Ready for Takeoff

The trading de-rating of selected mid-cap industrials will be to the benefit of large-cap financials, where just about everyone is underweight and earnings visibility is a whole lot better. I think that most large-cap financial earnings are underestimated in the medium term, as are capital management initiatives.
I've mentioned major banks at length in recent columns, but I also think there's genuine earnings upside coming from AMP, Axa Asia Pacific, Insurance Australia Group, QBE and Promina Group. Investors are dubious of insurance stocks, but there's plenty of money to be made in these market-linked earners, particularly AMP, which still suffers from investor discrimination due to past episodes.

AMP is one of those stocks that have to "prove" itself to the market; it's like a former star football player who got dropped to fifth grade yet now is trying to break back into the firsts. The market only believes the story is improving when it sees genuine evidence of the earnings, or form, recovery.

AMP's investment earnings will beat expectations, particularly if the funds have been paying attention to their own head of strategy, Shane Oliver (See Shane Oliver’s column in today’s Eureka Report). Oliver has been calling the market’s investment themes very accurately, when interviewed publicly, and I suspect AMP funds are very well positioned.

I think AMP is a huge buy, and headed back to $12 over the next 18 months (AMP is trading at around $8.43). I'd have 5% of my portfolio in AMP, but it seems most investors still don't believe the recovery.

I also think IAG is a huge buy, and the move to buy up to 40% of China's second-largest general insurer will reward shareholders in the medium term.

The Australian analysts and the Australian press have really been giving the IAG board a hard time over this purchase in China. Nearly all of them point to the experience of Lion Nathan and Foster’s in the 1990s, trying to grow in China and blowing hundreds of millions of bucks. Well, my argument is that China is a quite different country now. It is far more in the public eye, with the world watching, and the Government cannot afford to have offshore investors losing large investments in China because it needs to attract foreign knowledge in a range of Industries.

So why does IAG's purchase of up to 40% (when options are exercised) of China Pacific Property Insurance look interesting? Because you can see that every financial services company in the world is focused on China at the moment. You have some of the largest banks in the world buying minority stakes in the largest Chinese banks.

In recent months you have seen Goldman Sachs pay $US3.7 billion for a 10% stake in Industrial and Commercial Bank; Citigroup pay $US3 billion for a 60% stake in Pudong Bank; and Royal Bank of Scotland pay £900 million for a 5% stake in Bank of China. The Chinese need the expertise of these foreign banking giants to clean up their banking systems, which will lead to the entire financial services industry being improved.

According to IAGL: "The Chinese insurance market has grown a compound 20% per annum for the past five years and 9% GDP growth per annum for the past five years" Well, that is coming off a low base, and I think the growth in financial services in China will be the next focus of the world after the past few years focus on their commodities demand. The first leg of Chinese redevelopment is the building of infrastructure and housing, etc. The next leg is what the Chinese population do with their increased wealth, and that is why the largest financial services companies are so focused on China.

Everyone is obsessed with what IAG's insurance margin will be at the upcoming result. That is a short-term over-analysed part of the business. Why not look at what 40% of China Pacific Property Insurance could be worth on a five-year view? Who knows what size the Chinese general insurance market could be in five years time, but I'll tell you one thing, it won't be smaller than today!

I'VE WRITTEN previously that domestic institutional investors are underweight "traditional" financials, with their overweight bets being in investment banks, infrastructure, and selected listed private equity exposures. That strategy did work for the previous few years, but I don't think that strategy will continue to work.

Infrastructure looks sick, investment banking wobbly, and investors are starting to question the logic behind listed private equity stocks. There's even a rumour doing the rounds that 10% of Babcock & Brown is for sale.

Over the past few years, foreign investors dramatically reduced their exposure to traditional Australian financials, to the point where just about all foreign investors in Australia are underweight on large cap traditional financials.

I'd like to be heavily exposed to fully franked dividend streams coming into the May federal budget, where I expect to see genuine personal income tax and superannuation contribution tax reform. Those reforms will lead to the price paid for fully franked dividend streams rising.

You must use periods of broader index weakness to add to traditional financials, with St George Bank, Commonwealth Bank, Bank of Queensland and Suncorp-Metway being our key bank ideas. All have tight retail investor-based registers.

THE CASE FOR TELSTRA

LAST WEEK'S first-half result from Telstra was no worse than most of the pessimists were looking for, and in some cases better. Guidance was unchanged, yet the company did commit to paying 28¢ fully franked per annum in dividends for the next three years, which puts the stock on a 7% fully franked yield. That yield underpins the stock right here, and basically makes the stock a self-funding option on the new management team being able to execute a medium-term revenue and regulatory turnaround.

The institutional market remains grossly underweight in Telstra, all thinking they can reweight through the T3 sale process. As I keep writing, I think that's not the right strategy. T3 will be a partly paid entitlement issue to existing Telstra shareholders and there's every chance domestic investors will be left grossly underweight after the sale. Sceptics of this theory don't believe existing Telstra shareholders will take up the issue, but with an enhanced yield of 14% fully franked in the partly paid version, I think that's a very unlikely scenario.

The Government has committed to the sale of Telstra by writing down the expected sale price to $4.15. This is no different to management writing down the value of an asset on the balance sheet to generate a higher return, or to facilitate a sale. The Government has Telstra priced to go, and the Telstra management is very well aware of the outcome. Regardless of his abrasive style, chief executive Sol Trujillo has quality telco credentials. The plan is simple: drive down costs and achieve the right regulatory outcome, which generates an adequate return for their unbundled local loop (ULL) network. A stable platform is therefore provided to build revenue by the higher-margin broadband business, complemented by increased mobile phone penetration.

This is the transitional year for Telstra, and the inflection point for earnings. The Government has lowered the T3 sale price by 20% at the low point in the earnings cycle. At the same time, the domestic institutions are underweight, plus there is every chance it will be an entitlement issue to existing shareholders, who are mostly retail, and a large portion could go into the Future Fund. There is going to be an almighty liquidity squeeze in Telstra at the same time as the index weight doubles, and the earnings cycle bottoms. It is time to re-weight.

Telstra is a long-term buy down here, and could well produce a total return better than the market this year. It will clearly return better than unfranked cash. I only see the ASX200 producing a 10–12% positive total return this year, and Telstra will pay me 34¢ fully franked in dividends alone this calendar year if I buy it today. That's an 8.5% fully franked yield for calendar 2006, and you don't need much capital appreciation on top of that to beat the index. Telstra will also be a beneficiary of personal income tax and superannuation contribution tax reform after the May budget, when the market will start paying a higher price for fully franked dividend streams.

THE RELEASE of the latest Jones Lang LaSalle quarterly office market statistics have revealed significantly stronger net absorption in the central business districts than previously forecast, leading to a decline in vacancy rates in Sydney from 11.2% to 10.4%, Brisbane hitting a low of 3.0%, and Perth hitting 20-year lows at 6.1%, with the latter markets seeing growth in annual prime gross effective rents of up to 20%. Melbourne and Adelaide markets had a moderation in vacancy rates, both 8.1% respectively with the addition of new stock meeting the demand from tenants.

The drivers behind the growth in the key markets continue to be the growth in white-collar employment, with each city having subtle differences. Finance and insurance companies and overseas multinationals expanding their regional offices are driving the demand in Sydney market, Brisbane is benefiting from the growth of local government services and finance services, and Perth is benefiting from a growth in services supporting the resources boom.

The medium-term outlook for the Sydney and Brisbane markets remains very healthy, with limited new supply expected over the next two years. Of the new supply coming on line, a significant proportion of the space has been pre-committed.

While the markets had forecast improving returns, what the market is likely to have underestimated are two factors: the strength in the growth of prime gross effective rents, and the rapid decline in incentives to attract tenants.

The primary beneficiaries in the short term are the office and diversified listed and unlisted property trusts with exposure to these CBD markets; and in the medium term, property development and construction groups securing greenfield or redevelopment opportunities to increase supply.

Some of the listed property trusts to watch include Investa Property Group, ING Office Trust, Commonwealth Property Office Fund and Macquarie Office Fund, and of the property development and construction groups who have strong development and construction capabilities in these cities, Multiplex Group and Lend Lease will be well positioned.

Interestingly, most of the stocks I mention above are on multi-year relative lows versus the index and there is some genuine value, leverage, and yield to be found in this list. The themes I write about above will first benefit the trusts with large rent renewals pending, and then work their way through to the development and construction stocks with a 12–18 month lag. Steel and concrete stocks will also benefit from this theme in the medium term.

You know it's the time to have a think about buying development and construction stocks when you can't see a crane on the Sydney CBD between Market Street and Circular Quay. Sure, you have to get through some weak short-term results from the developers, but we do think a genuine medium-term contrarian opportunity will present itself over the next few months.

The CBD office markets may have climbed the first stairwell over the past year, with an initial lift in property valuations from the absorption in vacant space. It is now time to ride the elevator upwards as prime gross effective rents strengthen.

This tightening of CBD office markets is another sign that the corporate sector is confident of the future, and is also telling you that Australian unemployment levels will remain at generational lows.