Broker reports are history in this market

The investing world has once again dramatically changed in front of our eyes and nowhere has this become more evident than in securities analysts updating their views and valuations for Australian stocks. A few examples, randomly taken from today's (January 23) research updates:

• Analysts at Citi kept Allco Finance (AFG) on Buy, but decided to lower their earnings expectations by as much as 25% for the next few years. As a result, the broker's price target for the stock has fallen from $12.69 to $5.88. This is still 97% above Tuesday's closing share price.

• Analysts at Deutsche Bank kept their Hold rating for GPT (GPT) intact but lowered their forecasts by 5%, arguing that changing market circumstances could put up to 10% of GPT's forecast earnings at risk (implying there's an additional 5% at risk). Their price target has dropped from $4.70 to $3.81.

• Analysts at ABN-Amro retained their Buy rating for Harvey Norman (HVN) and their forecasts largely intact following another strong second quarter sales report. However, the target price has been pulled back from $7.76 to $6.63.

All three examples confirm the trend over the past two weeks: earnings expectations are being scaled back and the same goes for 12-month price targets as investors are no longer prepared to put a similar multiple on companies that are now operating within a quickly changing global environment.

The second factor also explains why the All Ordinaries index in Australia is gradually losing its premium over the S&P/ASX 200 index: smaller companies in general have enjoyed a larger re-rating of price/earnings (P/E) multiples than the big caps over the past two years. Now that global economic growth is slowing this process has gone into reverse.

A simple mathematical example shows the importance of these two factors:

Assume company XYZ Enterprises tends to trade on a projected profit multiple of 15. Market consensus believes this year's profit per share will be $1. Before the correction XYZ's share price would have been about $15.

Fast forward and research updates by securities analysts believe it is safer to slice off 5% from this year's profit expectations. Under normal circumstances, this would logically translate into a revised valuation of $14.25 – assuming a multiple of 15 times 95¢ – a net loss in value of 5%. However, reduce the multiple to 13 and what you get is a new valuation of $12.35 – a loss of nearly 18%.

And this example only uses two rather modest changes. Imagine what happens in case earnings forecasts are being lowered by 25% (as in the case of Allco Finance above) and when P/Es come down from 20-plus.

Nowhere is this better illustrated than in the market's top 10 stocks of potential investment return, which is calculated on the difference between share prices and average price targets plus projected dividend estimates. Usually this top 10 list carries a few problem stocks with projected potential returns of 50% or more, followed by perennial underperformers such as News Corp (NWS), Macquarie Infrastructure (MIG) and Downer EDI (DOW), whose potential value is estimated about 20–30% above what their share prices are trading at.

However, today each stock in this top 10 list is showing a potential total return of more than 100% for the year ahead. This is not solely a reflection of the severity of the correction that took place this month, but also of the fact that calculations and valuation models by securities analysts still have to catch up with the new reality.

On Wednesday, January 23, we enjoyed the a dramatic rebound. At 4.3% it was one of the best rebounds in recent years (see table)

In the middle of that rebound I recorded the top 10 Buys on the FN Arena Indicator. The results could best be described as a mixed bag of opportunity. The stocks are:

1. Centro Retail Group (projected total return for the year ahead, 471%)
2. Centro Properties Group (333%)
3. Commander Communications (244%)
4. AED Oil (235%)
5. HFA Holdings (224%)
6. Allco Finance (173%)
7. Perilya (164%)
8. Tishman Speyer Office Fund (136%)
9. Macquarie DDR Trust (124%)
10. Babcock & Brown (119%)

Of course, nobody can and should take these projections seriously. I am only using this as an illustration of how much this market has been disconnected from its roots since the peak on November 1 last year, and how much readjustment needs to be done.

In short, the price targets in almost every broker report in circulation are useless, they're history. In fact they are ancient history. We're at ground zero in the forecasting season.

The above examples also show us the importance of the upcoming results season with companies either confirming their growth paths, or not, and with securities analysts using these operational updates to adjust their ratings, forecasts, valuations and price targets.

The FN Arena Bear-Bull Indicator has sunk to an all-time low (meaning the relative number of Buy ratings in the market is at an all-time high), which, I would argue, is fairly consistent with a market that has lost about 15% in the space of a few weeks. However, for investors looking to pile up on value opportunities post the massacre of indiscriminate selling orders, the challenge will be to avoid the valuation traps.

One way to do so is to zoom in on recent research assessments. For instance, Citi analysts initiated coverage on fledgling gold producer Avoca Resources (AVO) with a Buy rating on Tuesday, placing a $2.80 price target on shares that were trading at $2.17 at the time. One would assume their assessment should remain free from significant re-assessments in the months ahead.

Similarly, UBS commenced coverage on Bradken (BKN) on the same day with a Buy rating and a maiden price target of $8.50, about 26% above Monday’s price.

Citi has been very active in adding new stocks to its research portfolio this month; it also issued maiden research reports on uranium producers Energy Resources of Australia (ERA) and Paladin (PDN) on Monday. Both companies are rated Buy. ERA’s price target of $26 is 26% above Friday’s close; Paladin’s $7.70 target is 43% above Friday’s close.

Last week, Merrill Lynch added broadband infrastructure provider Pipe Networks (PWK) with a Buy rating and a $5.50 target, 17% above the share price at the time; as well as broadband internet provider iiNet (IIN), also with a Buy rating and a $2.73 price target, suggesting upside of close to 20% (including dividends).

On January 11, Citi initiated Downer EDI with a Buy rating and a price target of $6.90. According to the analysts, if management cannot right the wrongs in the short term, a breakup of the group will become inevitable (suggesting value will be released one way or another).

The upcoming results season will provide both analysts and investors with plenty of opportunities to divide the winners from the losers. This will also assist in getting rid of a lot of froth in market expectations and broker ratings and that can only be a good thing for all parties involved.

Rudi Filapek-Vandyck is editor of FN Arena, an online news and analysis service.