With the S&P/ASX 200 now trading on 11x forward earnings – a 22 per cent discount to its 10 year average – there’s a growing number of  undervalued defensive stocks looking decidedly oversold – especially following recent market shocks. Investors have overlooked these ‘pockets-of-value’ in favour of easy capital gains from small to mid-cap miners.

However, there’s growing concern that given the run-up experienced by the resources sector, and the toppiness within commodity prices – which look vulnerable to correction – now could be a good time to take a closer look at value elsewhere across the market.

Threatening to undermine commodities are demand concerns to some worrisome GDP and inflation data coming out of China. Similarly, Roger Leaning head of research with RBS Morgans says there’s also the risk that growing confidence in US and Eurozone recoveries could trigger significant flows out of commodities into other asset classes where there are stores of value to be found.

With the market looking fundamentally cheap, he recommends prudent investors lock in some profit in small resources and consider re-investing in some pure industrials that – having largely underperformed the broader index – now look well positioned to perform strongly in 2011. Similarly, he says attractive valuation and yields justify increased exposure to some banks.

Admittedly, few are suggesting that there isn’t plenty more upside in the resources sector. But Elio D’Amato CEO with Lincoln Indicators says the pricing bubble currently surrounding junior resources serves to remind investors not to put all their eggs in one basket – especially when the sector is red hot.

D’Amato also reminds investors that even within so called hot sectors like mining, value can still be found. Notable standouts – with P/E ratios around 10x and sizable discounts to target prices – that may denote value within mining, adds D’Amato include Oz Minerals (OZL), and Mount Gibson Iron (MGX).

The growing realisation that many within the resources sector may be over-cooked, is prompting investors to widen their net into other sectors. Given the risk with junior resource stocks, Leaning suggests investors move more of their portfolio into large cap resources or industrial defensive plays that will offer good growth over time. “Fundamentals haven’t changed, but recent market shocks have thrown up opportunities to get into cyclical plays like Toll Holdings (TOL) that are longer-term beneficaries of economic recovery,” says Leaning.

Adding to the argument for better diversification beyond resources are better business conditions, improved consumer sentiment and increased credit growth. “Industrials have been left behind in Australia’s two-speed economy, and for the savvy investor this creates opportunities,” says D’Amato.

Based largely on relative P/E rankings, earnings and sentiment indicators, the value stocks favoured by Patersons Securities Analyst Kien Trinh include: Hastie Group (HST), Bank of Queensland (BOQ), Programmed  Maintenance Services (PRG), Rio Tinto (RIO), Macmahon Holdings (MAH), National Australia Bank (NAB), Commonwealth Bank (CBA), Wotif (WTF), Bradken Ltd (BKN), Newcrest Mining (NCM), Coca Cola Amatil (CCL), Goodman Group (GMG), Alesco (ALS), Boart Longyear (BLY), Whitehaven Coal (WHC), UGL Ltd (UGL) and Worley Parsons (WOR).

Price to earnings (P/E) is a useful value indicator, but D’Amato says what ultimately determines value opportunities is a more complex set of dynamics from financial wellbeing – balance sheet, cash flow & profit statements – through to debt levels and quality underlying earnings. He recommends investors also pay close attention to earnings per share (EPS) growth on the pretext that share price appreciation typically follows.

While not as popular as it should be, he says the PEG ratio is also a useful indicator for determining whether the share price is too high relative to the estimated future growth in earnings. Stocks with a PEG ratio lower than 1 offer investors a better share of assets than they’re paying for.

Using this measure, D’Amato says the following stocks offer good value at current prices: Rio Tinto (RIO), Qantas (QAN), Westfield Group (WDC), QR National (QRN), Suncorp (SUN), Harvey Norman (HVN), Boral (BLD), Bank of Queensland (BOQ), and Seven Group (SVW).

When TheBull asked Leaning and D’Amato to identify their most favoured value stocks, here’s what they came up with.

Roger Leaning, Head of Research, RBS Morgans

1)    ANZ, National Australia Bank (NAB), and Westpac (WBC)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

Looking increasingly more like hybrid income/value stocks, Leaning recommends buying these banking stocks now for an immediate dividend payment and a forward yield of around 6 per cent. Key themes he expects to dominate banks’ reporting season include: volumes, with NAB outperforming in total lending, while ANZ looks best in deposits, solid margins, cost control and productivity improvements and ongoing improvement in capital ratios. Driven by 5 to 6 per cent balance sheet growth, Leaning expects low single-digit underlying EPS growth in full year 2011 to improve along with business credit growth recovery, and a solid margin environment. Coupled with strong dividend yields, Leaning expects the sector to deliver total shareholder returns of 15-20 per cent over the next 12 months. Based on his analysis, buying bank shares in the lead-up to reporting season should provide an attractive entry point, coupled with an estimated 10 per cent forward yield over 15 months.

2)    Woolworths (WOW)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

Despite the GFC impact, Leaning says the PE contraction to around 15x is unwarranted. WOW is traditionally considered a core defensive holding of most portfolios based on a solid, reliable and predictable dividend reflecting its staple cash flows. But Leaning says investors should note that WOW is also offering 6.5 per cent EPS growth this year and in excess of 10 per cent annually over the next two years. He says an inspection of its performance over the past five years highlights a decreasing PE ratio, despite an increasing EBIT margin. With sellers running out of steam, he says the downtrend from the October 2010 high now looks to be in reverse. From a technical perspective WOW is Leaning’s top call which he says represents the best value defensive play suitable for all portfolios. “We believe that the stock has been building a base over the past few months and that is heading higher from here,” says Leaning. “The potential long-term upside price target is $30.00.”

3)    Lend Lease (LLC)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

Leaning says LLC offers investors inherent value at current prices with a significant pipeline of stgelopment opportunities. The group has acquired Valemus Group which is the old Bilfinger Berger Australia assets comprising of well known construction companies Abigroup, Baulderston and Conneq. The acquisition is expected to be 15 per cent EPS accretive in full year 2012. Catalysts he sees include: US construction continuing to turn upwards, the Valemus transaction closing, internal projects (especially Barangaroo) adding to the construction backlog, the stgelopment pipeline kicking earnings higher from 2H12, and King of Prussia and or Bluewater being sold. Leaning has a $10.70 target price.

4)    Fletcher Building (FBU)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

FBU is nearing the completion of its Crane Group takeover, which Leaning believes makes strategic sense, while providing myriad back office synergies. He also believes that FBU’s likely addition to the ASX200 along with their announcement to partially frank their dividend will act as a catalyst for the stock. “We continue to view FBU as the best positioned and best-value stock across our building materials coverage universe,” says Leaning. Leaning has a target of $7.94.

5)    Pacific Brands (PBG)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

PBG is a leading manager of everyday essential brands in Australia and NZ including Berlei, Bonds, Clarks, Dunlop, Everlast, Grosby, Hard Yakka, Holeproof, Hush Puppies, King Gee, Mooks, Mossimo, Razzamatazz, Sheridan, Slazenger, Sleepmaker, Tontine, and Volley. According to Leaning, the current share price doesn’t capture the strong earnings growth outlook or the improvement in balance sheet and earnings stability following the brand rationalisation and transformation program. “We also expect solid cash flow conversion to allow PBG to resume dividend payments in full year 2011. Currently trading at a 90 per cent discount to Leaning’s $1.45 target.

6)    Toll Holdings (TOL)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

Toll Holdings is an integrated logistics provider and one of the backbones of Australia’s ports. There’s still uncertainty weighing on the stock due to the subdued Australian retail market and uncertainty over the CEO transition. But Leaning believe current prices offer investors a good entry point into the stock before the market re-rates its current PE in line with its historical average as uncertainty is unwound. Leaning has a $6.39 target.

Elio D’Amato, CEO, Lincoln Indicators

Most favoured value-plays

1)    Acrux Limited (ACR)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

ACR delivered record EPS of 34 cents in the half year to 31 December 2010 compared to a loss in the previous corresponding half. This was a result of receipt of milestone revenue of US$87 million from licensing partner Eli Lilly following approval from the Food and Drug Administration (FDA) to market its product for the treatment of testosterone in the United States. ACR is set to receive up to a further US$195 million from Eli Lilly. The caveat though is ACR is a start-up company and future royalties are difficult to quantify. Currently trading on a P/E of 5x, and a 20 per cent discount to D’Amato’s $4.07 price target.

2)    Cedar Woods Properties (CWP)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

With a diverse portfolio of projects in Perth and Melbourne, the necessary approvals in place and ample funding, D’Amato says CWP is well placed to comfortably exceed its 10 per cent annual growth target in coming years. Currently trading on a P/E below 10x, a 30 per cent discount to NTA, and a 20 per cent discount to D’Amato’s $5.74 target – CWP is paying a fully franked gross yield of 4 per cent.

3)    Hansen Technologies (HSN)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

The decision by the utility billing software and services provider to acquire US billing software stgeloper NirvanaSoft late last year is expected to double its customer base for energy billing in North America, and lift revenue from the region by 50 per cent. Trading on a P/E of 11.8x, HSN delivered full year 2010 EPS growth of 35.7 per cent, and currently trades on a 25 per cent discount to D’Amato’s $1.08 price target.

4)    Patties Foods (PFL)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

Owner of iconic Australian brands including Four’N Twenty, Patties, Herbert Adams, Nanna’s, Creative Gourmet and Chefs Pride, PFL delivered 30 per cent EPS growth during the first half of 2011, and is confident of continued revenue growth during the second half. It also delivered a first half ROE of 15 per cent, and a 17 per cent increase in fully franked interim dividend, gross yield is 4.5 per cent.

5)    Oz Minerals (OZL)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

OZL is a significant producer of copper and gold from the Prominent Hill open pit mine located in South Australia which commenced production in the first quarter of 2009. The company has a substantial cash balance, is debt free and trades on an unflattering P/E of 10.8. Currently trades on a 25 per cent discount to D’Amato’s $1.85 price target.

6)    Mount Gibson Iron (MGX)

Chart: Share price over the year to 13/05/2011 versus ASX200 (XJO)

The first new iron ore producer in the Midwest region of WA, MGX tripled its first half net profit, despite a 15 per cent fall in production. The miner trades on an unassuming P/E of 9.8x, and a 40% discount to D’Amato’s $2.80 price target.

More articles from the newsletter:

STOCKS: 18 Share Tips – 16 May 2011

FOREX: Can the Aussie head higher? Profiting from AUD volatility

COMMODITIES: As we predicted back in March, silver comes crashing down

US – What S&P’s warning on US debt really means

Trading – How to trade the head and shoulders pattern

Investing – Is Warren Buffett really a value investor?

Forex – Top 7 questions about forex trading answered

News: Full list of breaking news

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