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As we expected, the market got the wobbles in October, right on schedule. From early October up to late last week, the Australian market had fallen by more than 7%. It has since regained composure and is now down about 6% from its late September peak. Reflecting market nervousness, volatility in October has been about twice its average over recent months.
Many of us had secretly feared a repeat of 1987. All the ingredients were in place: structural problems in the US (twin deficits), rising US interest rates and to a lesser extent global interest rates, rising global petrol prices and, finally, rising inflation best evidenced by soaring commodity prices. Stockmarket valuations were stretched but not ridiculous. Of course, most of these problems have arisen because the global economy has been so strong.

In the face of these challenges, in 2005 the US market has been remarkably steady and the Australian market has powered on. But confidence is a fragile commodity. Many of us feared factor X might wreak havoc on confidence in October. As Marcus Padley has said, a waterfall begins with one drop. Like Marcus, I still can’t figure out what caused the 1987 crash; I don’t think anyone can '” it was probably just a sudden and awful drop in confidence.

The sudden 2005 October correction clearly caught some by surprise. And it may take some time for exuberance to return to the market. But that just indicates that we are now experiencing a healthy correction. I think the important point is that no X factor has appeared to disturb the peace. Forecasting the future is always hazardous, but I think we’ve dodged a bullet.

Among the blue chips, early Australian company reports for the September quarter show companies are experiencing solid growth. I’ve compiled a list of 32 leading Australian companies that have either reported September quarter trading conditions or who have provided guidance for 2005-06. Nearly two-thirds provided OK to good commentary. The balance disappointed, but by and large the disappointments were marginal; such as lower-than-expected BHP Billiton iron ore production or Wesfarmers coal production.

The only really poor commentary emerged from Ten, Macquarie Infrastructure Group and Newcrest. Two emerging themes appear to be slower New Zealand trading, as well as higher costs particularly impacting resource companies. Taken together, the company reports so far give no reason to be overly concerned about the market. None of these reports show significant upside surprise, but they do indicate reasonable trading conditions. Similar results are also emerging from the US September quarter results, with overall earnings growth of almost 19%.

CONSUMER DISCRETIONARY

Media companies report tougher conditions in the advertising market. Many describe the market as “short”; that is, advertisers are not booking too far in advance. That makes forecasting harder than usual for media companies. Ten now expects TV earnings to be down in its November quarter, but perhaps this is a company specific issue given their season to date TV ratings are down up to 7.5%, depending on the demographic. WA Newspapers reported a 13% rise in pre significant (pre abnormal) September quarter results, but expressed some caution about the outlook, due partly to higher petrol prices. Rural Press expects earnings growth in the December half of about 5%, slightly below some expectations.

Coca-Cola Amatil reiterated guidance of low double-digit earnings growth; although it disappointed some, 12% growth is still reasonable. Foster’s re-affirmed Southcorp synergies of $40–50 million as well as earnings per share (EPS) growth guidance of 10%. UNiTAB commented that September quarter wagering revenue was down on a year earlier and October was flat.

Woolworths reported like-for-like sales increases of 3.2% for food and liquor, 1.2% for Big W, and 11.2% for electronics. Overall this was up slightly on a year previously. Harvey Norman reported a like-for-like sales increase of nearly 6% in the September quarter. Billabong re-affirmed its guidance of 15% EPS growth in 2005-06.

FINANCIALS

Perpetual said it expects 15% like-for-like growth. Again some were disappointed because the 15% excludes European start-up losses and the switch to new accounting standards (AIFRS). Stripping out the former leaves EPS growth of about 7–8%. AMP reported September quarter inflows up 31% and cash flow up nearly threefold to almost $1 billion, but cash flow was helped by some one-off adjustments. ANZ’s 2004-05 result was in line with expectations, but showed cost pressures and margin declines. ANZ reported tougher NZ trading conditions but otherwise declined to give specific 2005-06 guidance due to uncertainty of new accounting rules (IFRS). CBA reported September earnings in line with expectations. CBA expects cash EPS for 2005-2006 to be at least equal to its peer group.

OTHER INDUSTRIALS

AGL reported results to date ahead of expectations but left full-year guidance unchanged; however, Origin Energy increased guidance by about 5%. Transurban reported relatively strong September quarter revenue rises of 5.5–9.4% against the previous corresponding period. Traffic volumes were up by more than 3.5% in Melbourne and almost 1% in Sydney (Hills Motorway).

Westfield reconfirmed prior distribution guidance. Macquarie Infrastructure (MIG) reported generally soft traffic conditions with the M6 motorway in Britain down 11.6% and Canadian Highway 407 traffic up about 4.3%. However, the Sydney toll roads showed revenue rises of 3–7%.

Boral confirmed consensus expectations for the December half. Sims reported a September quarter result well below last year (down 50%) but in line with prior guidance. OneSteel reiterated its outlook for likely solid profits in 2005-06 but NZ and steel prices had softened. OneSteel’s second quarter outlook represented a decline in expectations. Brambles reported September quarter revenue and earnings were well above a year earlier. AWB increased its wheat harvest forecast to 23–25m tonnes (up 9%). Amcor reported September quarter results in line with expectations; however, costs were rising.

RESOURCES

Within resources, Newcrest was a big disappointment; it announced no first-half profit increase was likely. This was due to a range of factors including higher fuel costs. I count this as the sixth earnings downgrade in the past six months. Global gold miner Newmont also disappointed with lower gold production and higher costs. Woodside reported a 24% rise in September quarter revenue. This was slightly above expectations. Santos reported a September quarter production rise of 14% and an 82% revenue lift.

Rio Tinto’s September quarter production report was solid; key commodities such as iron ore and copper production were slightly ahead of expectations. BHP disappointed slightly with iron ore production almost 10% below expectations due to bad weather and a train derailment. Iluka maintained its profit guidance for the year. Wesfarmers reported coal production up 6% for the quarter. However, lower-than-expected coal production forecasts from Curragh disappointed the market. Zinifex reported September quarter smelter production down 6% but concentrate production up 1% on a year previously. The following table gives a brief tabular summary of recent company commentary.

Sector	Company	Overall impression	Comment
Media	Ten	Disappointed	Falling earnings in November quarter
	WA Newspapers	OK	13% rise in September quarter, cautious on December quarter
	Rural Press	Disappointed	5% rise in December half
Retail	Woolworths	Good	Reported better than expected sales growth in September quarter
	Harvey Norman	Good	Sales growth of 5.9% in the September quarter
	Billabong	OK	Expects 15% eps growth in 2005-06
Energy suppliers	AGL	Good	Trading so far better than expected, guidance of small earnings decline unchanged
	Origin	Good	Increased guidance about 5%
Toll roads	Transurban	Good	September quarter revenue increase of 5.5–9.4%
	MIG	Disappointed	Soft traffic in September quarter with the Britain's M6 down 11.6%
Building materials	Boral	OK	Confirmed consensus expectations for December half
Steel	Sims	Disappointed	September quarter down 50% but in line with prior guidance
	OneSteel	Disappointed	Likely solid profits in 2005-06 but NZ and steel prices have softened
Beverages	Coca-Cola Amatil	OK	Reiterated 10%-plus growth in December half
	Foster's	OK	Reiterated 10% eps growth guidance in 2005-06 as well as Southcorp synergies
Gaming	UNiTAB	Disappointed	Wagering revenue down in September quarter
Financials	Perpetual	Disappointed	Expects 15% growth like for like
	AMP	OK	September quarter inflows up31%, cash flow up nearly threefold to almost $1bn
	ANZ	OK	Result for 2004-05 as expected; cost pressures, margin declines & slower NZ; no 2005-06 guidance
Logistics	Brambles	Good	September quarter well above previous corresponding period
Packaging	Amcor	OK	September quarter in line with expectations. Costs rising
Property	Westfield	OK	Reconfirmed prior distribution guidance
Rural	AWB	Good	Increased wheat harvest forecast to 23–25m tonnes (up 9%).
Gold	Newcrest	Poor	Shocked market with no December half profit growth
	Newmont	Disappointed	Lower production, higher costs
Other resources	Rio Tinto	OK	Solid September quarter production report
	BHP Billiton	Disappointed	Iron ore production almost 10% below expectations
	Iluka	OK	Maintained earnings guidance
	Wesfarmers	Disappointed	September quarter coal production up 6%. But Curragh disappointed
	Zinifex	Disappointed	Smelter production down 6%; concentrate production up 1% on a year earlier
Oil and gas	Santos	Good	14% rise in production and an 82% revenue lift
	Woodside	Good	24% rise in September quarter revenue slightly above expectations

So with reasonable trading conditions, fears of a sudden loss of confidence in October should recede fast. I think it’s time to add to positions. This is not to say we should ignore the obvious challenges I mentioned earlier, but many of the global imbalances are actually favourable to Australia; commodity price booms, for example.

Overall, I’m cautious on the commodity stocks. They have had a fabulous run and there may still be plenty of upside, but future performance is totally dependent on commodity prices, which in turn appears to depend most on Chinese demand. And who can really tell what is going to happen there? Mine expansions are being announced almost daily, and the cost of new plant expansions is rising precipitously. In the 19th century gold rushes, more money was made out of selling pots and pans than actually using them to find gold. So if the commodity boom continues, those selling the pots and pans should do very well anyway.

I’m also cautious on the deal-driven investment banks. The Macquarie Bank group seems to have announced a deal a day during October, and on some days, more than one deal. Investors seem to be concerned that the deal frenzy may hide some lemons, as MBL has been one of the hardest hit stocks '” down 18.5% at the time of writing.

RECOMMENDATIONS

Right now I’m focusing on value stocks with high yields or trading at price/earnings multiples that historically have proved very attractive entry points. Among the banks, Commonwealth currently has the highest yield (5.7% fully franked). It has barely fallen in October from its recent $39 high. Low single-digit earnings growth is not great, though it’s coming off a high base. I would add to positions.

Wesfarmers (WES) has fallen 14.5% over the past two months due to lower coal profit forecasts. At $35.50, it’s now yielding 6.4%, with expectations that earnings will rise nearly 34% in 2005-06. Historically, the stock has traded at about a 20% premium to market. Right now it is trading at an 5% premium. Although its September coal production quarterly disappointed, Wesfarmers is partly shielded from recent coal price weakness (about 30% of earnings) by significant currency hedges. Its remaining businesses are experiencing strong conditions. The company is targeting return on equity in 2005-06 of a whopping 30%, up from a still very strong 22% in 2004-05.

BlueScope (BSL) has fallen by more than 18% in the past month and has been the worst-performing steel stock over the past year. This is probably because it is most exposed to rising iron ore and coking coal prices. However, at the current $8.30 share price, BSL is trading on a 2004-05 yield of 6.9% fully franked. Only Sims (8.2% half-franked) and Telstra (9.6% fully franked) have higher yields in the Australian market. Recent reports from US steel companies such as Nucor (US top-three steelmaker) show better-than-expected September quarter results and production volumes. In addition, they report a positive steel price outlook and strong order book for the December quarter. Indeed, Nucor has a positive outlook as far as it can see out '” to March 2006.

Transurban’s (TCL) share price has fallen 14.5% in the past six weeks. The market has been downgrading long duration stocks due to fears of further interest rate rises. Earlier this year TCL made a transformational acquisition when it acquired Hills Motorways. In addition to a good traffic report (as discussed above), in early October TCL announced its 40%-owned M7 tollway would be completed eight months ahead of schedule. This has significant financial benefits for TCL, including bonus payments ($1 million per month), as well as early revenue from both traffic and TCL’s tolling system. TCL is yielding 7.8%. Although unfranked, it is tax-deferred, which for 47% marginal tax rate payers, is even more attractive than franking.

Toll has fallen 12.5% since announcing its bid for Patrick (PRK). Although it is not a yield stock (2.4% fully franked) it is trading around its long-term average market premium of 25%. It may have to lift its bid for Patrick, but claims there are $65 million in synergies to be gleaned from the acquisition and could therefore lift its bid well above $7 and still generate EPS accretion. In that case, some might ask: Why not just recommend Patrick? The reason is simple: the Toll fundamentals stack up with or without Patrick. However, in the absence of a successful bid, the Patrick share price might have some considerable downside.

Then there is Telstra (TLS). This is currently the highest yielding stock in the Australian market at 9.6% fully franked. However, this assumes a continuation of the current 12¢ pa special dividend. The company is publicly committed to paying a 6¢ special dividend in early 2006, but beyond that a continuation of special dividends cannot be guaranteed ahead of a major strategy presentation by new managing director Sol Trujillo in mid-November. But even ignoring special dividends, Telstra is yielding 6.6%. The company is crying poor, but after a reasonable 2004-05 result, I’m betting there is plenty of gamesmanship in the new guard’s anti-regulatory rhetoric. At any rate, there appears significant profit upside from restructuring initiatives that may be announced in mid November.

Among smaller caps, McGuigan (MGW) has declined 15% in the past month and 37% in the past six months. It is now yielding over 6% fully franked. Although the earnings outlook remains very cloudy for the wine sector and there is unlikely to be a positive earnings surprise in the first half, I think this is already captured in the MGW share price. MGW is now trading on a 10-15% discount to the market.

Disclaimer: The author owns shares in TLS, TCL and MGW and has a derivative exposure to the remaining recommended