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The ASX 200 Index has struggled for years – failing miserably to match the performance of the US based S&P 500 over the past five years.  Some investors have jumped ship while others have waited patiently for good times to returns.  Since June this year conditons have improved somewhat.  Here is a six month price chart for one of our biggest companies, BHP Billiton (BHP) and the ASX 200 XJO:

In the last six months the ASX 200 has risen about 13%, which begs the question: has it overshot?

In early October, Deutsche Bank reported that the P/E for the ASX 200 stood at 12.7 – a rise of 18% since the middle of May.  By 7 November, the P/E had risen to 13.42.

Most concerning, however, is that the prospective or forward P/E is up 15% over the past six months despite a stream of company downgrades to earnings forecasts. P/E ratios are heating up while earnings estimate are cooling.

Forward P/E expansion means that investors are willing to pay more for stocks based on anticipated earnings.  But when earnings estimates are in retreat, this is unusual. 

Stock valuations rise for two reasons – fundamental reality and perceptions of that reality – which in a perfect world should work in concert, but in reality are often at odds. Perception is seen in investor sentiment as evidenced by escalating P/E ratios, which are sometimes contrarian to the purported “reality” as represented by fundamental facts. 

However, the fundamental view of global macroeconomic reality has not changed for the better. The European situation is still troublesome and the outlook for China is hardly as bouyant as times past. 

Some analysts attribute the rally to investors’ frantic search for yield. Others, like Deutsche, reckon monetary stimulus in the US and Europe could be behind it.

In the absence of real earnings improvements, the rally could be short lived. But sentiment as reflected by ballooning P/E’s has trumped reality in the past (just think tech boom in the late 1990s). In the meantime, current market conditions suggest some buying opportunities for top-down investors.

The following chart from Morgan Stanley shows a sector by sector breakdown for forward or prospective P/E expansion over the last six months. 

Note that the only sector showing prospective P/E contraction is consumer staples, which means analysts expect improved earnings in the future (this stands to reason since consumer staples are considered defensive stocks).

The following table lists five stocks in the consumer staples index (all stocks have a minimum market cap of $100m and a fully franked dividend of 4.0% or greater).

Company

Code

Div Yld

Forward P/E (2013)

P/B

P/S

2 Yr Earnings Growth Forecast

Coca Cola

CCL

4.1%

16.3

4.93

2.02

8.4%

Metcash

MTS

7.8%

10.52

2.17

0.22

-2.0%

Patties Foods

PFL

5.0%

10.28

1.68

0.98

5.7%

Ridley Corp

RIC

6.6%

11.3

1.2

0.47

19.6%

 

Coca Cola Amatil (CCL) is the largest stock in the ASX Consumer Staples Index, the XSJ.  The following chart shows the price performance of CCL against the index for the six month period of the rally in question:

Despite its respectable 2 year earnings forecast of 8.4%, some analysts think CCL is overvalued. On 9 October UBS downgraded CCL, arguing that CCL has become the victim of its own success.  The earnings forecasts do not support the current share price, the analyst warns. 

Nevertheless, one cannot overlook the power of the Coca-Cola brand. What’s more, CCL has a 2 year dividend growth forecast of 9.3% and the company has increased its dividend every year over the last decade. CCL is also expanding into Indonesia.

Metcash (MTS) also attracts lukewarm broker sentiment. Metcash operates in food, liquor marketing and distribution, and more recently hardware and automotive.  The company has 20% market share in food and groceries, and competes against behemoths Woolies and Wesfarmers. 

Citi is the only major investment house with a BUY rating on the stock, despite a slight downward revision in its earnings forecast for the company.  All others have HOLD or NEUTRAL ratings. 

Note that Metcash is the only stock in our table with a negative 2 year earnings growth forecast.  With the exception of FY 2004, Metcash has also increased its dividend every year during the past ten years.  Over the past six months, the share price has not kept pace.  Here is the chart:

 

Patties Foods Ltd (PFL) operates in frozen food and enjoys strong brand identification.  The company has a history of paying consistent dividends – and its earnings per share (EPS) has risen every year over the last four.  Citi is the only major analyst providing coverage with a HOLD rating but according to Thompson /First Call there are a total of 4 analysts covering the stock with 2 STRONG BUYS and 2 HOLDS.  

Patties’ brand strength and pricing power has meant that it has survived while others have folded. One of its competitors, Australian Convenience Food, went into administration in August. 

The company’s low forward P/E and solid dividend history make it worth a look. Patties is relatively new to the ASX, beginning its trading life in 2007.  Its poor share price performance means investors are not paying too much for yield.  Here is the company’s six month chart:

The Ridley Corporation (RIC) is yet another high-yielding consumer staples stock that has not participated in the six month rise of the ASX and the XSJ.  The company makes and markets nutritional solutions for animals.  Dividends have increased every year for the last decade and the company’s 2 year earnings growth of 19.6% is impressive.  According to Thompson/First Call, the stock has 1 STRONG BUY rating and 2 BUYS, along with 2 HOLDS.  Here is the company’s six month chart:

There is another good reason to take a look at companies like Ridley’s and Patties – merger and acquisition activity. With a market cap of roughly $347m at RIC and $233 at Patties, both are possible targets for acqusition. 

The rewards for holding an M&A target stock can be substantial.  American agricultural commodities processor Archer Daniels Midland (NYSE:ADM) recently bought a 10% interest in Australia’s Graincorp Ltd (GNC) and is looking for more.  Here is what happened to the share price on the news:

 

As the world’s big agricultural companies cast a covetous eye on Asian-Pacific markets, many Aussie stocks stand ripe for takeover. Here are four stocks worth watching:

 

Company

Code

Div Yld

Forward P/E (2013)

P/B

P/S

2 Yr Earnings Growth Forecast

Aust Ag

AAC

0%

27.10

0.91

0.64

41.9%

Bega Cheese

BGA

2.4%

14.42

1.13

0.27

8.2%

Tassal

TGR

3.0%

7.74

0.73

0.84

-2.0%

Warrnambool Cheese

WCB

4.1%

10.06

1.2

0.47

24.4%

 

Australian Agricultural Company (AAC) is attractive not only for its extensive beef production but also for its substantial rural holdings in land and water assets.

Tassal Group (TGR) is a low-cost and technology savvy salmon farmer with hatcheries in Tasmania. 

Warrnambool Cheese and Butter Factory (WCB) manufactures and distributes dairy products in Australia and internationally.  Rival Bega Cheese (BGA) has a wholesale arm for its dairy products and is expanding into Asia.

In terms of share price movement, ACC is the stand out, up 15% over the last six months.

 

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Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au. You should seek professional advice before making any investment decisions.