Good Value Stocks

Morgan Stanley's Australian equities strategist, Mark Skocic, this week produced a report entitled Quality Laggards, in which he runs a "screen" over the Australian stockmarket to identify good-value stocks after the correction. He's looking for quality companies that are cheap and that have low earnings risk (aren't we all?). What follows is a summary of his report, including, at the bottom, his list of the best buying opportunities.
Methodology

Our quality laggard screen runs over the S&P/ASX100 on the premise that there is (usually) greater quality in the large caps. Our screen is divided into two parts, namely price performance and earnings certainty. Price performance ranks stocks by their performance since the market high on May 11; the earnings certainty screen is broken down further evenly into two parts:

1. Positive earnings momentum: the four-week revision to 2007 forecasts.
2. Low earnings forecast risk: the coefficient of variation to analyst forecasts.

We then rank our universe based on these two price and earnings factors, before dividing the stocks into quadrants. The results are shown in the table below. Quadrant 1 is our target quadrant, with a strong earnings score, and weak price momentum. Quadrant 2 is also of desire, with similarly strong earnings scores, but with less weak price momentum.

Some quality laggards

Banks that pop up: ANZ, Commonwealth, National Australia Bank and Westpac. Our banking analyst, Richard Wiles, notes that near-term bank earnings remain well supported by the combination of continuing robust credit growth and ongoing low loan loss charges. While domestic banks may appear expensive compared with overseas peers, this has been the case for several years and for domestic-only institutions, this fact is simply that. Recent share price weakness and ongoing earnings certainty see the major banks trading at reasonable valuations.

Diversified financials that pop up: Computershare, Macquarie Bank, Perpetual Limited: Our Macquarie Bank analyst, David Humphreys, says current pricing implies no revenue or earnings growth near term, we expect 20% in 2006-07. Fears over Macquarie’s leverage to falling markets, ability to recycle assets and to effectively deploy fresh capital are overdone. This is a rare opportunity to acquire Macquarie at a compelling price. David remains positive on Computershare, citing solid core business growth fuelled by a strong forward book of M&A-related services. This should further be fuelled by mutual fund proxy activity, bankable integration benefits to be delivered through 2007-08 from the acquisition of Equiserve, being well positioned to participate in meaningful M&A in North America and Europe and smaller bolt-on type acquisitions to leverage scale, and having direct upside to rising interest rates through margin income on client funds. We expect 22% growth in 2006-07 and sense forward consensus earnings estimates are at risk of upgrade.

On Perpetual Trustees, he says to wait for Ireland to perform. The stock is fully priced for the potential upside from expanding offshore in our view. Given the venture has failed to deliver any growth in its first 18 months, investors should now stand back and wait for success until paying a premium multiple that factors it in. While Perpetual's value style should deliver fund outperformance in hostile markets, its direct leverage to market prices may test FUM (funds under management) growth and earnings in the near term. Finally, the Australian Stock Exchange has popped into this oversold category; however, its future prospects are contingent on how the current merger with the SFE pans out. With the news that Robert Elstone is now heir-apparent to the CEO role in a merged entity, the deal looks closer to being approved by shareholders, which may provide support to ASX stock. The merger terms are expected to deliver earnings per share dilution in the near term, being accretive in 2007-08 and 2008-09; accordingly it is not the same earnings growth vehicle it has been for the past four years. However, the stock does return 90% of earnings in cash and has the potential for its performance to decouple from the equities market as its earnings growth is likely to be dominated by SFE's interest rate derivatives business in the medium term.

Resource stocks that pop up: BHP Billiton and Rio Tinto. Part of our base case economic view for next year is the prospective lift in mining related export volumes, which would underpin resource earnings. With recent comments from CVRD management that China’s current growth rate is on track to exceed even the most optimistic of forecasts, we are comfortable to say that demand for our commodities remains high. Those comments add weight to comments from Rio Tinto chief executive Leigh Clifford, who says demand for commodities from copper to iron ore is robust and supply growth still trails consumption. “There's been volatility in recent weeks, but we're still looking at very strong prices '¦ China's demand for metals remains strong, even after the government raised borrowing costs and announced lending curbs to slow investment.” China's share of Rio's sales could increase towards 20% this year, up from 15% last year '” and that’s good for earnings.

Gaming stock that pops up: Tattersall’s. As with ASX, Tattersall’s direction is more likely to be linked to the outcome of the UniTab merger it has put forth. Given that the hostile bid from Tabcorp trumped the merger-of-equals proposal, investors may see fewer growth options in the Tattersall’s business.

Building materials and steel stocks that pop up: CSR, Rinker, OneSteel. CSR (arguably a diversified industrial) is well positioned to benefit from strong sugar prices and demand on the back of increased global targets on ethanol use as a clean fuel alternative. The company is also benefiting from buoyant aluminium prices. Rinker has significant exposure to the two fastest growing states in the US '” Arizona and Florida '” and has been caught up in the general sell of US builders.

Healthcare stocks that pop up: CSL, Sonic Healthcare. CSL may well have been sold down as investors took profits post the US FDA approval of Merck's Gardisil (from which CSL will receive a royalty). However, we see a potential upgrade to 2006-07 expectations for ZLB Behring as the full suite of integration synergies are realised followed by launch of the company's first generation liquid IVIG (although the market may have this priced in). Notwithstanding some expectation of a capital return, we note the company has two $US200 million contingency payments due to Sanofi-Aventis over the next two years; is facing increased R&D costs as clinical trials for US flu production are launched currently; with $A80 million in capital expenditure on expanded flu production. This occurs against a backdrop of a market shortages in plasma products (IVIG & albumin, which should see sustained high pricing over the mid term) where the normal response should be for users to use less and manufacturers to make more. Another de-rated stock is Sonic Healthcare '” perhaps on concerns with costs in the radiology business and short-term issues such as a doctors’ strike in Germany earlier in the year. We believe the market has also built in an expectation of a regulated fee cut from the Australian Government. We see these issues as built into the price at these levels.

Discretionary stock that pops up: Billabong.
The sell-down by two executives and subdued trading comments from major competitor Quiksilver in Australasia preceded a 12% share price fall from Billabong’s mid-May peak. However, consensus earnings remain unchanged.

Consumer staple stock that pops up: Foster’s Group. The intra-month inventory write-down by McGuigan Simeon no doubt reminded investors of the precarious state of the wine industry. However, the company remains committed to extracting integration synergies at the top end of guidance. Some concern also lingers over the sustainability of beer pricing growth.