What do the Aussie markets look like? ASX20 analysis

I recently conducted an analysis of the Dow Jones companies by stacking them together and considering it one big business. The purpose was to obtain an understanding of the facts and the potential impact on the markets in the event that QE3 does not occur. The risk that many people perceive is that there will be a massive withdrawal of liquidity from the markets, akin to the collapse in 2008 post-Lehman. The most common justification for this viewpoint is that the ‘markets’ are expensive and have been propped up by the liquidity injected into the systems via the US Federal Reserves ‘Quantitative Easing’ programs, which are due to end very soon and by the end of June.

The result of my analysis was that I concluded that the companies that constitute the Dow Jones Industrial Average are, in aggregate, in a solid position. They are generating a lot of cash flow, have been reducing debt and have been buying back some shares. They are definitely much stronger than in 2008/09. If earnings expectations are met, they are reasonably undervalued. Even if they are not met, the base is strong and there is no reason at this point in time to think that there would be a collapse in share prices. Ultimately markets respect real business value.

The next step is to have a look at the Australian market (ASX), which has been flat for some years now. Referring to the S&P 200 index (XJO), one can see that we are at 4485 on the index, compared to a peak of around 6,800 in 2007. The market has been flat since August 2009, which is now nearing 2 years. Will it end? Are we doomed to a stagnant market for another year or even more?

My purpose here is to conduct an analysis of the companies which are part of an ASX20 index and represents the largest companies listed on the ASX. They are generally well-known and account for a significant percentage of the total ASX market capitalisation. In this case, I’ve aggregated all the companies together and have adjusted them based on their size. Therefore, assuming the ASX20 is just one company, some components such as BHP and Rio Tinto account for a larger part of this business than others. The reason for this is that the ASX and the ASX20 are heavily impacted by financials (big four banks), BHP and Rio Tinto. Whilst it does not provide as great a generalisation, it does provide greater clarity for the impacts that these businesses are likely to have on the markets in Australia.

 

The current market capitalisation of the ASX20 is around $922 billion. It is heavily weighted towards BHP, RIO and the financials.

What does it look like?

Margin of Safety: 17%

This weighted average business has a theoretical share price of $38.54 and the forecast value is $46.51, providing a reasonable buffer. However the key here is that current price is not based on current value; it is based on expectations of future earnings over the next two years. This is fairly typical however it does mean that it is very important that the growth of earnings is achievable.

 

Without a doubt, we can see that since 2001, the value of these companies have increased substantially from $7.01 in 2001 to $25.56 in 2010. This is very strong growth and it is clear that profitability has been exceptionally strong with return on shareholder’s equity of over 20% in most years. 

Forecast earnings for 2011 and 2012 fiscal years are high compared to 2010. The consensus expectation is for a 34% increase to 2011 and 52% to 2012. These figures are high but there have been larger increases in recent years. Given the challenging economic environment it will be important to monitor the results to see if they are achieved. A very large component to this expectation is earnings from BHP, but also Newcrest Mining, Macquarie Group, Wesfarmers and Woodside Petroleum. Earnings are expected to fall for Telstra and Westfield Group.

Alternative scenario: no profitability growth

Given that earnings expectations are strong, what would happen if earnings expectations are unrealistic and are not met? For example, Woodside Petroleum just came out with news that the Pluto gas project has been delayed resulting in $900 million in additional capital costs and inevitable earnings downgrades. I’ve adjusted the figures to determine the outcome to the business value should current profitability remain at current levels. I actually think this is a more realistic outcome as there are certain segments of the market which are experiencing some difficulty, although others continue to stand on strong ground such as BHP.

Margin of Safety: 4%

Based on this scenario, the market is priced close to perfection and should not result in significant adjustment. The area to watch for downside risk would be bank profits, which have experienced a flat-line in earnings and may have some potential for increased bad and doubtful debts.

Remember, some of these statistics are skewed because there is a significant weighting towards the financials, which tend to have significantly higher debt loads, due to their business model, compared to other companies.While top-line revenue is reducing, earnings are growing which represents an increase in overall profitability.

The biggest take-out from the above information for me is that companies have very healthy cash flows. This cash is partially being used to pay down some debts and also buy back a few shares, which were raised through the financial crisis. This mirrors the US companies in the Dow Jones which were performing similar actions, although a bit more aggressively. Australian companies have been able to resume dividend growth back to trend, which is significant. This is generally preferable to Australian investors due to the benefits received from franking credits. The biggest positive above anything else seems to be the fact that cash flows from operating activities, or their usual business cash flow, is growing in a perfect trend and has not halted at all through the past few years.

Based on this information, Australian companies have very strong cash flows and are accumulating cash. I expect that they will soon either increase dividend payments and/or look for mergers and acquisitions. My prediction is that a bit of both will occur and I expect to see some evidence of this occurring in the next 12 months.

Conclusion

If everything goes to plan and earnings expectations are met, we could see double digit share price growth of around 20% over the next year which would represent 5,380 on the S&P 200 (XJO). If this transpires, it will likely result in significant increase in market confidence which is currently low due to the ongoing flat market conditions. If earnings expectations are not met and profitability remains flat, then we are looking at a continuing flat market with the S&P 200 at 4,500 to 4,700. 

Two final points: firstly, this earnings season will be very important in order to determine the overall direction of the market. I’ll aim to update my analysis after a significant amount of results have been released. Secondly, whilst the market may remain flat if earnings disappoint, there is still value to be found if you look hard enough and if you are selective, you can still generate a solid rate of return in a flat market.

Note: a significant amount of data is collected in order to put this together. The systems I am using continue to be developed, so please feel free to point out if there are any discrepencies that require attention.