Further to Climb

The interim reporting season delivered investors $22 billion in dividends, special dividends and buybacks/capital returns, the vast bulk of which came from large-cap resources. To put this in context, for the entire $22 billion to be reinvested, a company the size of Woolworths needs to be formed every six months just to meet dividend/buyback/capital return reinvestment requirements. The top 100 aren't raising new capital; they're giving it back, or using their scrip to acquire.

The only new capital supply is coming from mid-cap growth stocks, or proprietor sell-downs of existing stock (Billabong International, Babcock & Brown). The biggest placements in that space tend to be $200 million, and I can't remember the last decent scale new equity deal. Again, to put it in context, simple interim dividend/buyback/capital return reinvestment would see Snowy Hydro eight times oversubscribed. (By the way, I think Snowy Hydro will be worth buying).

Large-cap Australia is reducing the amount of capital on issue, yet investors have more capital than ever to invest in long-life "growth yield" assets. The problem is only going to get worse in the shorter term as the full-year reporting season, in July/August, will deliver another $22 billion or more of dividends, buybacks and capital returns.

This is a highly interesting situation. The consensus view among brokers is that the Australian equity market is at a mature stage of the earnings cycle. However, at this point in past cycles the market would be awash with equity, as corporates traditionally took advantage of high share prices to raise capital. Yet, despite the Australian market being at record levels, equity supply is actually contracting.

My conversations with business leaders confirm that corporate Australia is far less concerned than analysts about slowing earnings and rising interest rates. In fact, I hear no real concern in my conversations; I hear optimism. Again, analysts and equity strategists are confusing "overbought" with "overvalued". I think record levels of business spending are indicative of a bullish outlook for earnings by corporate Australia. Companies are investing for medium-term growth, via both mergers and acquisitions and investment in existing operations, and you don't do that if you're bearish.

The key point Australian business leaders make to me is regarding the "flexibility" that their unprecedented balance sheet strength gives them. Low interest rates, cheap equity market valuations, accelerating global growth, accelerating domestic growth, and unprecedented balance sheet strength; it's going to lead to a huge mergers and acquisitions cycle.

The corporate world is going to continue to take advantage of non-believers in the equity market. I believe there is a complete disconnect between the view of corporate leaders and the average equity strategist. It's as though they're talking about a different economic world. We continue to back the opinion of corporate leaders, the opinion of the Reserve Bank, and the opinion of the Queen! Under no circumstances do we listen to ABARE, the Australian Bureau of Agricultural and Resource Economics.

I also think the power of dividend reinvestment, when combined with compulsory superannuation flows, should not be underestimated. I suspect it will drive the large-cap benchmark index to new territory over the next few months, and I'm happy to remain fully invested in quality, high ROE (return on investment), high barrier to entry, highly cash generative, organic growth companies.

Why I am I happy to remain fully invested at record index highs? Because Australian equities are still offering me the combination of high double-digit earnings per share growth (18%), an average dividend yield of 4%, and corporate balance sheets have never been in better shape. From a macro level, global GDP growth is accelerating, domestic GDP growth has bottomed (as has the residential property market), interest rates are flat and both consumer and business confidence is very strong. The mergers and acquisitions cycle is moving up the market-cap food chain. I can buy all this for an average price/earnings multiple lower than the 20-year historic average.

Despite record index highs, I think investment themes are broadening, not narrowing, as is usually the case at record index highs. It's clear investment themes are broadening because the index is making record highs, yet BHP Billiton, Rio Tinto, Woodside Petroleum, Newcrest Mining and Macquarie Bank are all still 10% below record highs set in February. Heavyweight banks, financials, healthcare, retailers, rural, transport, office trusts, and other domestic cyclicals have driven the index to record territory, and that's the equity market attempting to reflect the view that domestic GDP growth has bottomed.

I strongly believe that domestic GDP growth bottomed in the December quarter of 2006, and the risks to domestic cyclical earnings, and the sectors that fund those sectors, are to the upside. Backwards-looking economists and analysts haven't worked this out yet.

One of my strongest strategic views this year has been that there was value in the beaten up and leveraged domestic "consumer discretionary" sector ahead of generation income tax changes, and a recovery in domestic GDP growth, driven by the NSW economy bottoming. The effects of the extension of the resource cycle also drive the recovery in broader GDP growth. I also believe that household wealth, and the income generated from that wealth, is underestimated in Australia.

THE MEDIA RALLY

That pro-consumer discretionary call has served me very well so far, and I wrote last week that the next sector to benefit from a GDP and consumer and business confidence revival would be domestic media, where just about everyone is underweight. I think I went as far to call the bottom in the domestic media sector, and kindly Helen Coonan came along the next day and removed the uncertainty over cross-media and foreign ownership.

I'm happy to have a real go in key domestic media franchises, particularly those that are "self-funding" in terms of dividend yield. That means the beaten-up and unloved John Fairfax Holdings, which is hated by every analyst. Fairfax has an extremely tight register, and it would only take a fraction of positive fundamental news to send the stock back to the $5 level.

Lets face it: this stock hasn't been well run. Fairfax sells its content way too cheaply, in my opinion; in fact they give it away. I spend quite a bit of time scouring offshore newspapers for themes that may affect Australian equities, and I subscribe to the Wall St Journal, Barron's, and the Financial Times online. They all charge me a yearly subscription, and the amount of "free" content is very small. All the articles you want to read are "locked" and require a subscription or viewing fee of some kind.

That is not the case with the Sydney Morning Herald, where I can read the entire newspaper online at www.smh.com.au and pay absolutely nothing for the content. I actually cancelled my home delivered hard copy of the SMH a few years ago when I realised I could read the whole thing online for free, and save myself a few hundred dollars a year. My labrador was disappointed by this decision, as one of her favourite games was destroying the SMH each morning.

I suspect Fairfax has tried to grow visitation numbers to the SMH website in an attempt to secure advertising dollars, but the simple fact remains that giving away your content cannibalises your core business. Media is all about the quality of your content, and charging an appropriate price for that content. I can't believe the right strategy is to give your content away free.

I see this as one of the opportunities for Fairfax's new proprietor: to charge appropriately for content. The Macquarie Media Fund (MMGCA) should bid for Fairfax and get the content pricing right. Or, Australia's best-performing media company of the past decade, Rural Press, should merge with Fairfax, put the highly regarded Brian McCarthy in charge, and create the first true national print media company. You don't see Rural Press giving away its content, and that's one of the many reasons it has an ROE of 40%, and P/E approaching 20 times.

This is pretty simple. Either Fairfax's new chief executive David Kirk will get this right, or the stock will be taken over before he does. Global media sector valuations are rising due to mergers and acquisitions, and most of the activity is in "traditional old media". I reckon investors have paid way too much for new media (such as Google), and the real value is in traditional media franchises that control genuine content.

With investment themes broadening, domestic investors will be looking at laggard sectors and stocks. Media is a big-cap laggard sector where negative earnings revisions have ended. Being underweight/short domestic media from this point is a mistake, in my opinion, and I continue to recommend Rural Press, Fairfax and Publishing & Broadcasting. I also recommend News Corporation as the global play on this theme, and that's worked nicely in recent months as the News share price has recovered by $5 a share.

BIG NEWS

While investment themes are clearly broadening, my core strategy remains being leveraged to Australian equities with global earnings, global pricing power, and rising returns on equity. The "Magnificent Seven" of News Corporation, Brambles, Cochlear, Patrick Corporation, BHP Billiton, Rio Tinto and Woodside Petroleum have served me very well this year, and will continue to do so. So let's look at one of my core global growth recommendations: News.

At News Corporation's recent second-quarter results announcement, the core satellite and cable businesses were the highlights, and management reconfirmed 2005-06 guidance of 12% EBIT growth. Despite the weaker performances from filmed entertainment and television divisions, News still generated double-digit EBIT and earnings per share growth. Although News is suffering the earnings drag from the "old-media" businesses of newspapers and publishing, the diversity of the earnings steams and the asset base remain the great strengths of the business.

The key to medium-term earnings growth will be the turnaround in the satellite businesses, DirecTV and Sky Italia, and the ongoing strength of BSkyB franchise. DirecTV lost $US185 million in 2004-05, while Sky Italia lost $US173 million. The combined earnings turnaround for these businesses in 2005-06 is more than $US500 million, and both are expected to generate profits for the first time this year. News has an unrivalled global satellite franchise, which will deliver massive cash flow and earnings in the future.

The new generation consumer is rejecting the bundled media and music packages, and it is becoming a real challenge for content providers. However, the big positive for News is its huge programming capacity and film libraries. I think the ability to deliver quality content will be the differentiating factor for the future performance of media companies. News is focused on establishing an internet platform to deliver its unique content rather than dilute its competitive advantage by licensing the product to Google or Yahoo. Similar to Fairfax, I think the real value in News is the ability to provide quality content. The challenge is to capture the earnings leverage by controlling the delivery platform.

In this context, we expect News to reveal more details of its internet strategy at the upcoming New York conference. In a recent speech in London, chairman and chief executive Rupert Murdoch reaffirmed News's commitment to expand its investment in internet technologies. The market has been critical of the $US1.5 billion investment in internet technology, but the performance of the key acquisition Myspace.com, is starting to bear fruit. Announcing the second-quarter results, News confirmed the site was growing by a million users each week and has now reached 50 million, up from 35 million at the date of acquisition. News expects revenue from online businesses to exceed $300 million in 2005-06 but I expect the company will upgrade its expectations at the New York presentation.

I believe News is on the cusp of a new growth leg, with the turnaround in the satellite businesses and the potential rewards of the internet strategy. The company has a strong balance sheet, and is sitting on big cash reserves, which will finance further internet acquisitions and share buybacks. News is trading at a significant discount to its US peers and has been a big underperformer relative to the S&P500. What better way to buy tracking error with zero weighting in the ASX200? I maintain our $30 price target on News, and it will be a contest with BHP Billiton to see which company can crack $30 first.

BHP'S BUY-BACK

BHP Billiton is approaching the pricing period for the setting of the buyback reference price (off which the off-market buyback discount is set), and the trading market is very kindly setting a lower reference price, which will lower the overall price at which it can buy back and cancel shares.

I've read the BHP Billiton Off-market Buy-Back booklet from cover to cover. It's a very thorough document, despite the disgraceful "anti-stockbroker" point 1.6 on page five, which says: "To execute a share sale on the ASX, you may need to appoint a broker and pay brokerage, whereas you should not need appoint a broker or pay brokerage to participate in the Buy-Back"!

Point 1.2 on page four is the key one. "BHP Billiton may, however, vary the size of the Buy-Back depending on demand (which means supply), and may significantly exceed the proposed $1.5 billion amount if there is excess demand [that is, supply] at an attractive price."

"May significantly exceed" '” they are the key words. I would use "will certainly exceed as we will be swamped due to the highly tax-effective nature of the buy-back". I think BHP Billiton will double the size of the buyback to $3 billion through the tender process, and that would deliver a highly EPS, ROE, and cash flow per share outcome for them, and long-term shareholders.

As BHP Billiton says in point 3.4 (page 26): "Impact of the Buy-Back on key financial indicators"; "The precise impact of the Buy-Back cannot be determined until the Buy-Back price and size of the Buy-Back are finalised. However, the Buy-Back is expected to improve BHP Billiton's earnings per share, cash flow per share, and return on equity in the 2006 and later financial years. The more shares that are purchased, the greater the expected enhancement."

So here's what's going to happen in BHP Billiton over the next two months. The size of the buy-back will be increased (doubled, in my opinion, to 3.9% of the issued $A capital), investors will then attempt to buy back on market the highly tax-effective stock they sold to the buyback, and this will coincide with the announcement of iron ore contract price rises of 20%. Consensus analyst earnings forecasts will rise at the earnings per share level due to the upgrade size of the buy back, and at the same time commodity prices will be exceeding consensus forecasts. In other words, a trading short-squeeze will be occurring at the same time positive fundamental news is occurring, and quant-related upgrade EPS buying will also be playing a role. The result will be that BHP Billiton will make new record highs in April/May, and resume its leadership of the Australian equity market as it heads to our $30 price target.

The market should work out that the whole iron ore import price game being played by the Chinese is just that: a game. It's the Chinese Government simply trying to pull the smaller steelmakers into line, and let the big guys like Baosteel negotiate for them as a group, rather than have 40 different mills all signing agreements on their own and sending spot prices to the moon. The Chinese have played games with many commodities in the past 12 months '” copper, nickel, manganese, soy beans, etc. This is just another, and look how spectacularly their copper price manipulation efforts backfired.