Wednesday, September 30 2015
The market sold off aggressively today on little news. The driver appeared to be a negative broker report on Glencore, which triggered a wave of hedge fund shorting across energy and resource names.
The hedge funds are targeting two key areas:
- Commodity stocks with significant amounts of debt (e.g. Origin Energy and Santos). These stocks appear to offer significant value but this will not be realised until they address their balance sheet while the hedge funds are targeting the stocks. We have no exposure to commodity stocks with large amounts of debt. Rather we have targeted those stocks with good balance sheets that can potentially acquire distressed assets and emerge from the current uncertainty in a stronger position.
- Stocks with exposure to Australian housing. The hedge fund view of the world is the Australian economy will face pressure from the resources slow down and this will impact housing. We believe the hedge funds are once again over playing the risk. Banks have not lent aggressively, Australian’s have been repaying loans faster than necessary in a low interest rate environment and only pockets of the housing market have experienced large price rises. The RBA retains the flexibility to lower rates.
Looking at simple multiples and yields the major banks and major resources appear to offer significant value. We note the grossed up yields below.
Of course there is an argument for both of these sectors that the dividend payout ratios are perhaps unsustainable.
The banks will face a higher share count following capital raisings, stronger growth in risk weighted assets and a likely steady deterioration in bad debts. To offset this pressure we expect them to further increase interest rates on mortgages and more aggressively cut costs. We are anticipating circa 5% EPS increases and flat dividends. We note even if the banks needed to cut the dividends by 10% the yields would remain attractive (which we doubt). As a consequence we see the market as overly focused on the downside risks rather than a balanced outlook.
Dividend yields are typically not a great measure of value within resources given the volatility of earnings depending on the commodity prices. BHP and Rio Tinto have adopted a progressive dividend policy where they attempt to maintain or grow their dividend through the cycle. At this low point the dividends appear somewhat stretched but we expect the major resource companies to continue to run their businesses aggressively to try to support the dividends. The major resource players have been removing costs and cutting capital expenditure to support their dividend. We note that one factor the market does not fully appreciate is that the payout ratio can remain above 100% at this point in the cycle given capex is running below depreciation levels.
Our preferred valuation method is using a net present value and running a sensitivity over commodity prices. The market is currently pricing into the major resource players an expectation that iron ore prices will fall towards the low $40 range (from $57 currently), that other commodities will continue to trade around spot levels and that oil will rise towards US$60 a barrel. That is the negative sentiment towards China and commodities appears to be largely reflected in current share prices and it will not take much improvement to drive a re-rating.
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