Few bargains but plenty of risk

PORTFOLIO POINT: They might look cheap, but don’t be fooled: they’re probably the rejects, the misfits, the failures '¦ the laggards.

Earlier this week I discovered what I had suspected all along: the stockmarket is not as cheap as it appears on first glance.

On some broker’s numbers the Australian market is trading on an average price/earnings (P/E) multiple of about 12. This is considerably below its long-term average of 14 and suggests there is a lot of upside waiting to be priced in. However, closer analysis shows me this P/E 12 is rather flattering.

Consider, for example, the cases of ASX 200 companies such as the junior oil company Arrow Energy (AOE) or a junior iron ore digger such as Aquila Resources (AQA). These two companies are trading on 2010-11 P/Es of 161 and 70 respectively. On the other side of the coin we find the likes of ConnectEast Group (CEU) and Extract Resources (EXT), which are both trading on negative P/Es, of –42 and –120 respectively.

I think everyone will agree that these P/Es are not representative of what is going on in the rest of the Australian market. Removing these extreme aberrations leaves us with a P/E of '¦ wait for it '¦ 14 – smack, bang in line with the market's long-term average.

This does not mean that equities are doomed to underperform, however. By digging deeper into the numbers we can still find plenty of companies on low, single-digit P/Es – companies such as Downer EDI (DOW), Cabcharge (CAB), QBE Insurance (QBE), Challenger Financial Services (CGF) and OneSteel (OST).

I don’t think I would be assuming too much to suggest that few of these are on subscribers’ radar as potential investment opportunities. But it does help explain why some of the more popular industrial companies are trading at fair value (and in some cases above fair value).

• For a company that is projected to grow earnings per share by 9% per annum in the foreseeable future, Woolworths' (WOW) P/E of 16 looks generous.
• Coca-Cola Amatil (CCL), widely cited as one of the standout performers during the reporting season in August, is on a P/E of close to 16.5.
• Wesfarmers (WES) is on 16.8, Iress (IRE) is on 17 and CSL (CSL) is on 17.5.

There are plenty of companies on even higher P/Es, including Elders (ELD), Santos (STO) and Paladin Energy (PDN), which might run an even greater risk of disappointing investors.

What investors might find even more illuminating that with the possible exception of the Commonwealth Bank (CBA), all major banks in Australia are still on fairly cheap P/Es while both BHP Billiton (BHP) and Rio Tinto (RIO) are still on P/Es of about 9.

This immediately provides us with a good reason why the stockmarket could move a lot higher still: the six leading bank and resource stocks are still trading well below their potential. Removing that discount would lift the market significantly.

So who else is still trading on a cheap multiple? In three words: resources, resources and resources.

OK, I am exaggerating, but only slightly. Looking through the list of cheaply valued stocks, it is difficult to escape the conclusion that tomorrow's upside for the market is all about resources stocks: Straits Resources (SRL), Hastie Group (HST), Medusa Mining (MML), Atlas Iron (AGO), Emeco (EHL). If it's not a pure-blood miner, it's probably a service provider or a seller of mining equipment.

The message in this seems to cut both ways. On one hand it reminds us that tomorrow's equity upside for the Australian shares is very much linked to China and its ongoing appetite for resources, but this also can serve as a stern warning for investors lest they get too carried away.

Investors should also note that resources are not the only value play left. Consumer stocks and media companies are also over-represented among the stocks with low P/Es, including the likes of Pacific Brands (PBG), APN News & Media (APN), Alesco (ALS) and Fairfax Media (FXJ).

Drill a little deeper and, as expected, this group of stocks contains many out-of-favour names and sectors such as (all) gaming stocks, (all) regional banks, (all) insurers, (all) major telcos, as well as property trusts, building materials and transport stocks such as Qantas (QAN) and Virgin Blue (VBA).

A similar picture emerges when we look into what is left in growth expectations post the August reporting season. On current calculations, the consensus forecast is for an average improvement in earnings per share of more than 19% for the year ahead.

This is well below the 28% projected by the more bullish forecasters earlier this year, but such growth prospects will still stand out on international comparisons. Look beyond the average, however, and most industrial companies are at 12% or lower. In other words, that growth figure too is heavily skewed towards resources stocks.

The main reason is that growth projections for these companies are so bullish. BHP is expected to grow 63% while Rio is expected to grow 97%. Compare this with the 0.9% this year and 7.4% next year anticipated for Tatts Group (TTS) or with Telstra's current outlook for two years of negative growth (if not more).

How are the banks looking amid all this? Here are the consensus growth expectations:

• ANZ Bank (ANZ) projected growth: 26% (FY10) and 13.7% (FY11).
• Westpac (WBC) projected growth: 20% (FY10) and 6.3% (FY11).
• National (NAB) projected growth: 6.8% (FY10) and 18.2% (FY11).
• CommBank (CBA) projected growth: 17.7% (FY10) and 8.9% (FY11).

This illustrates that the analyst community believes that growth momentum is about to shift from CommBank and Westpac towards ANZ and NAB. It also suggests that if current market expectations will prove correct, CommBank and Westpac will also under-achieve next year compared with many industrial companies.

The advantage of being in the banks is, of course, that they offer higher dividend yields than the average industrial stock.

One way of summing up all this could be that all the obvious value propositions have already been taken up. What's left are the rejects, the misfits, the failures, the laggards, the banks, resource stocks and eternal promises.

Another way would be that what has been left over are the more risky value propositions, or at least perceived higher-risk propositions. I still maintain that Australian banks' share prices are being unfairly kept low because of international developments, making the local plays a much less risky proposal, but hey, that's been my view since mid-2009.

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