03/12/2008 - 22:00

World waits on a market-turning event

03/12/2008 - 22:00

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THE ASX 200 Index is currently trading with a trailing price to earnings ratio of less than eight times historical earnings, while consensus estimates for the 2009 financial year earnings place the index on a forward multiple of 10.

World waits on a market-turning event

THE ASX 200 Index is currently trading with a trailing price to earnings ratio of less than eight times historical earnings, while consensus estimates for the 2009 financial year earnings place the index on a forward multiple of 10.2 times FY 09 earnings. The market is clearly over-sold.

Even if earnings fall by 20 per cent from current bearish estimates, the forward market PER would still end up at 12.75 times, which is well below the long-run average of 15.2 times forward earnings. These levels are about as low as the market ever gets in a serious downward cycle and the extent of any further downside will now be determined by views on just how badly corporate earnings will be affected into 2009 and beyond.

So far, outside of the property developers and miners, many companies have been bravely predicting that life continues, pretty much as normal, but we all know that earnings will not be maintained at predicted rates into 2009.

Areas of some slight earnings protection include the heath sector, where stocks like Sonic Healthcare and Ansell provide a steadier outlook. A recent rise in the price of gold towards $A1,300 per ounce is great news for the sector, which has begun to respond to an average doubling of its profit margins, resulting from this move. The gold sector is a beneficiary of closing nickel and iron ore mines, since it results in increased availability of skills at a reasonable cost, while falling oil prices mean that operating costs will be further reduced as the cost of diesel declines.

It may seem obvious, but it is worth restating that Briefcase is absolutely certain that the market will eventually rise again. Investors need to convince themselves of a value point for investment and also they must be sure that they will not require any savings that they put towards equities, for at least two years.

While the market is still scraping around looking for a base, it continues to look extremely oversold and is undervalued on most measures when taking a three to five-year investment view. Risk tolerance has evaporated and forced sellers, scrambling to cover debts, are pushing shares down to record low valuation multiples.

Just as a bull market turns down after one too many financial scares or interest rate hikes, so a bear market will turn up when events indicate the base. Market-turning events might include implementation of economic and regulatory renewals planned by the Obama administration, or a spate of takeover announcements by companies with well-positioned balance sheets which, by their actions, draw a valuation line in the sand as they come out to pounce on struggling rivals.

Once regulatory measures have been put in place to allow banks to have confidence to lend once again, economic activity will gradually recommence, but not until after the global economic system undergoes a few quarters of contraction.

Briefcase expects economic growth might pick up by the September quarter in 2009, but if the market is true to form, it will have begun to rise at least six months prior to news that economies have again begun to grow.

Major risks to the market remain, including a bust in the US auto leasing market and a big rise in credit card related personal bankruptcy in the US and locally, both of which look likely, but could be managed by appropriate policy.

Overall, Briefcase feels that the new team in Washington is on the case, whereas it is sad to say that the previous bunch was asleep at the wheel and mostly on vacation. Over the weekend, I heard a magnificent BBC interview with the governor of the Bank of Canada Mark Carney, which can be found at this address: http://www.bbc.co.uk/radio/podcasts/interview/.

It is so pleasing to hear really smart people talk about what is going on and the ongoing efforts to fix it. This interview shows that, thankfully, there are smart people out there and also illustrates how much on the outer the current US administration has become to the rest of the developed world.

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Gold is one commodity that is responding positively to the global credit crunch. The ancient metal is again acting as a currency of last resort.

Gold coin and bullion sellers all over the world have experienced a surge in demand for the yellow metal, which has put pressure on production capabilities. Globally, gold production peaked in 2001 and has been in decline since then. Seasonally strong demand out of India for the wedding season is exacerbating a supply demand squeeze, which may only be a short-term phenomenon.

Briefcase expects that the US dollar will weaken during 2009, putting further upward pressure on gold price in US dollar terms. While the Australian dollar is likely to remain relatively weak, as the prices and volumes of its commodity exports decline, Briefcase thinks that the $A will actually strengthen against the $US, lifting towards 78 US cents by mid 2009. The net result is expected to be a stronger $A gold price, which could rise to around $A1,600 during the second half of 2009.

So far, it has been the major producers - Lihir, Newcrest and Newmont - that have responded to the $A gold price move to over $A1,200/oz. Mid -rank and developers such as Avoca, Apex, St Barbara have begun to move, but they hold potential for much larger gains.

Ramelius is in the process of exposing high-grade ore at its Wattle Dam open pit mine. The company plans to produce about 67,000 ounces of gold from its 180kt pa Burbanks plant.

Head grades should average around 10g/t gold from this high-grade zone. Ramelius should generate around $65 million of operating cash flow from this pit expansion, with the funds being used to develop an underground expansion, targeting high-grade resources below the pit. Overall, Ramelius is a small company with limited mine life on known reserves, but it has strong exploration appeal and is likely to be self funding, despite the high management charges extracted by its board and management.

Dominion is also a low cost, high-grade underground miner, with a strong brownfields and greenfields exploration program, funded from operating cash flow. While mine life has been limited, the company has exploration appeal.

Avoca Resources mines high grade gold at Higginsville in WA. The company has more than 10 years of mine life mapped out, with strong exploration potential for expanding project life. Low costs and leverage to gold price make Avoca an attractive investment that deserves a rating of $245/oz of resources.

Newcrest is a very low-cost global gold producer with long-life mines. The company is Australia's premier gold miner and, as such, leads share market price moves.

Alkane is Briefcase's favourite explorer. The company has a viable project in NSW, and is in joint venture with strong partners. Alkane is however capital constrained, but looks cheep with a market capitalisation rating of $32/oz of resources. Apex is funded for project development, working on several old mines where the bulk of its ore is refractory in nature, requiring oxidisation to release gold values. The company will commence production during the first quarter of 2009.

St Barbara is working on the old Sons of Gwalia assets, where cash production costs have been more than $A600/oz. The company's earnings show strong leverage to the gold price, both up and down. Integra has a mill it plans to re-commission in a new location, close to its WA goldfields deposits.

The company is capital constrained, but a brighter gold market should allow it to achieve cash flow by early 2010. Resolute has mines in Tanzania, West Africa, and Queensland. It holds more debt than the market is comfortable with and has recently struggled to finance its developments. The company could be a surprise performer if gold remains firm.

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

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