Hot Potato - A Game Every Investor Must Play

Welcome to August. Very mild mid-winter weather here on the East Coast of Australia, yet experience tells you that winter has not ended and it's premature to be putting your jumpers away.

Similarly, the unseasonably warm sentiment conditions in the Australian equity market have experienced market participants concerned. The aggressive pricing of the ASX200 leaves no room for error coming into the full year 05 reporting season, and already those small number of industrial stocks that have reported, have either succumbed to a degree of profit-taking, or failed to trade any higher.


Buy the rumour - sell the fact?

"Great expectations" are priced in, and we believe that with very few exceptions, those expectations won't be surpassed. The larger risk is that these "Great expectations" aren't met, or a met in a lower than expected quality of composition way. We continue to believe that the market is broadly too nonchalant about margin pressure and outlook commentaries, particularly from domestic East Coast cyclical's.

There's a fair degree of "deja vu" about all this, as it was exactly this situation we found ourselves writing about coming into the interim-reporting season in February/March. What happened then? About one third of the way into the reporting season the market worked out it was all in the price, and that was the catalyst for the April/May correction.

Chronic over-analysis of leading stocks, combined with chronic over-guidance from companies, leads to this situation being created. It's leading to the reporting season being one giant "non-event", where for all the reams of paper produced on it, very little money is actually made.

You make far more money looking 6 to 12 months ahead, having a shot at positioning yourself ahead of the influential pool of earnings and price momentum money. By the time the reporting season is upon us, we should be in a position to take some short-term profits into those who are chasing yesterday's profitability.


Growth at any price

As year on year growth broadly peaks, we are seeing a higher and higher multiple being placed on genuine EPS growth as an investment factor. This is leading to unprecedented and unsustainable P/E's being placed on the decreasing number of companies that genuinely offer growth, to the point where I think we are seeing "Growth At Any Price" investing.

G.A.A.P isn't a style; it's an accident waiting to happen. The multiples applied to those who possess short-term EPS growth seem to be irrelevant to the investing decision, and quite frankly, there should never be a time when earnings and cash flow multiples are irrelevant.

The last time we saw G.A.A.P style investing was in 2000/01, when what was described as a "Magnificent 7" emerged in Australian industrials. The market was excessively parked in these seven names, and drove their P/E's into the stratosphere. Analysts felt pressure from investors and the share prices to keep upgrading their expectations, and we did see "new paradigm" research being written.

I can remember a fiery morning meeting at my previous employer when CSL were $50.00. The analyst said he couldn't value it at more than $25.00, even using optimistic assumptions, but the dealing desk told him he was "costing them business" with his unrealistic stance. Of course, the stock fell to a low of $11.50 over the next two years, and it became clear the market had grossly overpaid for short-term EPS growth.

In these situations there is always pressure to write the view that everyone wants to hear, but that is never the view that makes you long term money.


Always know where the exit is

We believe you should always consider an exit strategy before you invest, and the higher the short-term multiple you pay, the lower the number of genuine exit strategies you potentially have. If you pay 20 times earnings for a basic industrial company, then you can pretty much rule out being taken out by another company, you can rule out a private equity take out, you can rule out value funds taking you out, and you can rule out G.A.A.P funds taking you out. All you can really hope for is another G.A.A.P investor to take you out, which means you're basically playing one big game of "hot potato"

You need momentum of earnings and share price to continue, and you can't risk being caught holding the "hot potato" when the music stops. In post 2000/01 environment, the entire "Magnificent 7" went from growth stocks to value stocks over the following two years, and the capital decimation was enormous.

I feel this situation is again upon us in Australian equities, with the market increasingly parked in a concentrated list of large cap industrials that possess earnings and share price momentum. Valuations are stretched, brokers are writing research to justify the new multiples we are seeing, and it strongly reminds me of 2000/01.

That's why at a strategic level I refuse to be sucked into this dangerous short-termist game. At a portfolio strategy level we are trying to lower the overall p/e of portfolios, without lowering the overall prospective EPS growth of the portfolio, add sustainable fully franked yield that grosses up higher than the long bond yield, add companies with rising NTA's, and add companies who asset bases and multiples could potentially provide us exit strategies to all market participants, including other companies and private equity.


Where can I find low p/e's, strong EPS growth, strong cash flow growth, strong dividend growth, and strong NTA growth? Where can I also find clear corporate and private equity interest??


The answer is the Resource Sector

Throw into the mix clear risks of further positive earnings revisions coming out of the reporting season, and we have the one sector that due to undemanding investment multiples is potentially attractive to everyone in fy06

Next weeks Diggers & Dealer's conference in Kalgoorlie will be the forum where the analyst community realises just how upbeat the sector is about the year ahead, and the conference will lead to analysts revising up forecasts.

We have said for some time now that there is a complete contradiction between what the resource corporate world is tell us, versus what analysts are forecasting. The Diggers & Dealers presentations will be the catalyst for analysts to address their unrealistically low expectations for the year ahead, and you watch consensus estimates get revised up over the next few weeks.

They need an excuse because we are one month into fy06 and already consensus commodity price forecasts look ridiculously low. Oil and Copper price forecasts look the most ridiculous at this early stage, with 1H06 consensus estimates already running -20% to -25% below average spot prices. (buy BHP)

Southern Cross's top of the market Oil price forecasts of $50.00 for 1H06 are already -18% below the average price seen for July of $59.00, and while some of our competitors believe the Oil sector share prices are already discounting $60.00 oil prices, we think that is absolute rubbish.

If the market truly believed in sustained $60.00 oil prices, then the average Australian oil stock would be trading 20% to 25% higher than today's share prices.


Should we be using $60.00 Oil for the full year??

That is a good question, and our no.1 unlisted oil industry contact believes that would prove prudent. This is interesting, as this contact has been second to none in spot price forecasting, with his forecasts based off tightness in the global refining industry. This contact believes the spot price will settle in the $60.00 to $70.00 range in fy06, and if he's right again, the share price and earnings ramifications are enormous.

We made a lot of money last year playing the arbitrage between consensus oil price forecasts and physical reality, and I suspect we can play that game again this year.