Looking out across the valley of despair

14/01/2009 - 22:00


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FOLLOWING falls of unprecedented magnitude during 2008, the Australian share market looks set to recover some ground late in 2009.

Looking out across the valley of despair

FOLLOWING falls of unprecedented magnitude during 2008, the Australian share market looks set to recover some ground late in 2009.

Every bull market commentator has now been caged and the outlook is universally gloomy for early 2009. There appears to be growing consensus among analysts that continuing fallout from the global financial crisis during the first half of 2009 will impact negatively on our economy, but the herd is beginning to feel that the economy should begin to recover, showing some growth in the December quarter.

Readers need to draw a distinction between what goes on in the economy and what is happening within the stock market. There is often a huge disconnect between these two quite separate, but ultimately connected, sets of information. This crisis is now 19 months old - the US sub-prime market cracked in July 2007 - and if there is no recovery by July 2009, global stock markets will have been in a funk for two years.

Most bear markets resolve themselves within 24 months. Only the Great Depression of the 1930s took longer to repair the financial damage and find a base. Hopefully we have learned a few lessons along the way, which will lead to more certain resolution of the crisis by the middle of this year.

Ahead of this February's profit reporting season, we have already begun to see profit downgrades from the likes of Leighton Holdings and more companies will undoubtedly follow, deepening the gloom and misery which is likely to pervade this reporting season. During the June 2009 half year, numbers coming out of the local economy will remain unremittingly depressing. Briefcase is betting that unemployment will rise sharply by April as factories cut shifts and more mining and construction projects are delayed or cancelled. Personal bankruptcy levels will skyrocket and tourist numbers will plummet. The only people enjoying this environment are insolvency lawyers and accountants handling companies in receivership.

Adding to this financial gloom is a rising tide of corporate fraud and malfeasance. Fallout from the $50 billion Madoff managed fund ponsi scheme affair is only just beginning to unfold.

A recent $1 billion corporate fraud by the founder and chairman of India's fourth largest software services exporter and New York Stock Exchange-listed Satyam Computer Services could well be the frontrunner of more such cases to come. Briefcase casts its eyes towards Dubai for signs of further corporate stress, believing that bubble is well and truly bursting. Plunging markets globally continue to uncover cans of worms in many corners of the market and there is no doubt that it will take many years to untangle the mess, but from this chaos opportunity will arise.

While news from the local economy is certain to continue to paint a picture of growing concern, this is the time when companies begin to restore profitability by trimming wage and other costs. Rising unemployment, a rash of corporate failures and increasing levels of personal bankruptcy are lagging indicators of economic activity.

Usually, when such news predominates, companies are already taking advantage of opportunities to improve value and restore profits for shareholders over the longer term.

Briefcase believes the stock market has already begun to look across the valley of despair, to the greener fields that lie ahead in 2010. As 2009 unfolds, a time will arrive when the outlook for earnings growth in 2010 will begin to be the major influence on share prices, rather than the current, unremitting stream of bad economic news.

The market seldom behaves exactly as the majority believes it will. If the consensus says that the market will recover in the September quarter of 2009, then it is highly likely that it will actually begin to recover before that time.

Briefcase is still not certain whether we will see yet another down leg in this bear market before a base is finally recognised, and seriously doubts whether all the bad news that awaits us as earnings are announced in February has been priced into the market. Witness the caning that Leighton received after announcing that it will write down the value of some investments. Despite its claim that underlying earnings will rise 8 per cent and the value of its work-in-hand has increased substantially, the company's share price has been slammed.

When looking at results in February, readers should take notice of underlying, free cash flow. Cash flow is what drives value creation. Some value may be lost, if temporarily, as investments move up or down, but the real story is in a company's ability to generate free cash flow, after servicing debt and maintaining its stay-in-business capital spending requirements, with which it can grow its business or from which it can pay a dividend. Capturing these opportunities will present once in a lifetime opportunities for investors.

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There can be little doubt that the global financial crisis has been a lifestyle-changing event of mammoth proportions. The contraction of personal wealth has been astounding and will change the way we live for many years to come.

Many exploration companies are now simply closing shop and going into hibernation until the market improves. They are sacking the board and technical management, reducing costs to a minimum and holding tight.

Haddington Resources is a good example of this strategy, paring back its operating costs so as to survive the turmoil. Companies reason that they could find Lassiter's lost reef and the market would take no notice, so they might as well hibernate.

Salinas Energy has closed its Perth office, reduced its board from six to four, and has slimmed down its operating cost base, with its managing director moving to an operational base in Bakersfield, California, on a reduced wage.

Briefcase predicts that boards will have a short discussion with senior management during the early months of 2009 and wages will fall. This sort of action is unprecedented but a healthy market response to the current crisis. Many other companies will fail the test and Briefcase expects to see a growing stream of companies following Goldstar Resources to the knackery's yard.

Investors and retirees are also coming to terms with their reduced circumstances. Lower interest rates mean lower incomes for many pensioners. At the other end of the scale, a large chunk of new money has been torched, leaving the previously newly rich gen Xers now newly poor and joining their gen Y brothers and sisters looking for work.

European or North American holidays are a thing of the past for most; even local resort operators are having a woeful time. My scouts tell me that business class cabins on flights to and from Europe are almost empty, compared with 12 months ago when they were chock-a-block.

Amazingly, there is still a lot of cash on the sidelines in selected pockets. A lot of people just don't invest in shares and there are a few, mostly old-money types, who have managed to salvage a few bob from the market and their circumstances are such that they just keep storing the stuff up. Institutional investors are reportedly heavily weighted in cash and are prepared to wait until mid-year to pounce on the many bargains on offer after the reporting season reduces short-term investment risks.

Many resource companies are trading at or below cash asset backing. New Zealand Oil and Gas began buying its Tui Oilfield partner Pan Pacific Petroleum at its cash asset backing of 19 cents and has built its stake at prices up to 29-30 cents per share, ahead of receiving FIRB approval to move past 15 per cent and then, most likely, making a bid for the whole company.

Well run nickel and silver exploration company Legend Mining (LEG) could come up with no better way to use $5 million of its $10 million cash hoard than to buy 3.5 million shares of Independence Group (IGO) at an average price of $1.44 per share, which was close to IGO's cash asset backing.

Legend is up over $2.2 million after tax on this deal. Legend's share price has moved ahead, lifting from 0.9 cents to 1.4 cents, at which level it has a market capitalisation of $17 million, but its IGO holding and remaining cash has a value of over $13 million, leaving the company well placed to do deals in a difficult market for funding.

n Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au


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