Christmas rush

Traditionally Melbourne Cup week marks the start of the seasonal slowdown in trading volumes on the stockmarket. I certainly don't think that will be the case this year, and I expect heavy trading volumes right up until Christmas.

Why do I expect volumes will remain strong? Because I expect more large-scale merger and acquisition (M&A) activity to be announced before Christmas. I expect continued dividend and M&A receipt reinvestment. I also expect trading volumes around the T3 listing to be enormous, as investors switch from Telstra to the higher yield of the installment receipts.

I believe it is a big mistake to believe this is all about to move into the seasonal slowdown, and I actually expect activity to peak in December when one of the major takeovers is finalised (Rinker, Coles Myer or both).

From a fundamental perspective, I expect to see a raft of positive consensus earnings revisions to our two heavyweight sectors: financials and resources. The financials upgrades have started following a better-than-expected bank earnings and dividend season, and the resource sector upgrades will commence, as we get closer to the end of the calendar year. The resources analysts will get out their favourite analytical tool, the rear-vision mirror, and then they will wave the magic upgrade wand. I am of the view that consensus earnings estimates in the resource sector (excluding oil and gold) are about 20% too low for the 2006-07 interim reporting season in February alone.

So how does the index go down if we have upgrades to the two heavyweight sectors, unprecedented M&A and private equity activity that is going right up the market cap food chain, unprecedented dividend reinvestment, inflows from compulsory superannuation in a full employment environment, and a successful debut of T3?

The answer is it won't, and I expect to see the index make fresh record highs into Christmas as institutional investors put cash to work to appear more invested for year-end.

As usual, the better the market does the more bears come out of the closet. Yet, most of the bears are mistaking fundamental strength for speculative strength. There's nothing speculative about what is occurring right now; in fact, what we are seeing is the corporate and private equity world take advantage of a sceptical institutional investor base. We are also seeing superannuants and retail investors driving demand for fully franked dividend streams. Everyone is buying from the sceptical institutional investors, and the institutional investors don't seem to realise they aren't pricing the market.

The "barbell strategy"

My core strategy remains a "barbell strategy", which means to overweight in the two heavyweight sectors: financials and resources, as well as the "bar" of service companies that connects the two sectors. It really flies in the face of conventional portfolio construction, yet the "barbell strategy" has worked very well, with changes to the Australian tax system driving demand for the fully franked dividend streams that the financial sector throws off; while "Chindia" drives demand for large cap resources and those that service the resource industry.

I remain of the view that the price paid (in price/earnings multiple, or P/E terms) for assured fully franked dividend streams changed permanently at the May federal budget. Changes to personal income tax rates, combined with changes to superannuation contribution limits, will drive continued demand for tax-effective fully franked dividend streams.

I believe we are witnessing a permanent change in the price paid for assured fully franked dividend streams. Financials are simply priced off prospective grossed up dividend yield by retail investors and superannuants. As I've have written numerous times before, the performance of the financials all comes down to dividend yield growth. Analysts who simply look at Australian financials in P/E terms will continue to be bamboozled by their pricing. Yes, Australian financials will remain the "most expensive" in the world, but that's due to the unique structure of the Australian superannuation and taxation system, and the demand that systems drives for tax-effective dividend yield streams.

With rising global labour costs and rising materials prices it is now cheaper for the global corporate world to "buy" than "build". Existing operating assets now appear comparatively cheaper than new assets on a risk adjusted basis.

This is absolutely the case in the resource sector, but particularly the Australian resource sector that is subject to a materials and skilled labour shortage. In Australia particularly, existing cash flow-producing resource assets are clearly now better risk-adjusted value than new assets due to the risk of capital cost blowout associated with all new projects. Even BHP has had cost overrun issues at Ravensthorpe, and they are the benchmark of capital discipline.

Most large and mid-cap existing, operating, Australian resource assets now carry no debt, and are accumulating cash on their balance sheets. Enterprise values are below market caps in many mid-cap cases, and we have the amazing situation where mega-caps BHP Billiton and Rio Tinto could be effectively debt-free next year if they so chose (they won't and you can expect very big buyback programs to keep some gearing).

I believe the entire Australian resource sector is now vulnerable to takeover, and that includes takeovers by cashed-up private equity players. Treasurer Peter Costello thinks the commodity cycle is over; I reckon our entire resource industry is vulnerable to takeover.

We are simply not going to have a situation where 30 to 50-year mine life assets, in the lowest part of the cost curve, in the most politically stable operating environment in the world, continue to trade on 15%-plus free cash flow yields and single digit P/Es. Someone is going to take advantage of the potentially short payback periods for taking over these long duration assets and gearing them up. Someone is also going to take advantage of the fact investors in Australia won't pay for reserves or exploration potential.

Many people will say, "Private equity will never buy resource stocks". Incorrect. I believe private equity will set up specialist higher-risk mandated funds to invest in cyclical industries and they will start playing in the resource sector. Private equity needs to do larger and larger deals to satisfy the inflow into the sector, and they will come to resources.

Perhaps it is the private equity world that will finally release the value that is in the resource sector. Institutional investors won't commit to the sector, and it does require a new player to release the clear and present value that is apparent.

These are long-duration, massive barrier-to-entry assets, with huge pricing power and margins. The free cash flow generation is enormous, yet for some reason Australian investors just refuse to see resource stocks as anything other than cyclical trading stocks. That is a mistake, a big mistake, and I continue to urge you to accumulate our highest quality, irreplaceable, resource stocks from short-termists and "Chicken Littles".

Oil: at the bottom of the "new" trading range

Despite the recent short-term weakness in the oil price, I believe the long-term demand/supply fundamentals remain extremely positive. Global consumption continues to increase by an average 2% a year driven by strong non-OECD demand growth. However, decades of under-investment have severely limited the pace of new oil discoveries. At current discovery rates, future supply will simply be unable to match the expected growth in demand. As a result, global spare oil capacity has collapsed since 1999 from six million barrels a day just 1.7 million.

In 1930, oil companies discovered 10 billion new barrels of oil against global consumption of 1.5 billion barrels. The world reached a peak in 1964 when new discoveries yielded 48 billion barrels compared to demand of 12 billion barrels. The inflection point was reached in 1988 with new discoveries of 23 billion barrels exactly matching demand.

However, in 2005 oil companies found six billion barrels compared to consumption of 30 billion. These statistics are truly amazing and highlight the crucial need for increased exploration. As a result, I think there are long-term structural issues that will support a permanently higher oil price for longer, as in, permanently.

There is no doubt that investment in future production will substantially increase over the next decade. However, I think the easy discoveries are in the past, and future production will become problematic, with new exploration limited to costly deep-water, or Third World locations. The political risk requires a higher discount rate to be used.

This will result in a significant cost increase for new production, which will be reflected in a permanently higher oil price. The same argument applies to base metals. It is clear that underinvestment in future capacity, the increasing trend to nationalisation, and the lack of spare capacity have all contributed to a dramatic fall in oil production, relative to the increase in demand. As a result, the world is consuming oil at more than twice the rate of discovery.

In 1980–82, at the time of the third oil price shock, the oil industry allocated more than 80% of free cash flow on exploration. Last year the figure had fallen to just 40%. Clearly, oil companies are more focused on shareholder returns than exploration and future production. I am not saying this is a negative, but it does ensure the oil price will be higher for longer. Again, the same issue underpins my positive view on base metals. The challenge for global oil companies is to reverse the current trend of falling reserve-to-replacement ratios and declining production levels.

I do believe the US mid-term elections will be seen through time as the catalyst for a US military withdrawal from Iraq. The architect of the quagmire in Iraq, Donald Rumsfeld, is gone, and I reckon that is a huge signal.

That's why I believe the US equity markets closed higher on the night of the elections despite the Democrats being seen as less "business-friendly". You can see this withdrawal coming. I believe it will be a very significant event for the US equity market over the next 12 months as speculation about the withdrawals timing increases.

Currently, 85% of every new US retail investment dollar is finding its way into foreign markets, which in turn, is seeing record low percentage inflows into domestic equities from US investors. That is unsustainable, and an Iraqi withdrawal will be the "trigger event" for that asset allocation changing in favour of domestic (US) equities. US P/Es have been contracting, US corporate balance sheets are in tremendous shape, and I think the US market is cheap.

This view on an Iraq withdrawal, and its very positive ramifications for the US Equity markets, is part of the reason I continue to recommend heavy exposure to global earners.

The hydrocarbon age

Data recently released from the International Energy Agency (IEA) highlights two important issues. First, it supports my view of a higher long-term oil price; and second, it confirms the positive fundamentals for the specialist oil service companies.

The IEA survey reveals that investment in the oil and gas industry rose 70% to $US340 billion between 2000 and 2005. However, cost inflation accounted for almost all of the increase. Shell's latest per-barrel development cost for the massive oil/gas Sakhalin project in Russia is more than 10 times the development cost in the Middle East. Adjusting for inflation, the real investment in the oil and gas industry increased by just 5% between 2000 and 2005.

Considering global oil demand increased by 9.3% over the same period, it is hardly surprising that the oil price nearly doubled over the five years to 2005. If the global demand for oil continues at the same rate and investment continues to lag, the oil price is clearly going to at least $US100 a barrel.

There is no doubt that oil exploration cap-ex will have to increase substantially over the next few decades to reverse the declining production levels. This was confirmed by the IEA survey, which also revealed the future investment plans of international oil companies, independent producers and national oil companies. Their plans involve spending $US470 billion over the next four years to 2010, up 38% from 2005.

This supports my positive outlook for WorleyParsons and the other global oil specialist service companies. However, the IEA also expects that even if all the expected investment translates into committed projects, the industry's spare capacity will increase by just 1.3 million barrels a day by the end of the decade. These figures also assume that the increase in oil demand remains constant. Try telling that to 1.5 billion Chinese and Indians who are seeking a better lifestyle. Clearly the IEA report underpins our view that the oil price will be supported over the longer term by the lagged effect of underinvestment, but also that the oil specialist service companies will have decades of work.