The two speed economy is starting to define the thinking of brokers. Merrill Lynch looks at the reporting season and makes a few fairly obvious observations about where the weaknesses lie. Merrill argues that uncertainty is the theme: in earnings and valuations. They argue if there is no growth in earnings for several years and market settles on a PE of 12, then fair value now would be 4,100. Ouch. Merrill says this is much less than the 5,600 that comes from applying a historical average PE to the current forward consensus estimate. When they use historical average valuations using dividends and price/book the result is 4,800 and 4,600 respectively, giving Merrill a fair value estimate of 4,700. Not much reason to rush to invest in the market.
Merrill says Sydney and Melbourne are the epicentres of weakness in the domestic economy:
There is no doubt that the current weakness in consumer sentiment is exacerbated by other factors like uncertainty in Europe and, closer to home, tax changes. But after weighing up the data we have come to the view that conditions in these cities could remain tough for years to come.
Investing is accordingly developing a very defensive quality, with margin pressures growing:
Cost pressures
Costs are rising on a number of fronts, including labour, raw materials, fuel and utilities. Some companies – including retail and banks – need to look seriously at cost cutting programs as they adapt to an environment of low top line growth.
These programs could be announced this reporting season. Likely candidates are Macquarie (MQG), the banks, retailers and supermarkets.
Margin compression
As we outlined above, margin forecasts for the next yew years are way too optimistic particularly for non-financials. Earnings will be constrained by the lack of growth in the non-mining economy. Our top-down assumptions are for sales growth below 5% and margins to decline for the next few years. Current bottomup consensus forecasts are substantially higher with a sales growth rate of 7% for the next 3 years and rising profitability. ROE for the non-mining economy is currently forecast to rise from 11% to 13% by 2013, while the EBITDA margin is forecast to rise from 18% to 23%.” Merrill provides a list of companies with low gearing, whcih is one way to pick the good defensives. Companies generally have unusually low debt levels, as Merrill points out:
Aggregate leverage ratios are at record lows and, according to ML analyst forecasts, expected to fall over the next few years. The net debt/equity ratio for the ASX 200 ex financials is currently estimated to be 28%, already the lowest on record and falling. The fall in gearing reflects the cautious approach companies continue to take toward their finances. Payout ratios are low and falling in large part because of the strong resource companies’ profits.
It is very much a stock picking environment. No sentiment driven capital gains are in prospect.