Reading between the broker lines

The news reverberated across the market last Friday; a major broker had downgraded its outlook on Wesfarmers.

The impact was almost immediate. Stock in the conglomerate tumbled in relatively heavy trading for the quiet holiday season.

By the end of the session, the retail, insurance and mining group had dropped close to $650 million in market value as investors digested news of the downgrade by influential broking house JP Morgan.

But the reasons behind the downgrade – from neutral to underweight – were not in reaction to any problems with the company, its structure or its management. Instead, the perceived problems were related to its success.

While its growth prospects were appealing – the Coles turnaround on track, its Bunnings division performing well, and no obvious catalysts to threaten its relatively attractive future – JP Morgan analysts were of the view that the stock merely had run ahead of itself.

And therein lies the danger for retail investors, particularly value investors, acting in a kneejerk reaction to advice that has been tailored to institutional investors. It highlights the difference between information designed for traders rather than investors.

There was absolutely nothing wrong with JP Morgan’s thesis. It simply stated that Wesfarmers had been on a roll. In the past year, it had outperformed the top 100 by more than 12%, and improved on that in the past six months with a 12.7% outperformance.

It had even edged ahead of its competitors, Woolworths, Coca-Cola and Metcash during the same periods. That had pushed the company’s market valuation well ahead of the broker’s implied worth.

And so from a trading perspective, it urged clients to think about taking profits and switching into Woolworths.

Since last Friday’s falls, Wesfarmers stock already has partially recovered some of the lost ground, possibly as institutions, having sold and watched the price drop, already have switched back in at a lower price.

Very few retail investors can afford to juggle their portfolio on a daily basis. Bearing in mind the discounted brokerage available to institutional investors, there can be good rewards to be had in trading opportunities and arbitrage. A couple of cents difference over hundreds of thousands of shares several times a day, or even an hour, can deliver a handy profit.

Add the introduction of computer-run high-frequency trading into the mix, where some institutions hold a position in a stock for milliseconds, and retail day traders now find it almost impossible to compete.

For value investors, however, little has changed. JP Morgan’s advice was valid if a purchase in defensive retailers was under consideration. But for someone who has ridden the Wesfarmers juggernaut over the past 12 months, who is picking up an implied gross yield of more than 6%, even at these prices, there is little incentive to dump the stock.

Another good example of where it pays to take a sanguine view of trading advice is with our banks. There is almost universal agreement among banking analysts that the Australian banking sector has had its day in the sun. Or rather, its six months in the solarium.

Buying bank shares now, they argue, is buying stock that on any rational valuation is overpriced. Their arguments drip with logic. Consumer sentiment is weak. Business confidence is poor. The outlook for mortgage growth or lending growth of any kind is bleak. Earnings at best will be stagnant.

But even the most overpriced of the banks, the Commonwealth, is paying a grossed-up dividend of 7.66%. National Australia Bank – the big four financier with the most problems and hence the biggest turnaround proposition – is delivering a whopping 9.63% grossed-up yield.

Granted, if earnings fall this year, stock prices will decline and dividends will drop accordingly. But in a market where yield is king, that dividend premium being offered by the banks will continue to underpin stock prices.

For those hunting yield, liquidating bank stocks right now implies the need for an alternative. And there are not a great deal of options that deliver the kind of returns the big four are offering. It certainly won’t be found in holding cash.

This is where timing is crucial. Given bank valuations have outstripped earnings potential – or at least been stretched to the limit – now is not the time to take a big plunge into the big four. But for value investors who have been on board for years and ridden the cycles, a different set of imperatives applies.

An opportunity exists right now to take some profits and look for opportunities elsewhere. But a wholesale liquidation of banking sector stocks would be unwise in the extreme.

Where else to look? The investment banks and their analysts delve into every nook and cranny of almost every tradeable opportunity on the market.

But you won’t find any consensus. For all the mind-boggling financial analysis using the most sophisticated technology and modelling, subjectivity still reigns supreme with the end result that one analyst will completely contradict another on a sector or even a particular stock.

On Tuesday, Deutsche Bank recommended Sims Group as a buy. Macquarie Private Wealth rated the same company as an underperform. Both have pulled apart the same set of financials apart, looked at the same news and arrived at opposing views.

In the past few weeks, had you taken the advice of our leading investment banks, you’d have dumped BHP in favour of Rio Tinto because of its better exposure to iron ore, sold Rio and bought BHP, or sold the both of them and then bought them back this morning because the outlook for copper is rosy. Then again, there could be a major copper overhang this year because China will import 23% less of the metal as it uses up its stockpiles.

It is a confusing world in which we live. And the deeper you dig, the more information you can find with which to confuse yourself.

But here are the fundamentals. The global economy finally is on the mend. It will be a slow recovery with painful jolts. But Australia is part of that global economy and will benefit.

A significant readjustment in our domestic economy needs to occur, back towards the non-mining sector. This is being hindered by a stubbornly high Australian dollar.

It won’t remain at these historic levels forever. But it shows little sign of significantly weakening this year. When it does bend, however, it is likely to be swift and significant and that will swing the pendulum back towards a recovery in Australian corporate earnings.