re-rating of Brambles we have seen so far shows that a higher P/E is to be found purely by being Australian-listed. Don Argus is the chairman of both Brambles and BHP, and I would suspect a successful unwinding of the Brambles dual-listing would make him consider the future for BHP's. Interestingly, both Brambles and BHP under Argus's chairmanship are showing market-leading capital discipline, with a focus on sustainable return on equity growth.