Take Out The Trash

This is a chart of the ASX200 index since October. It is telling us that we are at the top of the short-term trading range.

It concerns me that the industrial side of the Australian equity market is broadly fully valued on what we know today. There are some very full price/earnings (P/E) multiples in the industrial side of market, particularly in mid-caps, where many funds are trying to generate index outperformance. The average industrial P/E of 17.5 times does require 2005-06 full-year earnings to slightly exceed the current consensus forecast to be a justifiable multiple, and I want to warn investors that any highly priced industrial that fails to meet the market’s expectations on full-year earnings will be absolutely decimated in share price terms. Below is a long-term chart of the ASX mid-cap 50 versus the ASX200 (base line).

The mid-cap index has been a massive outperformer since 2001; industrial mid-caps are trading at a 10% premium to the broader market, versus a historic discount of 20%. This index looks highly vulnerable to any disappointments.

When you look at the industrial average multiple of 17.5 times earnings, the implied equity earnings yield is 5.71%. The "risk free" rate of Australian Government 10 year bonds is 5.40%. This implies that the "equity risk premium" of the average Australian industrial stock is just 31 basis points. To put this in context, that equity risk premium for industrials has contracted from nearly 400 basis points just four years ago, and it shows you just how aggressively priced the average Australian industrial stock is.

To justify the tiny 31 basis point equity risk premium, you have to either believe that the "E" of the P/E is underestimated, and the real earnings yield is higher, or you have to believe bond yields are headed significantly lower. I believe neither, and I think the industrial side of the Australian equity market has never been more aggressively priced, and never been more likely to suffer from some sort of disappointment. The market is clearly anticipating further earnings upgrades and they need to come through.

All equity investing should carry a decent risk premium over the risk-free long bond rate '” you must be rewarded for the inherent risk of owning shares. In Australian equities, appropriate equity risk premiums are getting harder to find on what we know today, with the clear exception of one big sector: resources.

On 2005-06 numbers, BHP Billiton and Rio Tinto are trading on multiples of 10 times, or an equity earnings yield of 10%. On 2006-07 numbers, they trade on multiples of eight times using spot prices, or an earnings yield of 12.5%. The "risk free" rate is 5.40%; so on 2005-06 numbers the equity risk premium in BHP and Rio is 460 basis points, while on 2006-07, it is 710 basis points.

Can you see why I still think large-cap resources are still exceptional value? I know equity earnings yields and equity risk premiums are an "old school" way of looking at stocks, but I just wanted to remind you how aggressively priced the average Australian industrial stock is on what we know today. Equities do have inherent risks above the risk-free Government bond rate, and you must make sure you are getting paid for that risk via an appropriate equity risk premium.

Just as the "rising tide" brings more lobsters to the lobster pot, the rising equity tide has forced investors to invest. Below is a long-term chart of the ASX Small Ords index vs. the ASX200; it shows how the Small Ords is almost back to the lofty levels of the tech boom.

I want to repeat that my conversations with leading Australian institutional portfolio managers suggest they are generally struggling to find any absolute or relative value outside of large-cap resources. The guys I speak to are the leading Australian portfolio managers, who have been fully invested for the past few years, and have generated tremendous performance.

It is interesting to note the results from the latest Russell Investment Manager Outlook report (click here http://www.eurekareport.com.au/iis/iis.nsf/pages/F823958379674765CA25714000172D15?OpenDocument). In the three months since the December outlook, the number of investment managers who expect global markets will do better than Australia’s has risen from 67% to 80%. I recommend against direct investment in foreign equities; I would rather invest in Australian-listed companies with foreign earnings.

I believe this view is supported by comments that only 6%, of domestic managers surveyed thought Australian equities were undervalued. Considering that the bulk of the $22 billion in local dividends have been re-invested '” accounting for the market’s 200 point lift since it passed 5000 '” fund mangers are clearly struggling to find industrial value.

That is why I am recommending taking out some short-term index protection, ridding your portfolio of speculative rubbish and stocks that lack pricing power, and tightening the focus on ultra high-quality, long-duration, high return-on-equity companies. The list includes BHP, Rio, Woodside Petroleum, Brambles, Cochlear, Sonic Healthcare, Commonwealth Bank, St George Bank, Rural Press, Patrick Corporation, Woolworths, AMP, Publishing & Broadcasting, Macquarie Bank, News, QBE Insurance, Lend Lease, Sims Group and Telstra '” yes, Telstra.

Have a look at the chart below. It's a long-term chart of the ASX20 vs. the ASX200 (base line), and it shows you the chronic underperformance of our largest capitalisation stocks. I believe this chart shows that underperformance is ending, and that's another reason we want to concentrate portfolios in ultra high-quality, long-duration, large caps. It's worth noting that BHP Billiton accounts for 18.3% of the ASX20, and I reckon this chart is trying to tell you we are in for total domination of the broader market by BHP in the medium term. This has all the similarities of News Corporation in 2000.

This chart is telling you concentrate your portfolio, and take out some broader index protection to "leverage" the larger bets. Just remember, historic performance isn't a guide to future performance, and please lock in some profits where appropriate, or take out a little index protection.

I can't see where the next leg of broad industrial P/E expansion will come from, but I can certainly see where resource sector P/E expansion could come from. This is not what most people want to hear, but I reckon there's a much larger chance of some selected industrial P/E compression as investors come to grips with the broader macroeconomic ramifications of substantially higher, and sustained, global growth-driven commodity prices. The obvious ramifications of higher commodity prices are higher inflation, higher interest rates, lower operating margins, and higher bond yields. Industrials that lack pricing power lose under this scenario, and P/Es could compress a notch from the record industrial multiples we are seeing.

Any P/E that comes out of industrials will find its way into large-cap resources, as investors will want to remain fully invested. Yet, due to the low index weighting of resources that may mean we are close to the short-term trading peak of the ASX200. Just remember, we are 1000 index points above the lows of October, when everyone was worried about inflation. Under this scenario, the industrial stocks you own must posses "clear and present" pricing power, with high barriers to entry, low gearing, and high returns on equity. If you even suspect an industrial stock you own lacks genuine final pricing power, get it out of your portfolio now.