Plenty of steam left in stockmarket as we set sail for new year profits ::

Author: David Potts
Date: 03/12/2006
Words: 1641
Source: SHD
Publication: Sun Herald
Section: Investor
Page: 6

Bucking the usual trend of falling in price as interest rates rise, shares will keep rising on the back of strong results, David Potts writes.

THE pros think the sharemarket will do very nicely next year, thank you.

There's just one thing. Their problem is that most share prices are hot enough for them not to want to buy any more, but too cool to be wanting to sell either.

Perfect for going away for Christmas, I would have thought.

The share tipsheets are especially bullish, with wise-owl.com tipping that the All Ordinaries Index will "break the 6000 barrier later next year".

It's not so fanciful either, since it requires just a 10 per cent rise from now.

Not that it would go up in a straight line or, more to the point, necessarily stay there for very long.

What is tougher to accept is that it would mean an unprecedented fourth year in a row that the sharemarket has risen by more than 20 per cent. The long-term average is about 10 per cent a year.

But CommSec chief equities economist Craig James, who also predicts the market will reach 6000 by the end of next year, says this is "catch-up" time because of the market's underperformance in the years before that.

Forecasts of 5600 to 6000 are a common refrain, but remarkable all the same considering that interest rates have been rising, the commodity boom is widely seen as having peaked and there's a question mark over the US, where the housing downturn could turn nasty.

Besides, surely this can't go on forever?

Well, no, but it would be a big mistake to underestimate how much corporations around the world are thriving on low interest rates and little inflation. Even as we speak, by historic standards the Australian sharemarket is fairly valued and, if anything, a bit on the cheap side.

But with share prices at record levels, how can that be?

Boom-time earnings

Oh dear, you've forgotten already. Remember, profits are booming and apparently getting better all the time, though at a slower rate of increase.

So using the accepted measure of the price-earnings or P/E ratio, the industrials market is valued at about 15 times earnings - which makes it cheaper than a year ago when it was 20 times earnings. The norm for a sharemarket bubble is 25, if not a lot more.

Resource stocks are cheaper still. BHP Billiton, for example, is trading on a P/E of just under 11. BHP Billiton and Rio Tinto are stocks Michael Heffernan of Reynolds Stockbrokers says are bargains.

You'd have to wonder why they're out of favour at the moment, but it's all to do with sentiment about the US economy and predictions - already disproved in the case of zinc and nickel - that metal prices peaked months ago.

The fact is commodity prices don't even need to rise any further for companies such as BHP Billiton to increase their record profits. All they have to do is dig more.

As a rule, the profit-reporting season was notable for one thing - it wasn't notable. Everything went as expected, with no nasty surprises. Judging from the comments by chief executives and subsequent analysts' reports, the average increase in earnings per share this financial year is likely to be about 8 per cent.

Money everywhere

If the news is good for most individual stocks, it's even better for the market as a whole.

Talk about liquidity. Pity some of it can't be diverted to the drought . . .

Sorry, where was I? Oh yes - the world is awash with money.

We already have the super funds pumping money in from the compulsory employer levy, plus record dividend payouts and share buybacks, most of which are being reinvested into the market.

Most of all, we have private equity takeovers. Even just rumours of takeovers are enough.

You only have to mention private equity to put a rocket under the price of a stock. It's possibly even better than insider trading, because it will become self-fulfilling and nobody will suspect.

Stocks that brokers mention as the most likely to face a private equity bid are Amcor, Ansell, Brambles, IAG and Foster's.

So far private equity has stayed clear of resource stocks, but BHP Billiton, Rio Tinto and Oxiana would also have to be possibilities.

Mind you, it's ludicrous calling it private equity when it's really private debt. There's a glut of money just waiting to be lent to pooled funds that will pay almost anything for a good stock.

Just how they manage to make a quid, apart from pulling huge performance fees from their investors, is revealed in the box below.

The point is that this money won't go away in a hurry.

Rates on hold

Except, that is, if global rates rise. But that doesn't seem to be on the radar.

The Organisation for Economic Co-operation and Development (OECD), for one, thinks global rates will drop next year, including here.

That view is shared by Wall Street which, apart from pushing up the Dow, is also pricing in a 0.25 per cent rate cut in the new year and a couple more after that.

The only problem is that the optimism might not be for the right reasons. It's assumed that a slowdown in economic growth in the US will take pressure off inflation, which will allow rates to drop.

But growth might not slow as much as they think, or inflation could rise anyway.

The funny thing is that local stocks - which should be hurt by rising rates, such as retailers and banks - haven't suffered at all despite three increases this year and in many cases have even beaten the overall market.

I'll bet they've also been helped by high dividend yields which, fully franked, come with a 30 per cent tax break.

Higher rates might even be helping the sharemarket by hurting its rival, property.

"The soft housing market has, to the surprise of some, turned out to be good for equities," says Phil Shamieh of wise-owl.com.

"Money flows have been finding their way to stocks as the fundamentals supporting share prices look better than the fundamentals for housing."

Global growth

Fortunately, a slowdown in the US might not matter for the sharemarket anyway. That's because other large economies are growing faster than the US, providing a safety net in case the downturn turns dangerous.

While Japan, the Euro zone and Britain are all picking up momentum, fortunately for us China doesn't seem to be losing any.

So that means little threat to the demand for commodities.

As if on cue, the oil price is rising again, although it remains to be seen how much the fuel-guzzling US economy slows, whether OPEC carries out its decision to cut production and how cold the northern hemisphere winter is.

If inflation does prove to be a problem - and the world's central banks are far more worried about it than the market, judging by their comments at the recent G20 meeting in Melbourne - it might not be oil's fault anyway.

The bigger worry is rising costs in China, since its production of cheap manufactures has kept inflation at bay.

More likely the central banks will hold rates where they are, or lift them to make sure inflation doesn't get a foothold.

And it seems the world's sharemarkets won't mind one bit.

WHY DEBT IS KING

IT'S impossible to get past the business pages without coming across a private equity bid for something or other. And the bigger the something is, the more likely the other will be there.

Yet surely it would make more sense to take over a smaller company and either merge it with something bigger or build up its business. That's what used to happen in the 1980s, after all.

But that's not all that seems so illogical about private equity bids.

For one thing, it pays top price - too much by the look of things.

Most of all, the funds are borrowed to the hilt. Over-borrowed and over the top, how can they possibly turn a dollar?

Hmm, sounds more like the '80s now. Only there's still a crucial difference: back then the so-called entrepreneurs had an ace up their sleeves. It was merely a matter of moving assets and cash flow from the corporate account to, um, a personal account preferably somewhere out of the country.

This time the money is coming into the country, but it's still over-borrowed and over the top.

As it turns out, private equity needs a surprisingly modest profit growth to make a motza.

Oh, and a buyer, eventually.

Clime Asset Management managing director Roger Montgomery has done the maths.

Say a company is worth $100 with earnings of $8.33 a year.

Private equity comes along, using $75 debt and $25 equity. After interest at 7.5 per cent the return drops to $2.70.

So far so bad. Only get this: to the private equiteer, that's a 10.8 per cent return on the $25 it's invested of its own money. Since there'll be no dividends paid out - remember, no more pesky shareholders or embarrassing AGMs - the business needs to grow by just 10 per cent for three years, well below the recent average.

By then the earnings will have grown to $5.46 after interest.

Yes, it's way less than before the takeover. But it's the rate of increase afterwards that counts.

As long as profits grow faster than the interest rate they're paying, they're in clover.

Even better, the $25 equity has grown to $50 because the return has doubled from $2.70 to $5.46, none of which is paid out.

Hey presto! That's a 100 per cent return over three years, or 26.5 per cent a year.

To return 20 per cent a year, the business needs annual growth of a miserly 5.7 per cent.

"All that is required to generate high returns," says Montgomery, "are low interest rates, lots of gearing, modest improvements in the business's performance and a patsy in the room."

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