Time will tell ::

Author: Barbara Drury
Date: September 26, 2007
Publication: Sydney Morning Herald

Sharemarket volatility has shaken the bulls.

The subprime mortgage market continues to unravel like a ball of string, connecting banks in London, Paris, Sydney and Wall Street with borrowers in smalltown US. Talk of recession in the US and Australia is growing and Australia may or may not have a new government by Christmas.

With so much uncertainty, investors are understandably nervous about the outlook for shares.

Australian companies finished the 2006-07 financial year in great shape, with average earnings growth of 15 per cent. The share market had already factored this in, posting a total return of 30 per cent in the year to June. By last month nerves had set in and the market suffered a savage correction.

Investors are banking last year's profits and wondering if that's all there is from a bull market beginning to falter in its fifth year. Earnings growth is expected to slow to a more sedate 10 per cent in 2008 and share price volatility is set to continue.

Against this backdrop, Money asked three fundamental share analysts which companies they believe investors can buy and hold, with confidence, for the long term (see box).

John Price, of Conscious Investor, says over the short term the market does strange things but over the long term earnings drive share prices.

Or as Roger Montgomery, of Clime Asset Management, says, in the short term the market is a reflection of people selling to renovate the bathroom, not the health of the underlying businesses.

Montgomery says share market volatility is a sign that people need to stop investing in mediocre businesses that have been tossed up by the bull market and focus on what businesses are really worth. Only then can you make rational decisions about what and when to buy and sell.

In last month's market mayhem, Clime invested about $10 million in Macquarie Bank, ANZ and Westpac because he reckoned the market had over-reacted to the subprime mortgage crisis. Within 10 days of buying, the three companies posted an average share price increase of 22 per cent.

Macquarie's share price fell from a high of $98 in May to a low of $61.90 last month. "Yet for investors looking two to four years ahead the prospects for its business are very good," Montgomery says.

Price says it makes sense to join Warren Buffett and start by looking for companies with good growth prospects. "If you invest in a portfolio of companies that you bought at reasonable PE [price-to-earnings] ratios and whose earnings continue to rise, then you are going to do well," he says.

Tim Lincoln, managing director of Lincoln, says that even after four great years many companies represent value based on their strong financial health, quality management, share price and a solid operating environment.

In assessing financial health, Lincoln looks for a history of solid earnings, manageable debt levels and sufficient cash balances as well as strong cash flow from operations. Topping its list is BHP Billiton with its strong cash flows, conservative gearing levels and the largest profit in Australian corporate history - $16.3 billion - recently under its belt.

"The record high oil price as well as the expected increase in the iron ore price should see BHP produce another record in 2008 with earnings per share growth in excess of 20 per cent forecast," Lincoln says.

He has identified a dozen companies with forecast earnings growth in excess of 20 per cent this financial year, and some - Bradken, Mermaid Marine, Pipe Networks and SMS Technology and Management - with forecast growth of 30 per cent or more.

Lincoln says QBE Insurance, Seek and SMS are also suitable for investors seeking income as well as growth.

The trick for long-term investors is working out which of today's top companies will still be on top five years down the track.

Price has done research on both the US and Australian share markets and found that companies with a history of stable high earnings growth are more likely to continue growing. "You want high growth as well as stable growth," he says.

Price has selected 10 stable growth companies that he thinks will continue to do well, all with a market value of more than $500 million and average annual growth of more than 15 per cent over the past five years.

To ensure the five-year average growth rate has not been skewed by one terrific year masking several years of indifferent performance, Price has developed a measure that rates the stability of earnings growth on a scale of 0-100 per cent. The 10 stocks he's selected all have a five-year stability rating of more than 96 per cent. In other words, they are consistent high achievers, not one-night wonders.

Count Financial has been a standout performer with average annual earnings growth of 34.7 per cent over the past five years, followed by Transfield Services (25 per cent) and Reece Australia (20 per cent). But for stability of earnings, you can't go past Woolworths with a stability rating of 99.3 per cent and average annual growth of 16.7 per cent for five years running.

"Woolworths has a large client base with lots of small sources of income which brings about stability," Price says. By comparison, some companies may have stellar short-term growth but their reliance on a few products or sources of income makes them vulnerable to a fall in demand.

Montgomery says Macquarie Bank is well positioned to provide investment products to the baby boomers.

With interest rates climbing, Montgomery says prices for the infrastructure assets Macquarie buys should fall and the credit squeeze will wipe out weaker competitors.

ANZ and Westpac are the cheapest local banks and Montgomery believes they also stand to pick up business from struggling non-bank lenders such as RAMS Home Loans.

"Companies have got to be good value today and be good future prospects," Montgomery says. An example he gives is Blackmores - he thinks the ageing population and its enthusiasm for anti-ageing lotions and potions should continue to hit the spot.

"The demographics are also sensational for Blackmores which generates a 60 per cent return on equity for its owners," he says.

Debt collector Credit Corp is not only in a growth sector of the economy but Montgomery says it outclasses its peers. Since 2004 after-tax profit has grown 494 per cent and at a current market price below $11 it is fair value.

Many of the companies expected to do well in the future are already priced for success. Seek, for example, is currently valued at 48 times earnings, compared with an average market price-to-earnings ratio of 14. However, Lincoln says all the star performers he has nominated are priced fairly for their high growth.

Price uses the analogy of Sydney waterfront property. "You could have paid too much for waterfront property 20 years ago but over time, who cares. Even if you pay a little too much [for shares], if earnings keep growing strongly over time, that's what is important," he says.

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