Huntleys Your Money Weekly

Transcription

1 28 June 2012 Forecast Huntleys Your Money Weekly Forecast Count down to Teens Decade Bull Market This bi-annual feature is written on the premise of a subscriber asking what could be the key issues, trends and risks in the sharemarket and economy over the next year. It will help you understand how we approach the issues and how we update them during the year in our weekly overview. I look at many trends in the context of a decade cycle which tends to run in the classic pattern of a low point in the first year or two usually two and reaches a high point late in the decade from seven on, usually later. I write this forecast as yet another European crisis grabs headlines, a crisis yet again handled by last minute packages subject to 11th hour stop and go negotiations. It should have been settled by a mighty big monetary Bazooka put behind the European banking system, but instead it is itsy bitsy. The Germans want a USA-style central fiscal and workplace system in return for the Bazooka, and itsy bitsy grinds the PIGS (Portugal, Italy Greece, Spain) down to where they might accept peace terms. Or leave. The European affair has been bubbling since the GFC so many players are well set in advance. That is a positive as shocks cause the worst turmoil. The GFC was a major left field shock on top of a nasty oil price rise. The ECB has stated it will stand behind solvent banks, presumably it and other major central banks will stop any knock-on effects from bank failures if the Eurozone is to break up. One point many miss is that serious money in Europe has already piled into Germany as a safe haven. If Greece, Spain and Italy leave the Eurozone, then (a) their currencies would devalue sharply (b) the German currency would rise sharply (c) the serious money would make even more serious currency gains and would buy into very cheap assets in those Club Med countries. Former Italian PM Berlusconi, in suggesting Italian senior businesses want to leave the Euro would be highly aware of this. Forecast reasonable since mid 2009 Since mid 2009 I suggested the years through to the current, possibly early next year, would feature a work out strategy not dissimilar to Australia post 1987 through to January Yes the current global problems are worse than , not so for Australia. But a significant bull market can emerge BEFORE the developed world economies are firmly set on a recovery path. I looked to a broad 4,000 to 5,000 trading range on the All Ordinaries ahead of a Teens Decade bull market developing latish 2012, just possibly early The trading range view has proved remarkably correct it allowed for slippage to 3,800. So as I write the market is yet again testing the 4,000 level on the All Ordinaries Index, my most probable floor for this market with a possible slip to 3,800, and a very worst case of a downer to 3,500. My key call is that a sell off this year to these levels amid nasty panic headlines, will set the stage for the Teens Decade Bull Market, discussed further at the end of this article. The resource sector may well provide bargains as extreme pessimism provides the launch pad for a bullish surge. That first surge is a wonderful thing!! This corrective market is likely to run through to September October, with a lower probability of extending to early Current negative forces are Europe and fears of a fiscal cliff the end of various stimulatory tax cuts in particular in the US. That fiscal cliff is likely to be climbed not far ahead of the November Presidential election. There are also short term fears on the Chinese economy but by October further interest rate cuts there and additional fiscal stimulation but not on the giant 2009/10 scale will be evident. There will also be significant monetary easing in Europe. As the Top 20 goes, so do the major indices. What s interesting is that our forecast NPAT, EPS, and DPS are all rising, but the PE multiple is down, and the dividend yield is up. As the Dividend Yield table shows price weakness in the major resource Continued on page 2 Australia s Leading Independent Investment Newsletter Since 1973 Ian Huntley Editor Australian Share Market 6 Outlook Still defensive, dividend yields paramount Resources 8 Important to stick to quality, infrastructure-flush names Financials 11 Banks remain attractive. Yield supports selective AREITs and Infrastructure Consumer & Industrials 14 Safe havens Staples, Healthcare, Telecommunications Copyright warning: Our newsletter is available to paid subscribers only and no reproduction is permitted. If you work for an organisation that would like to take out multiple subscriptions to any of our products, our customer service department will be happy to advise you of the discounts available or site licenses.

2 2 Overview continued from Page 1 Key Terms : Substantially undervalued. Accumulate: Modestly undervalued. : Appropriately priced, neither buy nor sell. Reduce: Sell part holding. Sell: Sell all holdings now. Avoid: Not investment grade. : The moat is the competitive advantage that one company has over other companies in the same industry. Wide moat firms have unique skills or assets, allowing them to stay ahead of the competition and earn above-average profits for many years. Returns on their invested capital will exceed the cost of that capital. and Share price risk: The analyst s opinion of a company s business and share price risk relative to other stocks. Cyclical and speculative companies will be riskier on both counts. Low-risk businesses can be overpriced and high risk businesses can be cheap. Morningstar Equity Style Box: is a nine-square grid that provides a graphical representation of the investment style of stocks. It classifies securities according to market capitalization (the vertical axis) and growth and value factors (the horizontal axis). groups drives dividend yield up, while the banks are gradually increasing their dividends against flattish share prices. The table shows the change in dividend yields on the three major resource stocks against our forecasts since December and clearly illustrates the emerging dividend yield story. Further interest rate falls ahead good for defensive income stocks If that Teens Decade bull market does not emerge on my timing and that is my top probability I remain happy with a continuing bull market in TOP 20 Table June 2012* Actual F'cast Y1 F'cast Y2 PE (x) NPAT Growth (%) EPS Growth (%) Div Yield (%) /Intrinsic Value (%) 75.2 * June 2012 Actual figures include companies that reported December year end. TOP 20 Table December 2011 Actual F'cast Y1 F'cast Y2 PE (x) NPAT Growth (%) EPS Growth (%) Div Yield (%) /Intrinsic Value (%) 75.7 Morningstar Forecasts defensive income stocks, always a favourite. Expect at least another 50 basis points drop in Australian bank short term lending rates over the next six months, with the RBA dropping official interest rates perhaps by as much as 75 basis points to achieve this. With Forecast comes our list of Morningstar moat stocks, our Best Businesses, those we see as having a significant competitive advantage that will last many years the best place to search for defensive stocks that suit this era and most other eras. To get your mind around Moats, go to special TOP 50 Table June 2012* Actual F'cast Y1 F'cast Y2 PE (x) NPAT Growth (%) EPS Growth (%) Div Yield (%) /Intrinsic Value (%) 78.6 * June 2012 Actual figures include companies that reported December year end. TOP 50 Table December 2011 Actual F'cast Y1 F'cast Y2 PE (x) NPAT Growth (%) EPS Growth (%) Div Yield (%) /Intrinsic Value (%) 79.4 Investment Style Value Blend Growth Mkt Cap Large Dividend Yield % NPAT ($m) EPS (cps) Actual FY1 FY2 Actual FY1 FY2 Actual FY1 FY2 Jun Jun-11 BHP Billiton BHP ,890 20,411 23, Jun-11 Rio Tinto RIO ,054 14,994 17, Dec-11 Woodside WPL ,601 1,924 2, Small Dec Jun-11 BHP Billiton BHP ,819 27,233 25, Jun-11 Rio Tinto RIO ,216 16,701 17, Ratios and Data NPAT: Net Profit After Tax before one offs. EBIT: Earnings before interest and tax. ROE: Return on Equity (net profit before one-offs / shareholders equity) Net Interest Cover: EBIT / net interest expense Annual Share Turnover %: number of shares traded as a percentage of total shares outstanding over the last 12 months. Div Yield %: Historic numbers: dividends paid for that year divided by the average monthly closing share price for that year. Forecasts: dividends paid divided by last close share price. P/E: Historic numbers: average daily closing share price for that year divided by earnings per share. Forecasts: last close share price divided by earnings per share. 31-Dec-10 Woodside WPL ,545 1,570 1, Investors please note: To the extent that any of the content constitutes advice, it is general advice that has been prepared by Morningstar Australasia Pty Limited ABN: , AFSL: without reference to your objectives, financial situation or needs. Before acting on any advice, you should consider the appropriateness of the advice and we recommend you obtain financial, legal and taxation advice before making a decision. Please refer to our Financial Services Guide for more information at Contact Details Tel: help.au@morningstar.com Declaration Declaration of all equities analysts' personal shareholdings, disclosure list for Forecast These positions can change at any time and are not additional recommendations. AAO, ABC, ACG, ACL, ACR, AFI, AGK, AGS, AGX, AKF, ALL, ALS, AMP, ANO, ANP, ANZ, APA, APN, ARD, ARG, ASB, ASZ, ATI, AVX, BEN, BFG, BHP, BKI, BKN, BLY, BND, BNO, BOL, BOQ, BSL, BTU, BWP, BXB, CAB, CBA, CCL, CDD, CGS, CIF, CND, COF, COH, CPA, CPB, CRK, CRZ, CSL, CSS, CTN, DJS, DOW, DTE, DUE, EGL, EGP, EPX, EQT, ERA, ESV, EVZ, FMG, FXJ, GBG, GCL, GFF, GMG, GPT, GWA, HIL, HSN, HST, IAG, IFL, IGR, IIN, ILU, IPD, JMB, KAR, KBC, KCN, KEY, KMD, LEG, LEI, LLC, MBN, MCR, MFF, MIO, MPO, MQG, MSB, MTS, MUN, MYR, NAB, NEU, NHC, NMS, NUF, NUP, NVT, NWS, OSH, OST, PBG, PBT, PGA, PGM, PMP, PMV, PNR, PPT, PRE, PRG, PRY, PTS, QBE, QFX, QUB, RCR, REX, RFE, RHC, RHG, RIO, RKN, RQL, SAKHA, SEK, SFW, SGP, SGT, SHV, SMX, SOL, SRH, SRX, STS, SUN, SVW, TAH, TCL, TEN, TLS, TOL, TPM, TRF, TRS, TSE, UGL, UXC, WAL, WAM, WBB, WBC, WCB, WDC, WES, WHC, WHG, WOW, WPL, ZGL.

3 Huntleys Your Money Weekly 28 June Top 20 earnings and dividend forecasts Actual FY12 FY13 1 BHP EPS EPS Growth 56.7% -3.8% 14.9% Fair value Dividend Grossed up dividend Grossed up yield 4.8% 5.2% 6.9% Dividend yield 3.4% 3.7% 4.8% PE CBA EPS EPS Growth 10.2% 4.0% 3.5% Fair value Dividend Grossed up dividend Grossed up yield 8.8% 9.0% 9.3% Dividend yield 6.2% 6.3% 6.5% PE WBC EPS EPS Growth 5.8% 1.3% 3.9% Fair value Dividend Grossed up dividend Grossed up yield 10.8% 11.4% 11.9% Dividend yield 7.5% 8.0% 8.3% PE ANZ EPS EPS Growth 18.2% 0.8% 5.1% Fair value Dividend Grossed up dividend Grossed up yield 9.4% 9.9% 10.3% Dividend yield 6.6% 6.9% 7.2% PE NAB EPS EPS Growth 16.1% 5.2% 7.3% Fair value Dividend Grossed up dividend Grossed up yield 10.6% 11.1% 12.0% Dividend yield 7.4% 7.8% 8.4% PE TLS EPS EPS Growth -16.8% 10.6% 9.4% Fair value 3.85 Dividend Grossed up dividend Grossed up yield 11.0% 11.0% 11.0% Dividend yield 7.7% 7.7% 7.7% PE WES EPS EPS Growth 12.7% 13.0% 13.7% Fair value Dividend Grossed up dividend Grossed up yield 7.3% 8.1% 9.3% Dividend yield 5.1% 5.7% 6.5% PE Actual FY12 FY13 8 WOW EPS EPS Growth 6.4% 4.6% 7.9% Fair value Dividend Grossed up dividend Grossed up yield 6.6% 6.8% 7.3% Dividend yield 4.6% 4.8% 5.1% PE RIO EPS EPS Growth 0.2% 0.9% 17.4% Fair value Dividend Grossed up dividend Grossed up yield 3.6% 4.2% 5.1% Dividend yield 2.5% 2.9% 3.6% PE WPL EPS EPS Growth 1.4% 18.9% 15.5% Fair value Dividend Grossed up dividend Grossed up yield 4.7% 4.9% 7.4% Dividend yield 3.3% 3.4% 5.2% PE CSL EPS EPS Growth -6.3% 12.7% 7.9% Fair value Dividend Franking 6.2% 6.2% 6.2% Grossed up dividend Grossed up yield 2.1% 2.3% 2.4% Dividend yield 2.1% 2.2% 2.4% PE WDC EPS EPS Growth -20.8% -0.3% 8.8% Fair value 9.45 Dividend Franking 0% 0% 0% Grossed up dividend Grossed up yield 6.8% 5.3% 5.5% Dividend yield 6.8% 5.3% 5.5% PE NCM EPS EPS Growth -6.6% 4.6% -14.3% Fair value Dividend Franking 0% 0% 100% Grossed up dividend Grossed up yield 2.2% 2.2% 3.2% Dividend yield 2.2% 2.2% 2.2% PE QBE EPS EPS Growth -53.1% 113.7% 7.5% Fair value Dividend Franking 14.31% 15% 15% Grossed up dividend Grossed up yield 7.3% 7.6% 8.1% Dividend yield 6.9% 7.1% 7.6% PE Actual FY12 FY13 15 ORG EPS EPS Growth 2.4% 37.3% -4.0% Fair value Dividend Grossed up dividend Grossed up yield 5.7% 5.7% 5.7% Dividend yield 4.0% 4.0% 4.0% PE STO EPS EPS Growth 15.4% 35.6% -10.4% Fair value Dividend Grossed up dividend Grossed up yield 4.0% 3.9% 3.9% Dividend yield 2.8% 2.7% 2.7% PE AMP EPS EPS Growth -9.8% na 7.2% Fair value 5.60 Dividend Franking 60% 30% 30% Grossed up dividend Grossed up yield 10.1% 8.3% 8.5% Dividend yield 8.0% 7.4% 7.5% PE SUN EPS EPS Growth -18.3% 24.8% 44.0% Fair value 9.00 Dividend Grossed up dividend Grossed up yield 6.4% 7.2% 9.6% Dividend yield 4.5% 5.0% 6.7% PE BXB EPS EPS Growth 0.3% 12.9% 13.7% Fair value 7.50 Dividend Franking 20% 20% 20% Grossed up dividend Grossed up yield 4.6% 4.9% 5.3% Dividend yield 4.2% 4.6% 4.9% PE MQG* EPS EPS Growth -26.7% 22.0% 15.7% Fair value Dividend Franking 0% 0% 0% Grossed up dividend Grossed up yield 5.5% 6.0% 6.7% Dividend yield 5.5% 6.0% 6.7% PE Source: Morningstar Analysts MQG is a March balance date. Actual is FY12. Note: grossed up dividends are dependant on an individual's tax status. reports, and scroll down to Economic Moats the cornerstone to long term investment success. Gold: These debt supercycle problems should dictate yet another leg in the gold bull market though some players may be liquidating holdings to offset distress elsewhere. A rise through US$2000 would not surprise through the next months. Our Forecasts since mid 2009 on track As part of my range trading forecast I argued in following Overviews/Forecasts Australia was well positioned with a sound banking system, a buoyant trading partner in China, but an issue with the overleveraged household needing to pay down debt which could still take another two to three years from now. We have the major advantage employment wise of a giant resource investment boom, which offsets the deep freeze on the usual recovery driver, housing, with its immense multiplier effects through retail and services. Strong employment underpins the ability of our households to pay down their mortgages and with a savings rate of just on 19%, including the 9% superannuation levy, we are sure doing that. The Resource Investment Boom is now moving into its peak phase, and looks likely to be sharply lower in activity in three years time. But then Australian households should have debt under control. Mid last year we estimated approximately three years for this to be achieved. As in the US a third of Australian households have mortgage debt, a third own their own home, and a

4 4 YMW Portfolio Total Return (x) YMW Portfolio ASX All Ords Accum. Index /88 05/92 05/96 05/00 05/05 05/08 05/12 third rent and have no significant debt at all. So some households have plenty to spend. In the US over the last three years household equity measures have actually been lifting! There have been swathes of defaults so the drag of weak to negative equity on the average home equity has fallen quite sharply. US home prices are levelling out, perhaps lifting a touch in the mid to upper brackets. Heaps of problems remain in the US housing market. It will be long slow recovery before it really gathers steam later this decade, the main reason to expect very low interest interests in the US through to 2014/5. Our market sees a gradual price fall, no disaster. YMW Portfolio asset preservation through these times In 1987 I certainly predicted the crash and suggested 50% crash funds, then becoming bullish in late 1990 early January 1991 sufficiently bullish to spend all my available cash to buy back my business which I had sold early post crash. Unfortunately I did not foresee the severity of the disaster though I consistently warned against debt, particularly margin loans to finance portfolios. I also stressed the need for a quality, income producing, diversified portfolio, similar to the YMW Portfolio. Here we have slightly underperformed the All Ordinaries Accumulation Index but we have not seen anything like a wholesale smashing of our assets. Income held up extremely well, gently rising, though the portfolio is designed for a mix of growth and income. It does not include any discretionary retailers, heavily hit on all fronts in this market. I also avoided airlines and mining services. United Group does not have the majority of its business in mining services! I am wary of mid tier miners, but hold copper/gold rich OZ Minerals remaining positive on both metals. Newcrest, a major, is one of the best of our resource companies, again exposed to gold and copper. I try to only buy stocks with a genuine long term appeal, though will cut from time to time when I feel they have run out of gas for instance Fairfax at $4.00 some years back! Harvey Norman, too. The Australian index is dominated by the four major banks, the two major resource companies and Telstra, the key elements of the Top 20. It does not necessarily indicate the way your portfolio travels. For instance a quality portfolio of good dividend yielding stocks would have been in a bull market for some time now, led by Telstra kicking off from the late 2010 low of $2.60. I was a little early beating the Telstra drum, strongly recommending purchases up to $3.25 in 2010 and overweighting the portfolio, personally too. The annual dividend income at 28c a share fully franked easily won the day with the stock now at $3.60. Quality, defensive, dividend payers are a more important area than many of our so called sectors by nature of business. I say so called as in our small market by global standards; the sectors can include very diverse businesses. In the health sector to be reviewed next week, CSL, Ramsay Health Care, and Sonic are very, very different, in business and in operational geography. We have strongly recommended income stocks over the last two years, with our Income Portfolio nicely outperforming. In a world of falling interest rates, the chance of locking in high income for the medium to longer term is invaluable. Hybrids which set their rates at a margin over a declining bank bill rate simply do not measure up, for your income declines with the bill rate. That looks to have more downside, given our deep frozen housing industry. The Banks solid dividends! David Ellis brings an excellent note with this Forecast. But just a few points. The European crisis has been long brewing and many preventative steps have already been taken by financial institutions and companies. The Big Four have sufficient wholesale funding, local and offshore, to withstand several months of a shutdown in global offshore funding markets, an unlikely event given the predilection to 11th hour action by the ECB and other central banks. Through 2008/9, thanks to our annual superannuation inflows of $100bn and rising, a huge swag of our companies and property trusts were very well recapitalised. Sure, shareholders who did not take up bargain basement rights issues were savagely diluted, but the potential for major bad debts and nasty unemployment was rapidly relieved. We also have a major buffer as a commodity exporter in our currency, as it can fall sharply and offset weakness in commodity prices particularly when, as now, there are little inflationary pressures. I prefer the Big Four banks, and own CBA, NAB and Westpac. CBA is my favoured bank stock. Energy gas a major global game changer Mark Taylor explores this issue further on. But a few points. The huge change in the US energy market spells a major plus for the global economy in the coming decade or so. The explosion in shale gas and oil development in the US is a major game changer, even allowing it to switch from potentially being a major importer of LNG, to being a minor exporter. Over the next two years it is reasonable to expect the price of gas in the US to rise from current levels around US$2.60 per mmcf to industry

5 Huntleys Your Money Weekly 28 June History of energy consumption in the United States, Petroleum Hydroelectric Coal Wood Natural Gas Nuclear quadrillion Btu Source: U.S. Energy Information Administration Annual Energy Review 2009 Current US annual energy consumption of all types is around 92.5 quadrillion Btu. Gas reserves are 1,500 quadrillion Btu. That is gas reserves equate to an impressive 15 years of total US energy consumption assuming zero growth, no further increase in gas reserves, and total substitution of the USA s very substantial resources of oil and coal in particular. It does lead the US to (1) at least close to energy independence and (2) significantly cheaper energy. Australia has huge shale gas resources, and will share in these same benefits particularly, as with the US; we have the pipeline infrastructure largely in place. breakeven (after depreciation/interest etc) around US$6.50. Then to at least US$8.00 to restore industry profitability. BHP s Petrohawk purchase was correct! In the last two years there has been an explosion in supply of shale gas and last winter was the warmest in 100 years, so demand was down. In the US land is leased in 640acre lots for shale gas production and one producing drill hole has to complete within 15 months to hold the lease. That spelled an explosion in gas production and the price collapsing from $US12mmcf to $US2mmcf, now $US2.60. Drilling is shifting rapidly to oil prone shales where gas as a by product is far more limited. The initial flow rate from each shale gas well drops at least 50% in the first year, so supply will rapidly equate to demand as overall drilling is curtailed until price improves. Shale gas is at least a 50 year resource for the USA, some arguing 100 years. Now the US is self sufficient in gas, it is rapidly taking steps to replace oil and dirty old King Coal as much as possible. Gas is used increasingly in electricity generation. More importantly LNG is increasingly used to fuel long distance trucks, rather than petrol/diesel. Shell just announced plans to build 100 LNG stations to service long distance trucks across the US in their clearly defined routes. Volvo is churning out LNG truck engines. US road transport is the single largest user of oil in the world, so this cheaper alternative could gradually cap the price of oil driven upwards by Hubberts Peak considerations. The US is at least four years ahead of the rest of the world in harnessing shale gas, so over the next 10 years we will see not only an explosion in the US harnessing gas to replace oil in as many situations as possible, but around the rest of the world. US gas is not likely to put much of a dent in traditional Asian markets for our LNG, but it s possible other East Asian or Siberian sources just might. But that s not likely until post China is not our major LNG market and is likely to keep any shale gas development for its own lustily growing appetite. It may well need LNG to fill the gap through to 2020, and supplement own gas beyond that. Bottom Line: What the International Energy Agency estimates as a 40% increase in global gas reserves will cap the prices of many energy equivalents oil, coal, uranium, and blunt the effects of the Hubberts Peak syndrome with traditional sources of oil. The rapid supply overshoot with gas in the US is a contributing factor to current oil price weakness, plus the obviously weak global economy. The Teens Decade Bull Market I ve argued there will be a major bottom between now and end September, maybe even out to early That s a low with very bleak headlines and we see that developing around us. Gloom on Europe, Gloom on USA. Gloom on China, loads of gloom, and that s what makes major lows. So what am I looking for? 1. My first point relates to the nature of commodity booms. Following a steep sell off as in 1999 with copper at 60USc a lb, you get a massive boom which usually lasts about 10 years with very high prices. Those high prices encourage new supply. The quicker the new supply the quicker the price retreats. The following decade sees a downward sloping plateau effect, they don t just collapse. At present we have a major hiccup in commodity prices, which will likely make its grand finale around that low I expect later this year. Resource stocks will become excellent at least medium term buying. The Chindia affect is far from over. Copper, in particular, continues to face supply shortages, iron ore may see the supply equation come into place far earlier You will see from my notes on the Top 20 how weakness in the major resource stock prices is leading to higher and higher dividend yields. From the point of view of the buyer, this could get better yet! 2. Expectations of further monetary easing in Australia, China, Europe, and the USA. In particular our local bank loan rates look to fall by at least 50 basis points, led down by a 75 basis point cut in the Reserve Bank official rate. Good for defensive, quality, income stocks. Bad for all that money on bank deposit, though the capital is secure. Look to our Moat stock review with this Forecast, and look for yield, and where the yields are low, very carefully consider whether the growth in earnings and dividend in the years ahead justify this high PE/low yield. The baby boomers average 55years old today and they seek income increasingly! 3. I m looking for a minimum two year surge with market breaking out of the current trading range. I d look to a mid cycle correction and then another move to a peak later in the decade as the US economy gathers steam. China too. K

6 6 Australian Share Market Outlook Still defensive, dividend yields paramount Andrew Doherty Head of Equities 33Global economic woes are likely to persist for some time, creating a slow growth environment with occasional shocks to confidence and asset prices. 33The sell-off in resources appears overdone and, while this may go further, there is value for patient investors. Australia s top four banks also offer value and healthy fully franked yields. 33Grocery retailers (supermarkets) are attractively priced and offer more certain earnings growth and dividends than most industries. 33The uncertain, slow growth environment points to a healthy portfolio weighting to moat companies with strong balance sheets and above-average yields. Despite the global uncertainties, we think the market is mildly undervalued, though unquestionably less so than in December last year following the lowering of fair values of a number of stocks in that time. A contrarian investor could take this as a signal that we are approaching a market low. The median discount to fair value for our coverage universe is 12%, down from 20% last December. The market was flat over the period. Analysts are finding it difficult to make outright positive or negative calls. Some 51% of stocks covered are in the range, with 11% and 29% Accumulate. The remaining 8% are Reduce, Sell or Avoid. Debt reduction and the resources boom are dominant themes The economic climate appears to be deteriorating with business and consumer confidence constantly hit by news of deepening sovereign debt issues in Europe and lack of political consensus on how to rectify massive fiscal imbalances. The 0.7% fall in Germany s industrial production in the year to April demonstrates a declining ability of Europe s largest economy to support the periphery. At least the US economy is growing, albeit at a slow pace, which better positions it to handle its debt load. Consumer spending and job creation maintain positive trends despite a slowing in growth in recent months. Unemployment appears to be heading toward 8% by year-end which along with record low interest rates supports a recovery in housing. Spending cuts and tax increases are scheduled for early next year but policymakers are likely to agree to postpone and restructure these to avoid recession. The resources boom should drive the Australian economy to outperform western peers in the next couple of years. Strong business investment should continue to be a clear positive so long as a financial catastrophe is avoided in Europe. Commodity prices are off historic highs on European crisis and China growth concerns and will likely ease further over time, though some support will be found if supply is adjusted through delays in expansion. Demand is weakening in much of Australia s non-resources economy, pressuring margins. Consumers are bunkering down due to a focus on debt reduction, lower job security and the negative wealth effect of lower house prices. The carbon tax net of government handouts is also likely to detract from spending power. Housing activity could worsen further, dragged by affordability problems and limited land supply. Building approvals were down as much as 24% in the year to April. Fiscal policy is tightening as the Government endeavours to balance the budget. The case for further rate cuts is virtually made though it is likely the Reserve Bank will wait for a couple of months to assess the impact of recent moves. Resources and banks are the most undervalued industries Resources companies continue to be pressured by commodity price falls and rising operational and capital costs. While these issues could persist for some time, we think the sell-off is overdone, offering opportunities for patient investors willing to accept the characteristic heightened volatility in this space. On our numbers, resources stocks are as much as 27% undervalued. We favour BHP and RIO which have diversified revenue streams, vast long-life, low-cost assets and healthy balance sheets. Woodside is our favoured Energy exposure given ongoing earnings growth as planned expansions in the next two years offset lower commodity prices. Banks are 26% undervalued and offer fully franked yields of 6 8%. We favour investment in Australia s top four banks given their strong competitive positioning, solid capital ratios and likelihood of mildly positive earnings growth supported by weak but positive credit growth and cost containment, offsetting pressures from higher wholesale funding costs and softening house prices. Food & Staples retailing is undervalued by 16%. The three companies in this sector Metcash,

7 Huntleys Your Money Weekly 28 June To see our full list of moat companies, please go to We will be publishing our Best Ideas and Income Ideas in the following weeks. Wesfarmers and Woolworths each benefit from scale efficiencies and a not-overly competitive market. The repeat nature of food and grocery retailing provides the basis for recurring earnings streams. On current prices the fully franked yields of 5 7% are also attractive. Utilities and healthcare are fully valued but offer some opportunities for yield investors Utilities and Healthcare stocks have been popular for their stable yields and on the whole are now trading slightly above our fair value estimates. Some exposure to these sectors remains prudent given the uncertain climate. SP AusNet and AGL Energy and have Accumulate recommendations and an unfranked yield of 8.0% and partly franked 4.1% respectively. None of our healthcare stocks are undervalued at this time. We remain wary of discretionary retail due to weak consumer sentiment and the shift online and offshore hastened by the high Australian dollar. Traditional retail margins remain high relative to international peers and are set for further falls. Conditions are likely to worsen further, and the lack of competitive advantages supports a negative outlook. We do see some opportunities in the higher-risk mining services space but peaking demand, full share prices for many stocks and a lack of companies with sustainable competitive advantages means this is not one of our preferred areas. Moat businesses bought cheaply make excellent investments Companies with structural competitive advantages, or economic moats, should be the first added to any long-term investment portfolio. They are able to invest capital at rates of return exceeding the cost of capital for many years ahead, thereby growing the business sustainably and creating value for investors. Around 50 stocks in our coverage universe have moats and each is discussed in the sector reports that follow. We will highlight attractively priced moat companies in the Best Ideas and Best Higher Yield Stocks tables published next week. A full list of moat companies can be found on line. Across our research, we have discovered five moat sources: Intangible assets, switching costs, network effects, cost advantage and efficient scale. Intangible assets include strong brands (examples being Coke and Gillette) which encourage repeat sales and support price rises over time. Intellectual property rights like patents, trademarks, copyrights and government approvals are other intangible assets that can lead to moats. Switching costs make it too expensive or time-consuming to shift to an alternative supplier. Computer software providers frequently enjoy this advantage. It can take substantial effort to learn and implement a computer system, so we tend to refrain from switching to another unless we really have to. The network effect is a virtuous cycle allowing strong companies to get even stronger. It occurs when the value of a particular good or service grows as the number of users grows. An example is a stock exchange, where transaction costs decline as transaction volumes increase. Cost advantage can derive from increased scale and efficiency, allowing the company to increase margins. Efficient scale occurs when a limited market is effectively served by existing players and the profit opportunity does not justify entry by others. Airports, ports and shopping centres tend to benefit from efficient scale. Performance of moat companies has been well above market in the past year, median total return being +0.4% compared to median of -5.5% for S&P/ASX200. The top moat performers were defensive businesses where investors sought refuge from market volatility and uncertainty. Telecom NZ, Telstra, Ramsay Health Care, SP AusNet, Coca-Cola Amatil and CSL all returned above +18%. James Hardie also made the cut here, benefiting from its good performance in a terrible US housing market which may now be bottoming. Monadelphous benefited from increasing resources infrastructure work. The worst performers amongst the moats list in the past year were cyclicals RIO, BHP, Woodside, QBE, GWA and Leighton, all producing returns below -18%. These are point-topoint returns and don t take into consideration our recommendations. Over the last five years, median return of our moat companies of -2.2%pa was slightly ahead of S&P/ASX200 return of -2.7%pa. Defensive moat companies posted an impressive +3.7% pa over this period. Top defensive company performers were Ramsay Health Care, +17% pa, APA, +13% pa and Coca-Cola Amatil, +11%. Iress and Wesfarmers posted worse than -2% pa. Cyclicals performed relatively poorly in the past five years, with -4.9% pa total return. The worst of these (Goodman Group, Asciano and GPT) posted returns below -20%pa, dragged by financing problems and capital raisings. K

8 8 Resources Important to stick to quality, infrastructureflush names reasons, including the emergence of mega-scale laterite nickel projects and the role of nickel pig iron as a large but higher cost source of supply. Nickel pig iron utilises sub-scale, obsolete steel plants so the capital cost barrier to entry is dramatically lowered. Basic Materials, Energy, Utilities Mark Taylor Mathew Hodge Gareth James Per Capita GDP compared to the US Japan Taiwan Korea China India 100% 80% 60% 40% 20% 33The iron ore market can be expected to be more balanced from 2015 and investors should stick to miners with sustainable competitive advantages low costs and long life. 33We don't believe shale gas is a material threat to Australian LNG exporters, particularly in the short to medium term. 33The best placed players are those with a head-start on infrastructure spend. Metals and Mining: For nearly a decade miners rode a wave of surging Chinese demand to stellar profits. A sharp and sustained slump in commodity prices represents the greatest risk for most. The threat is less for those occupying a favourable position on the cost curve. Large, low cost, and expandable assets are the litmus test for staking out an economic moat in the mining industry. Worldwide industrial production and fixed-asset investment are crucial to demand and the trajectory of emerging-market demand is particularly important. For some metals like copper, recent world-class discoveries have been few and far between, average head grades are declining and labor-related production disruptions significant leading to a rather tight near term outlook. Gold follows a similar script, as miners battle the headwinds of declining grades and deeper mines. The supply outlook for aluminium is less constrained as a sharp decline in consumption early in the recession forced warehouse inventories to record levels while global smelting capacity increased. Nickel supply is also less constrained for several 0% Source: Vale The fate of bulk commodities rests on steel demand where the real question centres around what will happen outside the US namely in Europe and China. softness in late 2011 gave way to modest improvement to US$140 per tonne plus in the first quarter 2012 but in the second quarter prices again softened, briefly dipping below US$ 130 per tonne delivered to China. Weakening growth in demand stems from soft global growth in the first half and concerns about the global economic outlook. Global steel production is up only 0.7% for the first four months of Over the same period last year, global steel output was 9.1% above 2010 levels as volumes surged in almost all major producing regions. But the post-global financial crisis boom is over now, replaced by renewed liquidity concerns, contagion in Europe and potential spillover effects to the rest of the world. Steel consumption is highly correlated with per capita GDP, so demand was traditionally strongest in the developed world with production concentrated in these areas. But the past decade has brought substantial developing economy growth with China now consuming half of the world's steel. The developing world did not suffer the dramatic cyclical declines that the developed world did in In fact, 2009 was a record year of consumption for China, since eclipsed in 2010 and This year we expect only moderate growth in steel demand as the global economy slows, weighed down by the issues in Europe and the US and credit tightening in China, a credit tightening which is now rapidly loosening. We expect the iron ore market to be more balanced from fiscal 2015 as low cost producers like BHP Billiton (BHP), Rio Tinto (RIO) and Brazil s Vale expand at the expense of high cost supply, particularly from China. There is also potential for new high grade, low cost supply from Africa in the second half of the decade. As producers in the highest quartile of the cost curve exit, the iron ore price can fall sustainably. This gels with the outsized returns on new invested capital. With all up cash costs of roughly US$50 per tonne and assuming a benchmark fines price of US$130 per tonne, low cost miners make a fat pre-tax margin of approximately US$80 per tonne or US$56 after tax. Even at a record high capital costs of US$200 per

9 Huntleys Your Money Weekly 28 June Iron Ore (US cents per DMT unit of Fe {FOB}) Fines Lump Platts 62% China Spot Source: Rio Tinto tonne of new installed capacity, spot prices generate a return on new investment of 28%. There is no scarcity of iron ore in the world and over time new investment will encourage supply and drive down prices. We are cautious on the potential for China to continue to consume ever increasing amounts of iron ore beyond Iron ore is an early cycle commodity as steel is used to build the heavy infrastructure like roads, buildings and bridges in the initial stages of a developing economy s move towards western world standards. China already consumes as much iron ore per person as the west and there is risk in assuming further growth. Negative real interest rates on cash deposits Oil versus US domestic gas price NYMEX WTI $/bbl (LHS) NYMEX Henry Hub $/mcf (RHS) 160 PRE 2005 HISTORICAL SPREAD AVG. SPREAD FORWARD SPREAD 16 1:1 Btu ratio 1.5:1 Btu ratio 7:1 Btu ratio Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16 Jan-18 0 Source: Chesapeake Energy All in costs for US gas producers (Mcfe) $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 Average: $5.62 UPL CHK DVN CRZO EQT FST NBL PQ HK APA COG NFX ROSE RRC QEP AREX BBG GMXR KWK CLR EOG GEOI PXD APC GDP WRES WLL VQ CXO SM BRY SFY PETD OAS Source: Ultra Petroleum encourage speculative investment in other asset classes like real estate. This weak underpinning calls into question the long term viability of the investment driven economic growth model. Metallurgical coal prices also depend heavily on global steel demand. Coal stocks have been hard-pressed by weakening metallurgical coal prices due to increased Australian supply and slower steel production demand. The more normal lack of flood disturbance to Australian metallurgical coal production pushed prices to US$225 per tonne in third quarter 2012 from a flood affected peak of US$330 per tonne in the second quarter of The third quarter settlement is up slightly from the second quarter's US$ per tonne due to strikes at BHP s Queensland mines impacting supply, rather than any meaningful pick-up in demand. Energy: Negligible growth in oil production, despite prices well over US$100 per barrel, supports the peak oil theory. Constrained supply against the backdrop of 2.5% compound annual growth in global primary energy consumption is compelling. Explosive growth in US shale gas resources and the resulting decade low US domestic gas price is cause for concern for energy producers. Could additional supply even reach far enough to impact the attractive prices Australian LNG producers receive in key Asian markets? The US has vast unconventional gas resources and the revolutionary technology and service companies to produce them. Growth in shale gas production is staggering, but not at any price. A weak natural gas price encourages utilities to switch from coal to gas where possible. This is having a minor impact on the Pacific thermal coal export market with some US coal finding its way to export. It exacerbates demand weakness at a time when Australian supply is improving following extreme weather in 2010 and But low prices encourage a rational response from producers. The number of shale gas drill rigs in the US is being cut with best of breed producers requiring a gas price of US$2.70 per thousand cubic feet of gas for cash break even. The US based Morningstar energy team estimates the long term marginal cost of shale gas production to be around US$6.50 per thousand cubic feet, roughly triple current prices. Henry Hub gas prices near US$2 are simply unsustainable. Add in depreciation, compression and shipping costs and gas from the US probably can't reach Asia for less than US$12. US domestic gas prices above US$6 will make US shale

10 10 BHP Billiton BHP Rio Tinto RIO Woodside Petroleum WPL $ /04/12 (YMW14) $ /04/12 (YMW14) $ /05/12 (YMW16) High High gas to LNG a marginal prospect. We don t expect meaningful shale gas to LNG exports from the US before 2020 and even then restricted to swing exports to Asia. The US market may only require a relatively small global export capacity to operate as a relief valve in times of anaemic domestic prices. China is potentially a more serious threat than the US. If gas can be produced in country, the cost of compression and shipping is avoided, replaced by a pipeline. Pipelines have high up front capital costs but very low operating costs. Chinese shale won't need to be as cheap as the US to take away some of the growth potential for Australian suppliers. Chinese shale gas will be used internally, unlikely to compete with Australian exports to traditional markets in Japan, Korea and Taiwan. The potential Chinese shale gas threat to LNG is in its infancy and is unlikely to displace LNG import growth this decade. China faces difficulties commercialising shale gas. Reserves need to be proved up, technology successfully imported and pipelines lain. reform on Chinese domestic gas is needed to unleash the power of supply and demand and for Chinese shale gas to emerge as a source of meaningful supply. Another touted cause for concern for growing LNG suppliers is capital cost particularly in Australia. From the mid 1980s to the completion of a fifth LNG train in 2008, the North West Shelf joint venture (NWS/JV) spent US$19 billion building capacity to 16.3 million tonnes per annum (Mtpa). That equates to a retrospectively modest US$1,165 per annual tonne of LNG nominal or US$1,650 in today's dollars. Fast forward to 2012 and Woodside's (WPL) 90% owned 4.3Mtpa Pluto project commissions 11% over budget at US$13 billion, or US$3,020 per annual tonne. In nominal terms this is a 150% increase on the NWS/JV's 25 year average capacity cost. Adjusting for inflation it's an 85% increase. Pluto is yet to build additional trains to leverage existing infrastructure with the capital intensity of subsequent trains at just 40 45% of the first. That may mean cost comparison with NWS/JV is closer to 30% higher for Pluto after adjusting for inflation. That 30% real cost escalation might not sound scary but appears to be accelerating. Chevron's massive three train 15Mtpa Gorgon project at last count was expected to cost US$45 billion. That's 80% more than the NWS/JV in real terms. And the company's two train 8.9Mtpa Wheatstone project at US$29 billion is 95% higher. It's not inconceivable the real cost of building LNG capacity in the near to medium term will be double that experienced by the NWS/JV pioneers, of course far higher again in nominal terms. This puts anyone with operating LNG capacity at an extreme advantage to the less advanced players. s will need to be permanently higher to incentivise new supply. It also suggests deals, takeovers, mergers and joint ventures to extract cost savings are likely in the space. Moat Comment Commodity prices can be extremely volatile so investors should stick to miners with sustainable competitive advantages low costs and long life and the ability to generate good returns in almost any metal price environment. This is particularly relevant for miners most leveraged to the Chinese fixed asset investment boom, such as iron ore and metallurgical coal. Our preference in the mining sphere remains with BHP Billiton and Rio Tinto. Both produce a range of commodities, BHP differentiated by its full suite of conventional energy products. Both can benefit from rallies in any of their product lines though Rio Tinto is particularly leveraged to iron ore. World class asset bases mean they are among the few miners which generate returns above their cost of capital throughout the commodity cycle. Revenues derive predominantly from resources in the safe havens of Australia, North America and Europe. BHP Billiton and Rio Tinto have limited pricing power over most products except iron ore, where along with Vale, they control 75% of the seaborne market. Minimal pricing power is aggravated by volatility and cyclicality in commodities. However, we assign narrow economic moats to each given their large, low cost and irreplaceable operations. The lack of comparable mega deposits and increasingly prohibitive capital costs pose formidable barriers to entry. Woodside is the only Australian listed company currently producing LNG in quantity. It is also the most LNG infrastructure-rich. That makes it a prime target in an environment of high capital costs. Previous CEO Don Voelte's decision to press the envelope on infrastructure spend prematurely in many eyes looks increasingly inspired. It is also a potentially very tasty morsel. At a market capitalisation of just US$26 billion (enterprise value US$30 billion) and over 7Mtpa of installed equity LNG capacity, why bother building new capacity? Acquiring producing assets avoids construction risk and delivers cash generating assets immediately. We believe Woodside Petroleum has a narrow moat because of world-class, large, long-life, low-cost, and expandable gas assets off the Western Australian coast. K