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It mightn't feel like it now, but times of crisis are often great opportunities to profit
It mightn’t feel like it now, but times of crisis are often great opportunities to profit. Companies that are cashed up, with robust balance sheets are the ones that will come out of this crisis on top. The task of the stockpicker is to locate the stocks that are best positioned to ride out the storm.
So what are the hallmarks of tomorrow’s out-performers?
Roger Montgomery, managing director of Clime Asset Management says investors should be less fixated on share price at the moment and more focused on key fundamentals.
One fundamental measure he values most in determining a stock’s longer-term (three years-plus) fortunes is intrinsic value (IV).
Essentially, the value of a company’s long-term cash flows, IV is a formula based on:
IV = Return on equity (ROE) ÷ Required Return (RR) X Equity
Montgomery believes that consistent investment in stocks at a discount to IV is a key driver of superior long-term excess returns. “Instead of trying to predict price, we’re using IV to identify a value proposition sometime into the future,” advises Montgomery.
He’s banking on the expectation that the gulf between share price and IV will narrow into the future, and cites ABC Learning Centres (ABC) and Telstra (TLS) as useful examples. When ABC was trading at around $8 on 14 April 2006, Montgomery’s IV on the stock was closer to $3, yet it took until mid July 2008 before it got anywhere near that value.
Meantime, while Telstra’s share price topped $8 post-ASX listing in 1999, it took another eight years before it converged closer to Montgomery’s (then) IV of $2.
He says the 11-fold growth of ABC’s reported profit in the four years to 2007 (while profitability and ROE progressively plunged), should remind investors that stocks exceeding earnings expectations today, won’t necessarily outperform tomorrow.
So what other criteria does Montgomery use to verify the value proposition that IV might throw up? He says stocks enjoying a dominant position within their sector, with quality future earnings will weather the economic downturn better than their peers. Two hallmarks of standout stocks he favours include:
ROE: A ratio measuring earnings (revenue minus expenses, taxes and depreciation) divided by equity, ROE helps determine whether every $1 used to growth the business has converted into $1 of market value. To compensate for risk premium associated with equities (instead of bonds or bank debt), Montgomery says stocks should look to deliver an ROE of between 12-14 percent and around 16 percent depending on their debt levels.
Net debt-to-equity ratio: A measure of a company's borrowings calculated by dividing all financial debt by shareholder equity. While Montgomery prefers net debt-to-equity under 30 percent, he says higher levels are manageable when there is sufficient cash flow to cover it, and cites Woolworths’ (WOW) net debt-to-equity of 34 percent as a useful example.
So based on the above criteria, what stocks does Montgomery expect to outperform their peers over the long haul? Given their IV, ROE, net debt-to-equity positions, market positions and quality earnings, the six stocks he expects to post progressively higher share prices over the next 12 months include: Reece Australia (REH), Australian Securities Exchange (ASX), Harvey Norman (HVN), The Reject Shop (TRS), WOW, and ANZ.
While the big four banks are traveling better than expected on revenue and cost, ANZ is trading closest to equity-per-share of around $11.60, and is at a 24 percent discount to its IV of $16.46, according to Montgomery. At 18.5 percent, ANZ’s ROE is well above Clime’s 16 percent required rate-of-return (to justify price). Montgomery expects access to cheap funding (courtesy of its AAA rating) to better position the bank to maintain its net interest margins.
When it comes to industrials, Montgomery says it’s hard to ignore discount retailer, The Reject Shop’s (TRS) consistently high ROE, which at 71.6 percent is almost five times Clime’s 14.8 percent required rate-of-return. Given its conservatively geared balance sheet and the quality of its underlying earnings, he says The Reject Shop is well positioned to capitalise on growth plans, including a further 20 store openings in 2009.
So what sectors or stocks are ripe for consolidation this year? According to Roger Leaning head of research with ABN Amro Morgans, balance sheets will quickly separate potential acquirers from sellers this year.
On the resources front, BHP has already signaled its interest in mopping-up the distressed assets of smaller counterparts needing to deleverage, notably Oz Minerals (OZL) and Rio Tinto (RIO), which recently received interest from Amcor (AMC) for its packaging business.
Given the ongoing tussle for assets within coal seam gas, Leaning recommends a watchful eye on remaining players, especially Arrow Energy (AOE) and Eastern Star Gas (ESG). Also in energy, he says stocks like Origin (ORG) and ALG Energy (AGK) are among likely suitors of distressed assets of Babcock & Brown Infrastructure Group (BBI), the NSW government’s energy assets or structured utilities like Transfield Energy (TSV), Duet Group (DUE), and Spark Infrastructure Group (SKI).
Following their recent capital raising, Leaning expects the big four banks to join QBE in eyeballing moves to split Suncorp’s banking from its insurance business. He also expects regional banks, like Bendigo and Adelaide Bank (BEN) and the Bank of Queensland (BOQ) to come under the banks’ acquisition radar this year. “While the need for scale will trigger corporate activity, the big question is, will there be willing sellers given current valuations?”
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