How To Ride A Raging Bull

I've had numerous queries from investors over the last few trading days along the lines of - 'do you guys actually take sell orders?'.
This is a highly appropriate and prudent question to ask as the benchmark index makes record highs each day. Yet, despite prices being broadly at record highs, it is not the easiest question to answer. (yes, we do take sell orders)

In a strange way, despite record share prices, I can actually come up with more stocks I want to buy than I want to sell. That sounds counter-intuitive, yet it's not if you take into account that commodity prices continue to advance, and the Australian economy continues to expand as measured by GDP and corporate profitability.

I am watching the entire Australian economic and corporate earnings cycle lengthen and strengthen before my eyes (driven by business investment); I am also seeing overall corporate financial risk lowered as measured by balance sheet strength; therefore I must resist the temptation to prematurely take profits in companies whose prospects also continue to strengthen, and their risk profiles improve.

Share prices discount the future, and the future for the Australian economy is brighter than previously forecast. The equity market strength we are seeing is reflecting these brighter prospects in terms of equity earnings and dividends, and also starting to reflect a high global investor opinion of our corporate ability. It's also reflecting a clear "supply problem".

We are witnessing a concurrent upgrading of Australia's economic prospects, and equity earnings prospects. Yet most importantly, we are seeing a global price earnings (p/e) ratio re-rating of the equity asset class due to the combination of management skill, intellectual capital, industry structure, political stability, corporate honesty, compulsory superannuation, and a clear shareholder returns focus.

When contemplating taking profits, you must first ask yourself one key question. Are we in the middle of a complete re-rating of Australian equities?

I believe we are, and I believe the p/e of the ASX200 will move to a 20% premium to the MSCI (Morgan Stanley Capital International) index over the next two years. However, my personal beliefs shouldn't stop you taking profits, and I never - ever - discourage investors from physically taking profits, particularly when you are approaching the final quarter of the calendar year and share prices can get a little over-heated on a short-term view.

I believe the best course of action for those considering locking in some profits in the current environment is actually to write some 10% out-of- the- money call options over your holdings. Call option writing gives you a higher effective exit price if you're exercised, and also lowers you're effective entry price if you're not exercised, as you keep the premium you write.

In the frothy asset class environment we are in, call writing is a far more prudent way of locking in some profits than physically selling stock. The implied volatility with option pricing is increasing, which is equating to better prices for option writers.

How many occasions in recent times have you thought a stock was full from a trading perspective, only to watch it rally another 10%. If I learned anything from prematurely taking profits in Macquarie Bank (MBL), it's not to underestimate the power of momentum. The MBL example should remind you of the perils of premature profit taking in stocks with momentum. This is the sort of market we are in, and why we prefer call writing as a profit taking strategy over physically selling stock.

It's Time To Explore Some Options

So where would we write some calls?

It's a limited list, and most of it is based around rising bond yields and falling energy prices.

Our core equity strategy is based around global and domestic cyclical stocks that command a solid p/e discount to the broader market. We don't recommend concept stocks, and where we recommend growth stocks we don't want to be paying through the nose for that growth. We want fully franked yields that gross up higher than the bond rate, and we want high quality board members and management teams. But most of all, we want it all at a discount to the market.

So while our core strategy is positive, we have pricing discipline within that strategy. I suspect the average p/e of our strongest stock recommendations is 11 times for 2006, while the average yield is 5% fully franked. All our strongest recommendations have falling gearing ratios, rising net interest cover ratios, clear "pricing power", and rising ROE's. That's why I'm not tempted to take any profits in our core strategic ideas, because they remain cheap and leveraged.

We also believe we are in the early years of a sectorial leadership change in Australian equities, and we expect to see p/e expansion from this point from our strongest "old economy" cyclical ideas.

Part of our positive cyclical stance is based on energy prices, particularly oil prices, retreating to more sustainable levels around US$55bbl. Falling energy prices will be the catalyst for a strong pro-cyclical/ anti-bond rotation into Christmas, and on that basis we think the best call writing/ profit-taking opportunities lie in the energy sector itself, and sectors such infrastructure, property trusts and selected financials that are bond sensitive for valuation.

I suppose property trusts are their own asset class, and I can't claim to know too much about them, so I would prefer to concentrate the profit taking on energy, infrastructure, and selected financials.

"Survey says"

Lets have a look at the results of the Russell Investment Management Fund Manager Survey (see attachment).

The percentage of fund managers who believe the Australian equity market is overvalued jumped 11% in the quarter to 46%. The percentage of fund managers who viewed the market as undervalued dropped from 9% to 4%. Only 4% of domestic fund managers believe the domestic equity market is undervalued. 50 fund managers were surveyed, and only 2 believed the domestic equity market was "undervalued". That's why it's going up.

The percentage of managers favouring overseas equities increased by 3% to 51%.

I find this all a bit strange. Why do we all need to head overseas when we have a growing number of large cap global leaders of their industry, listed right here? You don't have to worry about currency risk, political risk, or management fraud risk. Why then isn't it better to but global exposure locally?

Why physically invest directly overseas, and become a step further removed from your money than you need to be? I think it adds unnecessary risk, particularly given we have so many global industry leaders listed in Australia today, and most of them command p/e discounts to their offshore listed peers.


The Coming Oil Price Correction

The oil price just can't make fresh highs, it's in the classic "death roll" position of a commodity that is running out of trading puff. The price isn't going higher despite wave after wave of incrementally bad news being thrown at it. The world is starting to work out we aren't physically short crude oil production, we are short refining capacity.

As one respected commentator said the other day: "when you see pension funds investing in oil futures you know its the top!."
I would say when you see broker analysts forecasting oil prices above the spot price, you know it's the top.

The Australian energy sector is trading on a 40% p/e premium to its global peers, and has been the best performing sector of the last 18 months. Just about every stock is trading at record highs, and most are 200% above the lows of a few years ago.

These energy stocks have all had wonderful momentum, yet the game of getting in front of consensus WTI Oil price upgrades is ending, and I actually think there's actually a higher risk of consensus oil price forecasts for the year to June 2006 being too high now, not too low.

The pending oil price correction will see bond yields rise globally, and see speculation about further global interest rate rises increasing. Both these events will hinder the performance of the major infrastructure stocks.

I have absolutely no idea how to value or price infrastructure stocks. I suspect I'm not alone, and I suspect there are many, many holders of infrastructure stocks who simply don't know how to truly value their investments.

Why do I say this? Because I'm fearful that if bond yields rise, there will be an exodus from the sector from all these people like me who really don't know how to value the stocks.

I also believe the poor performance of Sydney's cross-city tunnel, despite my own loyal patronage, is the first cautionary tale on infrastructure investment so far. Pardon the pun, but it's been 'one way traffic' in infrastructure investing, and now we are seeing the first signs of not every "concession" being an instant gold mine.

The trickiest part of this whole call writing/ profit taking strategy is the financials. The textbook says if bond yields rise, financials under-perform. I think that's going to be the case, but I don't think they are physically going to fall in price, particularly as the major banks are on the cusp of being cum large fully franked dividends.

Rising Bond yields will be a reaction to re-accelerating domestic GDP growth, and a slight recovery in domestic consumer confidence as petrol prices ease. The large cap Australian banks are "GDP proxies", and a re-accelerating economy eases pressure on bad debts, and ensures all-important "full" employment levels are maintained. It's a fraction hard to see what will physically de-rail major bank earnings in the short term, albeit earnings growth will be dramatically lower than global cyclical peers deliver in the year to June 2006. Remember there's actually a fair amount of equity market leverage within the major banks due to funds management businesses and online broking operations, and they are indirect beneficiaries of the continuing out-performance of equities as an asset class.

I really don't want to take profits in anything with equity market leverage, but particularly fund managers, life insurers, listed brokers, the ASX itself, registry businesses, or service providers. It's way too early, and the earnings upgrade cycle has much further to run in these leveraged sectors.

So, in summary, if you're keen to lock in some profits, the two sectors we think offer the clearest profit-taking opportunities are energy and
infrastructure. Interestingly, they're the two best performing sectors of the last 24 months, and the trick is to switch to some large cap industrial laggards with leverage.

Charlie Aitken is a stockbroker with Southern Cross Equities