The Unloved Ones

PORTFOLIO POINT: The market’s obsession with short-term results has blinded investors to the value in quality stocks that have hit temporary difficulties.

One of the more difficult tasks we face at FN Arena is having to explain why a Buy recommendation by an equity broker on a listed company does not necessarily mean the share price will go up tomorrow ' or even next week.

The matter becomes even more difficult to explain when the overall consensus among 10 leading securities experts says Buy.

The recent weeks have provided us with a few examples such as Hardman Resources (HDR), James Hardie (JHX), Macquarie Bank (MBL) and Aristocrat Leisure (ALL).

All are respectable household names to most investors in Australia. All are rated highly (some very highly) on the FN Arena Sentiment Indicator, which is a direct reflection of the positive ratings issued by 10 leading local experts. But shareholders in each of these companies have seen the value of their investments only further decline in value.

Surely there must be an explanation for this?

Highlight Stocks

Telstra (TLS): Macquarie Bank and Telstra. The two were mentioned in one sentence on several occasions this week. First Macquarie's telecom team joined Telstra chief executive Sol Trujillo's worries about the Google threat. The analysts cut their earnings forecasts and believe Sensis is unlikely to achieve market forecasts over the next few years. A few days later we all found out that Macquarie might put a plan on the table to buy the Government's stake in Australia's suffering incumbent telco. Meanwhile, securities analysts remain cold on the company's prospects. The only exception is Credit Suisse with a price target of $4.78 for the shares. Including this, the average price target is still only 5% above the current share price.

Rinker (RIN): Few companies can see their share price fall by more than 30% and receive even more support from the broking community. The dust seems to have settled, for now. The result is that two brokers have remained ultra-positive on the shares, holding on to price targets of more than 50% above the current share price. All the others are simply positive setting revised price targets between $15.58 and $18.50. This still implies upside between 15.8% and 37.5%. Only ABN-Amro and UBS don't rate Rinker a Buy. Another one that is bound to require some patience, we think.

Goodman Fielder (GFF): Goodman Fielder's share price has weakened recently as the market is getting worried about increasing costs. The outlook for the coming few years should be for strong growth, but the current market focus is on the immediate future and thus on likely disappointing results. Credit Suisse published more negative news on Monday and this pushed the share price even lower. Value for the longer-term, brokers say, which is simply another way of saying patience required.

Rio Tinto (RIO): Resources companies may have a shaky future with US growth likely to slow, central banks killing off global liquidity and China bound to step on the brakes again. This week's production report by Rio Tinto surprised on the upside, pushing the average price target up by close to 5%. The new average target of $97.74 is awfully close to three figures. Rio Tinto, just like BHP Billiton, remains among the top-ranked stocks in the Australian market, although expert opinions are divided about the prospects over the next few months.

Cardno Limited (CDD): Engineering consultancy Cardno received two initiations of coverage this week. Both were positive, raising the total number of Buy recommendations to three. The average target price suggests more than 20% upside. Expectations are for 20% earnings per share growth over the next few years. The share price jumped a few percent following the initiations.

Hardman Resources is the easiest to explain. It is one of Australia's most outstanding success stories of the past decade, having made the transformation from a small but ambitious explorer to one of the nation’s largest oil producers.

Unfortunately, for management and the company shareholders, its only producing asset, the Chinguetti field off the coast of Mauritania in north-west Africa, has run into some unforeseen hiccups. As a result, previous market expectations won't be met. Earnings forecasts are trending lower, and so are analysts’ valuations and price targets.

The market has not taken this lightly. Hardman shares hit $2.50 in August last year. They were back at that level just before the recent correction at the end of April. On Monday they closed at $1.55.

Back in April four out of nine leading equity experts would have rated the shares a Buy. Since then another four experts have applied the Buy rating, making Hardman one of the most highly recommended stocks in the Australian market.

The average price target of $2.08 suggests shareholders should see their investment grow by 34% over the coming year. And that doesn't take into account that the spot oil price can easily surprise on the upside over the period.

Don't be surprised, however, if Hardman sinks below $1.50 over the coming weeks. Market insiders believe the problems at Chinguetti are serious and likely to cause more negative news. The oil sector is suffering from similar shortages as the minerals and metals miners: there's simply not enough equipment and qualified staff available.

This means that whenever an oil well runs into problems, the repair can take several months. The result is that in the meantime production is lower, and so is income. For a one-well company such as Hardman the impact of such an event is significant.

Over the past week, the average 12-month price target as set by the nine leading experts in FN Arena's universe who cover the stock has fallen from $2.21 to $2.08, more than 6% in the space of a few days. And if it wasn't for a persistently high spot oil price, which led to several brokers increasing their future oil price forecasts, the fall would have been in double digits.

A gap of 34% between share price and target is something that is bound to attract the attention of investors. Especially with eight out of nine experts saying the shares are a Buy.

However, read the recent broker updates on Hardman and you'll see ' explicitly and between the lines ' few would expect the share price to narrow the gap with the price targets in the near future.

That is because the market has now firmly put its focus on Chinguetti. When it does this little else matters. In the case of Hardman, this is understandable, given the importance of that single well to the company.

It happens elsewhere as well. Take Aristocrat, for example. Its shares have continued their slide since peaking at $15.13 in May. As of Monday, they have lost 29.5% in less than two months. Expectations are that the shares could easily drop below $11 in the weeks ahead as the stock's price/earnings (P/E) multiple remains relatively high.

The slide in the price of the shares goes hand in hand with securities analysts scaling back their earnings estimates for this year as regulatory changes in the Japanese gaming sector are curbing Aristocrat's sales in the country.

This comes despite several experts, such as the analysts at GSJB Were, pointing out that Aristocrat is performing very well in US markets. For the time being, however, all that matters to the market is the insecurity about Japan and it remains yet to be seen whether management can reverse this situation at the presentation of the half-year figures on August 22.

The irony is that earnings forecasts for 2007, which is next year because Aristocrat's fiscal book period runs from January to December, are trending upwards with several brokers raising their 2007 forecasts over the past few weeks.

The mean market expectation is for Aristocrat to improve its earnings per share by nearly 30% next year. Any question about whether the shares are cheap or expensive is therefore best answered by asking: On what year's figures? (The difference is between a P/E multiple of 21 or 16).

Similar to Hardman Resources, Aristocrat's reading on the FN Arena Sentiment Indicator has improved quite considerably over the past week. The shares are now rated Buy by six out of 10 leading equity experts. The average price target of $14.47 suggests 22% upside, dividends not included.

The story of Macquarie Bank (MBL) is similar to Hardman's and Aristocrat's, with the exception that most analysts have kept their Buy recommendation for the shares unchanged over the past year. Macquarie Bank has remained one of the highest-recommended stocks in the market since last year, currently reading 0.9 on FN Arena's Market Sentiment Indicator.

Its share price, however, is now lower than 12 months ago. Everything seemed fine until the shares reached a peak of $78.23 at the beginning of last year's closing quarter. They haven't been back near that level.

Investors have taken a more conservative approach since. Wobbly sharemarkets, indications that the previous highly successful fee-generating spin-off model was due for revision and a series of asset sales that have yet to be concluded have kept the share price down.

Macquarie Bank is an ingenious financial monster in transition. The recently reported plans for a split between the banking division and the other operations as well as a possible proposal to take control at Telstra (TLS) are testament to this.

It is likely that shareholders will have to wait until the next successful asset sale before the share price will start to recover. This may occur in September. However, any further delay is bound to be regarded negatively and thus push the share price even lower.

James Hardie's (JHX) story is similar to Rinker's (RIN): too high market expectations lead to gradual lower earnings forecasts and this weighs the share price down. The shares peaked at $9.95 in April and investors can now buy them for $6.82.

Anyone interested in what the average price target indicates at James Hardie? An upside of 45%, dividend not included.

James Hardie is FN Arena's highest recommended stock in the Australian sharemarket. With the exception of GSJB Were, which rates it Marketperform/Long-Term Hold, every expert rates the shares a Buy.

Hardie's investment story is similar to all the previous examples mentioned; time will come for the share price to close the gap with the price targets in the market, but shareholders are likely to need patience.