Volatility produces opportunity

Volatility Leverage
Global equity markets have experienced two mid-year trading corrections over the last 2 years. The first in 2005 reflected an increase in inflationary fears. At the time the expectation was that the sharp rise in commodity prices would translate to higher raw material prices, compressing margins, and impacting earnings. Last year the catalyst for the mid year trading correction was the expected slowdown in global growth due the US housing meltdown. Ultimately in both cases the fears proved to be unfounded. However in both instances, global equity markets and asset prices were extended ahead of the trading correction. In effect the trading correction was merely a safety valve, allowing a release of pressure from a build up of excessive leverage. The end result was an aggressive short-term repricing of perceived risk across all asset classes.

With the acceleration of equity market outperformance there is a corresponding increase in investor's appetite for risk. In an environment where investment themes begin to narrow, invariably investors seek to generate returns in more traditionally risky asset classes using leverage. As a result, asset prices become stretched, leverage increases, and risk premiums contract. The end result is a trading correction and the re-emergence of value. The whole process is the inevitable translation from greed to fear for a short period. We have already witnessed the impact of greed. At present, equity markets are in the fear phase and the fear phase is when value emerges.

The risk adjustment phase nowadays happens very, very quickly and very, very violently. The widespread availability of leverage to everyone from hedge funds to the man in the street (margin lending, CFDs etc) leads to price action being aggressively negative and headline grabbing when the leveraged herd moves to de-risk.

As we have written before the way leveraged investors take profits is very different nowadays. This is no slow grind down followed by a blow off down day crescendo. This is a blow off down day crescendo in one big across the board hit as trailing stop-profits and stop-losses trigger each other. The dominos fall and prices retreat to levels where long only investors are prepared to buy stock. Leveraged traders drive prices down to levels where long only investors (pension funds, super funds, etc) are prepared to buy and that sees the worst of the trading correction out in absolute terms.

The mistake I made strategically in February was to believe this would be more than a short-term event. The February lesson is clearly NOT to be sucked into believing anything fundamental other than aggressive leveraged profit taking is occurring. The fact is that companies are priced off their earnings and dividend prospects and with very few exceptions those prospects for Australian companies are unchanged by US sub-prime lending issues.

At this point it is important to stand back and have a reality check. The fundamentals for Australian equities remain very strong. The global economy is currently growing at well above trend rates supported by the industrialisation of China and the emergence of India. Rising bond yields are reflecting the strong global economy and not inflation. In fact inflationary pressures are well contained compared to historic levels. Global central banks, with inflation targeting mandates, are gradually tightening policy. The positive macro drivers of equities remain in place. In addition broad market equity valuations remain well below past levels consistent with the major corrections of 1987 and 2000. We view the current environment in a similar light to the two previous mid-year trading corrections. This is a healthy short-term risk-adjustment process in a structural bull market for Australian equities.

It is important to note that the sharp increase in volatility is part of the risk adjustment process.
Investors have been seduced by a long period of unusually low volatility by historic levels.
The return of volatility reflects the repricing of unsustainably low credit spreads. In the short term the main casualties will be private equity, infrastructure, the “financial engineering sector”, and listed property trusts considering their models are based on access to cheap liquidity.

The trading correction in equities also reflects an expected reduction in global private equity corporate activity which has provided an unsustainable impact on industrial valuations. In Australia, non-bank industrials were priced for perfection with PE multiples at historic high levels. Again, the trading correction is a positive development, allowing a re-emergence of value in non-bank industrials as the private equity P/E premium gets priced out.

In addition the sharp increase in volatility levels is not necessarily a negative for equities. On Friday the Chicago VIX index, which is a put/call ratio measuring investor’s appetite for risk, rose to its highest level since April 2003. It is worth remembering that March 2003 represented the start of the current global equity bull market.

Last weeks events are an overdue reminder of the reason for the traditional risk premium for equities over bonds. We have been wary of non-bank industrial valuations for months, particularly considering the recent negative earnings yield compared to risk free Government bonds. The trading correction is violent and headline grabbing; however it represents a rebuilding of that risk premium for equities. We believe equities should always command a risk premium to Government Bonds.

Make no mistake; this repricing of equity risk is not pleasant when it occurs. Nobody likes looking at a screen that is all red. It’s not pleasant but does provide opportunity. People always reduce risk at the wrong risk adjusted price. They also always sell the wrong stocks the hardest.

The way this appears to work is that any stock that has performed the best over the last 6 months gets hit the hardest. Any stock that has recently raised new equity gets hit hard. Any company that has perceived equity market leverage also gets hit hard.

However, while this is the way risk-adjustment selling seems to work it makes no fundamental sense to our way of thinking and that’s why it offers clear and present opportunity.

For some reason the market continues to believe “resources = risk”. Every time the market enters are broader risk adjustment phase resource stocks get belted. It happens every time and every time it proves to be an outstanding buying opportunity.

It does surprise us that the market chooses to continue to associate resources with risk. Resources have the lowest P/E’s, the lowest debt, the highest earnings growth, the highest ROE’s and the highest free cashflow multiples. In risk-adjusted terms the best value in Australian equities clearly lies in large cap resource stocks yet it is these stocks that get punished when the trading world is in forced risk-reduction mode.

Perhaps they are victims of their own high liquidity and index weights. Metal prices haven’t really fallen at all through this risk adjustment phase, while the A$ has. This is very good news for the Australian resource sector from an earnings perspective yet the sector gets belted by leveraged investors. It’s simply not fundamental; it’s forced liquidity.

The good news is all this is happening before the fy07 reporting season starts in a few weeks. In the last few years stock prices have rallied hard in anticipation of record earnings. This has led to a classic “buy the rumour sell the fact” trading reaction to earnings numbers that simply meet expectations. This year will be different now that we have experienced a broad trading correction from recent highs. The hot money is out and that means there is a genuine chance for investors to find some value.

This reporting season, considering the share prices we are now starting from, genuine earnings and capital management surprise will be rewarded with positive share price response. This reporting season “the fact” will be bought.

I really want to focus on this reporting season and beyond. I am simply not interested in sup-prime issues other than the opportunity it creates in long-duration companies. I want to use that macro distraction and the cheaper risk-adjusted entry prices it has presented in long-duration companies as an opportunity. As Lord Rothschild said, “buy on cannons, sell on victory trumpets”. The sub-prime cannons are firing loud and strong right now and this is the crescendo in sub-prime fallout sentiment.

13 month yield

We also want to focus on “13-month yield”. The 13-month yield opportunity comes up just before the full year (final) dividend season and really is a way of sneaking in some extra income. You can genuinely get paid for a risk you haven’t taken with the 13-month yield idea and with the market giving you a chance at lower risk-adjusted entry prices the idea becomes more compelling.

The 13-month yield concept means you get on the register of a given stock just ahead of the full year earnings and dividend announcement and then hold the stock for the next 13-months. Therefore you pick up the fy07 final dividend, the fy08 interim dividend, and the fy08 final dividend giving a high 13-month yield. We like to do this in fully franked dividend payers to get the tax advantage.

We are going to explore the 13-month yield opportunity in a little more detail later this week, but its fair to say that the big cap industrial names to focus on right now are QAN, TLS, TLSCA, CTX, WES, CBA, FXJ, QBE, BSL, SGM, OST, MBL, SUN, and LLC. This is where you start on the 13-month yield strategy and back-testing shows the 13-month yield strategy works extremely well in the right industrial companies. You have to be confident in the 13-month earnings outlook and all the companies we mention above fit that bill.

1^st stop is BHP

While we like 13-month yield strategies at the right risk-adjusted entry prices in quality large cap industrials, the simple fact remains that the first stock you should buy during this trading correction is BHP Billiton (BHP). You must use this opportunity to get set in BHP. This will be your last chance at silly prices.

If you buy BHP today you will be on the register for the record August 22^nd full year result of somewhere around A$15bil. It would be fair to assume the company will reward shareholders with another round of strong capital management with the result. It would also be fair to assume the company will again reinforce its view on the commodity cycle and the pipeline of growth projects it has in its portfolio.

Yet its fy08 and beyond you are really buying BHP for today. My view remains that fy08 consensus numbers for BHP will prove -20% too low. The fy07 “consensus” numbers reported on 22 August have been revised up by 25% in the last 12 months and by 50% in the last 24 months. I look where commodity prices are today and I look at futures curves and I again see the clear and present risk that consensus BHP earnings forecasts for fy08 (a year which is already 30 days down) are -20% too low. The consensus earnings forecasts for the largest stock in the resource world and a stock which represents 10% of the benchmark ASX200 index are underestimated by -20% in the current financial year.

There is no stock in large cap Australia where we can see such large consensus earnings upgrades coming in the current financial year driven by simple organic growth. It really is an amazing situation, but the same situation that has been present for the last 3 financial years in BHP forecasting.

I believe BHP will earn EPS of $A3.60 per share in fy08. A$3.60 will become the consensus fy08 forecast over the next 12-months as analysts use their favoured tool, the rear-vision mirror. At $36.00 today you are buying BHP on 10x “real” forward earnings when the right multiple for a global growth stock with the best assets in its industry is 15x. You are being given the unbelievable opportunity to buy BHP on 10x ahead of a period of strong organic growth and ahead of generation management change. We believe that generational management change is a real positive and few people understand its implications.

The Marius era

Marius Kloppers will take over as CEO of BHP on the 1^st of October. We believe BHP under Marius will be a different animal. It will still have the greatest set of assets in the resource world, but we expect those assets to be run harder and leaner by the next generation of BHP management who report to Marius. Marius clearly leads the next generation at BHP and most investors don’t realise how strong and deep that next generation is. These guys are all in their early forties, as is Marius; they are very highly educated and have resumes that have seen experience across a wide range of global industries. They bring next generation financial thinking and execution to what has essentially been an “old economy” industry. The fact Marius leads the next generation of BHP leader is one of the many reasons we believe that Marius was an inspired choice as CEO by the BHP Board.

One of the reasons that our Commonwealth Bank (CBA) recommendation has been so successful is because we believed incoming CEO Ralph Norris was a genuine “cultural change agent”. We believe Ralph’s enthusiasm and drive, when combined with aggressive financial and service benchmarking, would be able to turn CBA into a high performance business whose organic growth options and profitability would surprise all the sceptics. We see exactly the same cultural change leadership characteristics in Marius Kloppers at the helm of BHP. This is going to become a more dynamic business that will lead the resource industry across all financial benchmarks.

We back great people running great assets. People currently think BHP is making as much money as it possibly can. We certainly don’t believe this is the case. The first leg of the BHP story has been cyclical profit growth driven by commodity price rises. The second leg of the BHP story is going to be organic growth driven profitability and that is when we are going to see the long-overdue P/E expansion. One day in the not-too-distant future the world will pay 15x forward earnings for this set of irreplaceable growth assets, and that day will come while Marius is in charge and the next generation are running the assets as hard as possible.

There are very few times in investing when the market gives you the chance to make serious long-term money in a mega cap stock. Right now the market is giving you that chance in BHP Billiton.

If you listen to nothing else we ever write make sure you use this period of forced selling driven by US sub-prime lending concerns as your last chance to get a serious weighting in BHP Billiton. Paying sub 10x for this stock is a gift. In risk-adjusted terms it’s an incredible gift from the market. This is your last chance to get a serious exposure to the Marius era, and that is an era we want serious exposure to.

The first stock you should buy in this trading correction is BHP. You should be buying it today and buying it in scale. They are suffering from their own liquidity and index weight and that must be taken advantage of.

Go Australia