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  1. 1. October 2003 John Banos report: issue no 30 Bull market in Australian equities likely to continue, in my opinion Summary 4 The Australian equity market has increased by 24% from its March low, but the ASX All Ordinaries index is still roughly where it was three years ago and the ASX Small Cap index is at 1996 levels – see Chart 1. 4 I consider in this report two valuation measures – the “rule of 20” (where Australian equities now appear on the expensive side of fair value) and the earnings yield ratio (where Australian equities appear 15% undervalued relative to bonds). I increase my 12-month target on the All Ordinaries index from 3,500 to 3,650 – implying total prospective returns (including dividends) over the next 12 months of almost 15%. 4 Small cap stocks in Australia have outperformed the overall equity market in the past six months but now appear relatively expensive – see Table 2. 4 The consensus view appears to be that investors should switch out of banks into resources in an environment where world growth is likely to improve. I compare the valuations of the largest resource stocks to the largest bank stocks in Table 3 and conclude that it probably pays to take a different view from the consensus. 4 To benefit from the bull market in equities, HSBC clients may arrange to see one of our financial planners who can recommend a range of managed funds. Self-directed investors can purchase equities (on a no-advice basis) through HSBC Stockbroking. 1. Small stocks outperform from low base in past six months (Indices start at Jan 95 = 100) 90 110 130 150 170 190 95 96 97 98 99 00 01 02 03 Index ASX All Ordinaries Index ASX Small Cap Index Source: HSBC, Bloomberg, ASX John Banos, CFA Economics & Investment Strategy Australia Chief Strategist John Banos, CFA 612-9255 2215 Disclaimer This document is issued by HSBC Bank Australia Limited (ABN 48 006 434 162) and HSBC Bank plc, Sydney branch (ABN 98 067 329 015). We shall not be liable for damages arising out of any persons reliance upon this information. Members of the HSBC group or associated persons may have an interest in futures contracts, options, commodities, securities or derivative transactions of a type referred to in this document and may trade for its own account as principal, or earn fees, commission or other income in respect of transactions related thereto. This document does not constitute an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. No consideration has been given to the particular investment objectives, financial situation or needs of any recipient. HSBC recommends investors seek professional advice to ensure that particular investments are suitable for their own objectives, financial situation and needs. HSBC Bank Australia Limited 580 George Street Sydney 2000, Australia GPO Box 5302, Sydney, NSW 2001 Switchboard: +61 2 9006 5888 Facsimile: +61 2 9006 5440
  2. 2. October 2003 John Banos report: issue no 30 HSBC Economics & Investment Strategy 2 Strong fundamentals for the Australian equity market I believe that the Australian equity market is benefiting from strong fundamentals – particularly improving earnings and attractive valuations. On the earnings front, there is widespread agreement from equity market commentators that we have in the past few months witnessed one of the strongest profit reporting periods in many years. There is, however, some disagreement on the quantum of the profit increase. Some who optimistically talk of double-digit earnings growth in FY03 are usually referring to net profits growth, without taking into account dilution from the increased number of shares on issue. I prefer to focus on growth in adjusted earnings per share and on this basis EPS (as calculated by Aegis Equities) increased by 6% in FY03. I sometimes refer to Government tax records to get a second opinion on company profits, knowing well that most companies try to be as conservative as possible when reporting their profits to the tax office. Government records indicate that income tax on companies increased by a phenomenal 23% from $27.1B in FY02 to $33.4B in FY03. While the Australian Stock Exchange and the Government use a different sample of companies – the Government sample is much larger and also includes non-listed companies – I do not need any further convincing that earnings of listed companies are clearly on the way up. Looking forward, Aegis analysts are forecasting at least 11% EPS growth for each of FY04F and FY05F. I believe the risks to these earnings forecasts are probably to the downside given that a strong A$ should have a dampening impact on export revenues and may also lead to lower overseas earnings in A$ terms. Furthermore, borrowing costs may also rise from early next year. However, I believe that EPS growth in line with nominal GDP (+5 to +6% per annum) should be attainable over the next two years. I have used the following yardsticks in the past decade to ascertain whether share prices provide value in a particular inflation or interest rate environment: • “Rule of 20” – the prospective PER on the overall equity market plus the prospective inflation rate need to add to less than 20 for the equity market to be good value. The logic of this yardstick is that high inflation increases the risks for equities because monetary policy is often tightened aggressively during such periods. Furthermore, high inflation reduces the quality of earnings (for example, historic cost depreciation may understate the true level of depreciation when prices are rising rapidly) and real return on equity is often much lower. Therefore, equities should be penalised and should trade at much lower price-to-earnings ratios (PERs) during high inflation periods. At present, the prospective PER on the All Ordinaries index (using Aegis forecast earnings to October 2004) is 14.3x and using a prospective inflation rate of 2.6% (forecast from HSBC Economics) gives an index of 16.9. This is well below the danger level of 20, but is in the top half of the “fair value” norm between 12 and 18 that has been appropriate for the past 40 years. • Prospective earnings yield ratio – the prospective earnings yield on the overall equity market needs to exceed the prospective 10-year bond rate for the equity market to be good value. The earnings yield of a stock can be defined as earnings per share (EPS) over share price and is a good proxy for profits accruing to
  3. 3. October 2003 John Banos report: issue no 30 HSBC Economics & Investment Strategy 3 shareholders. Similarly, the 10-year bond yield is a good proxy for the expected return on risk-free government bonds. Now one may argue that surely the earnings yield on shares should significantly exceed the bond yield to compensate share investors for higher risk. Keep in mind, however, that the earnings yield on shares is an after-tax return while the bond yield is a pre-tax return. At present, the prospective earnings yield ratio is 0.85x – using a 12-months forward bond rate of 5.95% and a 12-months forward earnings yield of 7.0% (inverse of PER of 14.3x). The Australian equity market therefore appears 15% undervalued relative to bonds using this measure. Beware of valuations among ex-100 stocks Ex-100 stocks have strongly outperformed the All Ordinaries index in the past six months, but it is now much harder to find value in this area. Smaller stocks have historically traded on more attractive valuations (PERs and dividend yields) than the overall equity market to compensate investors for the higher risk. However, the prospective PER for smaller companies is now higher than that for the overall market – 15.7x versus 14.4x (see Table 2). Admittedly, the average PER for the smaller companies sector appears to be distorted by large losses from ‘fallen angels” (small companies that were once in the top-100) and large exposure to small gold miners and exploration companies that often trade on high PERs. It is also evident from Table 2 that ex-100 companies in aggregate are significantly less profitable – with an average return on equity (ROE) of under 9% forecast by Aegis Equities for FY04F versus an ROE of 12.8% for the overall market. Despite the lower ROE, ex-100 companies are trading at similar price to net tangible assets (NTA) ratios as the overall equity market. In conclusion, the ex-100 sector as a whole no longer appears undervalued. One way to continue to make money in small caps is through managed funds – your HSBC financial planners will be able to guide you in this regard. For those who try to pick small stock themselves, it is often true that those companies with the best news (e.g. imminent new discoveries in the biotech sector) usually also have the most expensive valuations. 2. Valuation parameters for Australian equities* FY03 FY04F FY03 FY04F (x) (x) (%) (%) All companies 17.2 14.8 6.2 11.3 Banks 12.9 11.9 8.6 6.5 Ex-100 companies 20.9 15.7 -0.7 22.3 Price/NTA ROE FY03 FY04F FY03 FY04F (%) (%) (x) (%) All companies 3.8 4.0 2.6 12.8 Banks 5.0 5.5 2.3 16.4 Ex-100 companies 4.4 4.7 2.4 8.6 PER Dividend yield EPS growth * Equity market valuations based on share prices as at 13 October 2003. Source: Aegis Equities
  4. 4. October 2003 John Banos report: issue no 30 HSBC Economics & Investment Strategy 4 Is the consensus view correct that resources are likely to outperform banks? The consensus view appears to be that stronger world growth over the next six months may contribute to higher bond rates in Australia (and overseas) – implying that Australian investors should be shifting out of banks (or other high-yield stocks) into resources (or other cyclicals). Let me analyse each component of the above statement in more detail. First of all, I find it interesting to know about the consensus view on markets, because I believe that to profit significantly you need to take a view different from consensus. It certainly does not make sense for retail investors or – even professional money managers – to try and second- guess where consensus is headed. My philosophy is to buy excellent businesses with excellent management teams at attractive prices and you usually only get this opportunity to buy quality businesses cheaply when the consensus for some reason has a different view. On the issue of world growth picking up next year, I am finding it very difficult to predict this with any degree of certainty. It may happen and it may not. It certainly does appear that many of the leading economic indicators particularly in the US and Japan have picked up in the past two quarters. Furthermore, global policy settings (both monetary and fiscal) appear strongly stimulatory. However, I believe that the US economy is in a post-bubble environment and it is possible in such an environment to see strong share market rallies only to be followed by further declines. For example, the Japanese equity market has been in a 13-year “post-bubble” bear market, but there have been three significant rallies of +55% (92 low to Jan 94), +44% (1995 low to 1996 high) and +79% (1998 to 2000) in between. Even in the bleakest of post-bubble environments there are false dawns and the current rally is certainly not enough to undermine the post bubble hypothesis. Even if the world economy continues to improve, one may argue that this is largely discounted in current prices for resource stocks. I believe that the best way to value resource stocks (or other finite life businesses) is through a discounted cashflow analysis that provides an NPV (or net present value) for each stock. However, of the five major resource stocks only Woodside Petroleum is trading a little below its NPV – as calculated by Aegis Equities. The other major miners are trading on premiums varying from 17% (for BHP Billiton) to 58% (for Alumina Limited) – see Table 3. In contrast, the five big banks in aggregate are trading 6% below their NPVs. Furthermore, the five big resource stocks are 52% more expensive than the big five banks on the basis of FY04 PERs (19.1x versus 12.6x) and provide only half the dividend yields (2.7% versus 5.5%).
  5. 5. October 2003 John Banos report: issue no 30 HSBC Economics & Investment Strategy 5 3. Comparing valuations – resources versus banks Price/ PER* Dividend yield* Share price Aegis NPV FY04F FY04F (cents) (x) (x) (%) Major resources Alumina 583 1.58 22.7 3.9 BHP Billiton 1142 1.17 18.5 2.1 Rio Tinto 3514 1.23 18.2 2.8 WMC Resources 503 1.35 17.5 2.0 Woodside Petroleum 1375 0.99 19.4 3.0 Average (equal weights) 1.26 19.1 2.7 Major banks ANZ Bank 1822 0.89 11.4 5.8 Commonwealth Bank 2833 1.01 14.0 6.0 National Australia Bank 3099 0.92 10.6 5.7 St George Bank 2140 0.91 15.5 4.8 Westpac Bank 1653 0.97 13.0 5.2 Average (equal weights) 0.94 12.6 5.5 Overall equity market 14.8 4.0 * Earnings and dividend forecasts are consensus numbers from I/B/E/S. Source: HSBC, Aegis Equities I continue to have a large weighting in banks in the recommended equity portfolios and include only one miner (BHP Billiton) in the growth and balanced portfolios – see Table 4. 4. Recommended equity portfolios for retail investors Growth Balanced High-income ANZ Bank ($18.22) ANZ Bank ($18.22) AGL ($10.67) BHP Billiton ($11.42) BHP Billiton ($11.42) ANZ Bank ($18.22) QBE Insurance ($10.07) Centro Properties ($3.94) Centro Properties ($3.94) Macquarie Bank ($35.60) QBE Insurance ($10.07) St George Bank ($21.40) Resmed ($6.75) St George Bank ($21.40) Stockland Trust ($4.90) St George Bank ($21.40) Tabcorp ($11.88) Tabcorp ($11.88) Westfield Holdings ($14.07) Westpac Bank ($16.53) Westfield America ($1.89) Woolworths ($11.09) Westfield Holdings ($14.07) Westpac Bank ($16.53) Source: HSBC John Banos, CFA John Banos is an authorised representative of HSBC Bank Australia Limited, a licensed dealer in securities. He owns shares in the following companies that have been discussed in this report – ANZ Bank, QBE Insurance.
  6. 6. October 2003 John Banos report: issue no 30 HSBC Economics & Investment Strategy 6 Neither HSBC nor any member of the HSBC Group guarantees the capital value or the performance of the securities. PRIVACY INFORMATION HSBC Bank Australia Limited and members of the HSBC Group would like to contact you from time to time with various product offers, special promotions and information. This may happen via mail, email or telephone. If you do not wish to receive this information you may tell us by telephoning us on 1300 308 008, or writing to us at HSBC Bank Australia Limited, Marketing Department, GPO Box 5302 Sydney 2001. If you would like to see a copy of HSBC’s Privacy Policy one can be obtained by calling 1300 308 008 or by writing to HSBC at HSBC Bank Australia Limited, Marketing Department, GPO Box 5302 Sydney 2001, or from your local HSBC branch. Alternatively, you can view the HSBC’s Privacy Policy on our website at