Why defensive CSL is trailing

PORTFOLIO POINT: Its shares held their value during the downturn but CSL is not leveraged to the recovery, meaning investors are finding better value elsewhere.

Shares in flu vaccine and blood plasma company CSL went into the stockmarket downturn at about $38 and that's exactly where they were ahead of the market’s surge in March, proving the true meaning of a solid, high-quality, defensive stock throughout turbulent times.

However, its performance for loyal shareholders since then has been far less impressive.

The Australian market has recovered more than 30% since the second week of March, but CSL shares went the other way, losing some 8.5% in value, opening up an even larger gap with the recovering stockmarket. In case anyone wondered: it's a similar story for Woolworths and Invocare, as well as many other defensive favourites.

If there is a problem with CSL, it certainly has not registered on anyone's radar yet. The company is likely to continue enjoying solid market fundamentals, while further building on its strong market positions and R&D efforts. Earnings per share growth should come in double digits for years to come.

Earlier this year, management experienced a setback when US authorities knocked back a takeover proposal for smaller market player Talecris, but expert opinion at the time was united around the fact that CSL didn't need the deal to continue growing at double-digit speed. This put CSL management in the somewhat awkward position that it all of a sudden had a lot of money in the bank but nothing to spend it on. Hence why management announced a share buyback.

CSL is a major player in the US. Even if we assume the US dollar is likely to weaken further in the year ahead, and that most stockbroking analysts will have to adjust their earnings estimates for this, surely the share buyback will provide CSL with a sufficient cushion to continue guaranteeing double digit earnings per share growth?

So what's the problem? Why are CSL shares going backwards when most other stocks post firm advances?

The problem with CSL shares is one of relative valuation in combination with the fact that many other companies carry a far greater leverage to a recovery in economic growth. Put these two elements together and compare the outcome against the rest of the market and CSL shares still do not appear overly attractive.

No doubt, market expectations will go through a lot of changes this month as company profits and guidances will assist stockbroking analysts in projecting the future, but as things stand right now, CSL is expected to lift its earnings per share by about 19% in 2009-10 and by 13% in 2010-11 (I skip 2008-09 as I believe backward-looking results play a secondary role at best). If all this proves correct, CSL shareholders who bought at $31 should enjoy a 3% dividend yield in 2010-11.

For this, shareholders and investors are currently paying more than 13.5 times projected earnings per share for 2010-11.

Stockbroking analysts will tell you this makes the shares cheap. Historically, CSL shares trade on a price/earnings (P/E) multiple of about 23. That may be true, but it does not mean the P/E is about to surge back to historical averages anytime soon. What this probably does explain is why the large majority of all analysts covering the stock have slapped a Buy rating on it.

Eight out of the 10 stockbrokers and stockmarket researchers monitored daily by FN Arena rate CSL shares as a Buy; two rate it Neutral. This makes CSL one of the highest-ranked stocks in the Australian market. Mind you, the average price target is $37.24, which is below the $38 price level the shares were trading at prior to March, but about 18% above their present level.

Let's have a look at what is on offer elsewhere.

Australian banks should experience a genuine earnings per share growth spurt once they free themselves from the shackles of bad and doubtful debt provisions. Current market forecasts anticipate earnings per share growth for the Big Four of about 26–38% for 2010-11. This puts major banks in Australia – even after the significant rally in July/August – still on P/Es that are well below what is implied in CSL's present share price.

Commonwealth Bank remains the most expensive of the Big Four, but its 2010-11 P/E of 11.4 still doesn't come close to CSL's. The shares pay a projected dividend yield of 5.4% on top (the others pay 6% or more).

The differences become even more pronounced if we take into account what could possibly be in store for companies that are truly leveraged to recovering economic growth, such as producers of raw materials. OZ Minerals, for instance, could well be trading on a dirt cheap 2010-11 P/E of 9, while Kingsgate Consolidated could be on a 2010-11 P/E of 6. Admittedly, these recovering miners come with a far greater risk profile (OZ Minerals is expected to pay out some hefty dividends nevertheless) and for all we know investors have once again pushed the recovery theme a bit too fast, too far for commodities, but the optimists will counter that it cannot be excluded these stocks might still surprise to the upside.

In fact, most companies that have a similar growth path as CSL ahead, such as insurer Tower Australia, either trade on lower multiples or pay higher dividends or, in the case of Tower Australia, both.

What goes for CSL also goes for most other defensives. Woolworths is currently still trading on an implied 2010-11 P/E of 15. Invocare is on 15.5 (with single-digit growth expectations only). These above market share price valuations come with below market growth prospects.

Investors might want to keep this in mind as these stocks might outperform during stockmarket pullbacks, just as they did throughout most of the selldown between late 2007 and early 2009, but it remains yet to be seen whether they can retain their present above-market valuations, not to mention their relative premiums when compared to the rest of the market.

Rudi Filapek-Vandyck is editor of FN Arena, an online news and analysis service.