Has BHP hit a ceiling?

PORTFOLIO POINT: As its shares have difficulty rising above $38, partly because of the strong dollar, investors can find better value elsewhere on the market.

The stockmarket has risen 48% since March, of which 25% was achieved since mid-July. Both numbers have triggered repeated expert calls for a pull-back, dubbed as being "long overdue".

The gains are impressive by anyone's measurements, but I try to refrain from drawing any conclusions on the basis of what happens at the surface of the market.

I prefer to look at the underlying market dynamics, trying to figure out what really is going on, and whether any binding conclusions can be made on the basis of the market's inner-workings. Last week I noticed something interesting that I believe should have investors' attention.

Shares of BHP Billiton have effectively gone nowhere since they crossed the $38 mark (on multiple occasions) in June. They pulled back sharply to $32 in July – so it is partly a matter of timing – but after rallying strongly back to $38 by the end of the month, BHP shares have effectively gone nowhere since. Yet the market as a whole has added another 10% since July 31.

One of our analysis tools at FNArena is a relative ranking of ASX 200 stocks on the basis of consensus projections for the years ahead and relative share valuations. The past few weeks have seen BHP shares gradually climb higher in the relative rankings, indicating the shares have been underperforming most others.

This observation has now been confirmed by a more detailed analysis, which has revealed that with the exception of only a few stocks, such as Rio Tinto and Paladin Energy, BHP shares have broadly underperformed other stocks, if not on a three-month horizon, then since early August.

Only during the past few weeks have BHP shares done better than junior mining stocks and the gold miners, but only slightly so.

Before we move on to drawing any conclusions: higher-risk stocks that are considered to be representing more value potential – such as Alesco – have outperformed BHP shares by more than 30% since July. Another higher-risk stock – AWB – has so far outperformed BHP shares by more than 10% in September.

OK, let's try to find some answers now.

An important part of the strength of the Australian stockmarket is coming from positive earnings revisions that have continued supporting the market. BHP is certainly no exception.

If we include the billions of write-downs that marked the company's 2008-09 result, then consensus expectations are now pointing to the company potentially doubling its earnings per share over the next two years, recording profit growth for shareholders in Australian-dollar terms of about 56% for 2009-10 and 41% for 2010-11.

There is one problem with these projections: that while earnings forecasts continue rising, and they could potentially rise some more, the same is happening in the currency market, where the Australian dollar continues to strengthen against the US dollar.

An Australian dollar close to US87¢ effectively means BHP shares above $38 are trading at 14.5 times projected consensus earnings for 2010-11. Problem number two is that most market experts will tell you the Australian dollar is likely to strengthen further over the months ahead. US90¢ is often mentioned as the target for either late this year, or early 2010.

All else being equal, this will automatically offset any further improvement in market forecasts. There is a danger the Australian currency might strengthen quicker than market expectations rise, which effectively means BHP shares will become more expensive even if they do not rise in price.

Now, we can argue all night about what is and what isn't a fair and appropriate valuation for the world's pre-eminent and debt-free miner. However, the market clearly has problems with BHP shares moving close to 15 times 2010-11 consensus expectations.

One of the reasons is probably because we are still in 2009. Another reason might be that the long-term average price/earnings (P/E) multiple for the Australian stockmarket is about 15 times (usually one year ahead, not two) and while BHP shares mostly traded at lower multiples throughout the last bull-market, an argument can be made that its P/E will be closer to that of the market as a whole in the years ahead. But should it be higher? Can it be higher?

It seems to me that the market has made up its mind when it comes to BHP Billiton: the shares should not be chased above $38.

The fact that Rio Tinto shares are unable to consistently outperform BHP is probably a signal about what the market thinks about its shares above $60. However, it should not be interpreted that investors have given up on making further profits in this market. They're just looking for value opportunities elsewhere.

This takes us back to some of the observations I made earlier in this article. While BHP shares might be perceived as "fully valued" right now, others have either caught up or outperformed. This might indicate that although BHP shares might have run into valuation limits, this market could potentially rise further still, as long as there are sufficient stocks around that still have a valuation gap to close.

The good news is that on a rough comparison, only about half of the ASX 200 constituents are presently trading on 14 times projected 2010-11 earnings per share or higher. Could it be that the other half still represents enough value to keep this rally going? Only time will tell.

I do note, however, major Australian banks are still only trading on 2010-11 multiples of 11 and 12 times. Three out of four majors will be reporting their 2008-09 results in October. Regional banks are valued even cheaper.

Steel companies OneSteel and BlueScope also still seem relatively cheaply priced, as are airlines Qantas and Virgin Blue.

If you really want to go hunting for cheaply priced stocks, you'll probably end up with the likes of Beach Petroleum, Boart Longyear and PMP Media – stocks that are trading on single-digit 2010-11 multiples.

As we have seen in recent months, hefty profits can be made once these stocks do turn around and start closing in on the relative valuation gap with the rest of the market.

However, and this is certainly something that needs to be pointed out, there's probably a logical reason why these stocks, including the likes of Astro Japan Property, Macquarie Media and Suncorp-Metway are still among the laggards in a stockmarket that has rallied almost 50% since March, and pushed the likes of BHP Billiton to what appears to be full valuation.

Remember, we're still in 2009 – all of the valuation metrics used above are on consensus projections for 2010-11. Also, while this analysis and its conclusions do not take into account the fact that certain stocks and sectors tend to trade at multiples above the market average, the underlying message still appears clear: further gains from present index levels come with increased risks.

However, it would also seem we're not yet in bubble territory either, as argued by market commentators elsewhere.

What’s more likely is that a continuously rising Australian dollar has now become part of the headwinds that are impacting on the Australian stockmarket. The better half of the market, including BHP Billiton, requires ongoing economic improvement, and further rising expectations, to justify present share prices, not to mention sustainable further gains.

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