Irrational Scepticism

Record index highs usually coincide with widespread optimism in the financial press, yet right now we have the complete opposite. Everywhere I looked in recent days I saw scepticism and caution, from commentators, editorialists, analysts, strategists and fund managers. To a person, those quoted believed the Australian equity market was heading towards a correction, both in expectations and share prices.
They all acknowledge the strength and quality of the current reporting season, yet they all think the future looks less certain. They all believe price/earnings multiples are stretched and that genuine value is hard to find. They also believe the corporate sector’s move away from physical earnings guidance is a sign of their caution on the future.

Sure, Australian equity market p/es are high by historic standards, yet nobody seems to consider if that is a justified development, and likely to be sustained. The key point the disbelievers in the Australian equity market focus on is that the Australian market p/e has moved into line with the MSCI World Index. They say this must mean Australian equities are expensive.

I don't subscribe to that view, and believe that for the best part of a decade Australian equities have been seriously undervalued – the nation perceived as “low-tech, old-economy” -- yet now trade closer to a fair global value as everyone wants our "old economy" products.

Why not a world price?

We have experienced 14 years of uninterrupted GDP growth, we have clear political stability, we have had -- and continue to have -- dramatic corporate-friendly labour market reforms, we are continually upgrading public infrastructure, we have lowered corporate tax rates to 30%, we have world-class management who are clearly delivering shareholder-friendly returns, and the vast bulk of our industries are either duopolies or oligopolies with large barriers to entry. Our listed companies pay the highest dividend yields of any developed market, while the domestic tax structure makes those fully franked dividend streams worth more to tax-paying individuals. We have full employment, and compulsory superannuation flows underpinning the asset class. We have rising wealth, low inflation, and excellent corporate governance practices.

But most of importantly of all, our equity market has real liquidity now. Over the past decade ASX turnover has tripled; we now have deep and liquid markets, particularly in the top 100 stocks. The argument that Australian equities should trade at a discount due to illiquidity is completely invalid nowadays, with global and local investors of all sizes now able to get set in the scale they require. If you want to see a market that should trade on a p/e discount due to illiquidity, look to New Zealand.

As a retail investor I can buy tax-effective yield in the equity market, with lower physical risks as balance sheets improve, and also have the hope of some capital gains. Retail investors are being rewarded with their loyalty for equity yield over bond yield via corporate Australia delivering better-than-forecast dividend growth this reporting season.

So basically, if you want tax-effective income streams in Australia you need to be invested in the equity market. People who compare the equity market to the domestic bond market simply aren't comparing apples with apples, as bond yields are artificially low due to a lack of supply.

Lessons learnt

We are witnessing a retail driven re-rating of Australian equities, basically a yield-driven re-rating. Unless the "grossed-up yield" of the Australian equity market deteriorates dramatically, we simply aren't going to get the deep and sustained correction in the asset class that most commentators predict. No doubt there will be trading volatility during the year, and trading corrections, and these are most likely to occur when the market has broadly gone "ex-dividend" after a reporting season and retail investors take a step out of the market for a short period.

That will occur a couple of times a year, and we must position ourselves to take advantage of it.

There are three clear points from this 2004-05 reporting season.

· Resource sector earnings were underestimated.
· The wider economy flow-through effects of the commodity cycle were underestimated.
· The power of full employment was underestimated.

Australia is one of the very few global economies that is a net beneficiary of high commodity prices, and a net exporter of energy. All economists and strategists have underestimated the broader domestic economic power of commodity prices, particularly on the West Australian and Queensland economies. They have underestimated the wealth effect of the rising price of skilled labour, and underestimated asset price wealth effects of rising regional residential property prices. They have underestimated state mining royalty revenues, and underestimated the federal income tax bills the mining sector is paying. The have basically underestimated the rebalancing of GDP growth drivers.

The commodity cycle is a massive event for Australia, and its sustainability is the key to forecasting GDP growth accurately, and in turn equity earnings and dividends.

BHP ups the offer

BHP Billiton was widely criticised by the media for a lack of capital management initiatives when it released its 2004-05 results last week. It has addressed those concerns by extending its announced on-market buyback by 12 months, until the September 30, 2006, and almost doubling the number shares to potentially be bought back from 186 million to 358 million, or 1.4 million shares every trading day for the next year.

The single best way for the company to dispel misplaced market speculation that it is cautious on the cycle would be for it to start buying some of those shares on the market today. I'm waiting by the phone, Chip!

The scale of BHP's buyback, if executed at current prices, is $7.1 billion - another $7.1 billion of supply that will be permanently removed from the Australian market. BHP's buyback alone is the equivalent of a quarter of T3.

Watching the directors

BHP chairman Don Argus topped up his BHP holdings after the result, and we note that a longstanding director of PBL, Robert Whyte, more than doubled his personal shareholding in PBL after that company announced its profit last week.

Directors increasing their personal holdings is a sign I look for, particularly when they are substantial increases. I have also been well served by avoiding stocks companies whose directors have been selling down their shareholdings.

For all the reams of research written on companies, monitoring the changes in directors’ interests remains one of the best guides to a company’s prospects.

The good news is that hurricane Katrina didn't kill us all, and we continue to recommend buying the trading dip in high-quality Australian companies, particularly global consolidators and regional beneficiaries of the extended commodity cycle.

Charlie Aitken is a director of Southern Cross Equities.