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15 December 2011 | Forecast 2012

Huntleys Your Money Weekly


Forecast 2012 The Teens Bull Market to start 2012
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. My scenario first put in 2009/10 is little changed. For calendar 2011, I looked to the All-Ordinaries index trading between 4000 and 5000 with a 20% chance of upside to 5500, an upside which didnt eventuate. I allowed slippage to 3800, which did eventuate. Briefly, I thought the downturn might stop at 4500 this year. I expect this trajectory will continue in 2012 with the possibility the market might overshoot a couple of hundred points on the downside but not for long. I have repeatedly said the 2012 low just perhaps edging into 2013 would launch the Teens decade bull market. That low would feel bad, there would be feelings of panic. But just like the post 1987 crash market to January 1991, the market might not fall below previous lows, or much below them. A breech of those lows would simply engender the panic that creates the bottom. Meanwhile you can see the earnings and dividend power building from the forecasts for the Top 20 and Top 50 indices below, and our individual company forecasts for the Top 20. We have fear driving down price earnings ratios while in important areas EPS and DPS are on the rise. The major developed world of the Northern Hemisphere faces a prolonged period of debt deleveraging yet that will come with very low interest rates to at least 2013/14. Most corporates have good balance sheets. As I point out under the USA heading, some sections of the populace are doing well, so theres many a market to make a good profit. Falling interest rates and increased monetary stimulation in China, India and Europe, will be the order of the day in 2012. The US will likely extend its quantitative easing program early on. With Europe, the central banks are doing a lot to contain this crisis in confidence and I back a muddle through scenario. I see little further downside in gold, more likely upside, though the difficulties in Europe imply some countries may sell down gold reserves for much needed funds. For Australia I am unsure if there will be further interest rate falls in 2012, but certainly no increases. Weak consumer confidence supports the downside case. Should Europes problems grab the headlines we have plenty of room for monetary policy to ease. We have major stimulus from the resource investment boom even if we get significant cutbacks in 2012. As with the rest of the world we dont have inflation, so no need for a credit squeeze ala 2007/08. Our strategy for some time is to go for defensive, income stocks. Two favourites are Telstra and Woolworths, I own both. The income portfolio is furnished with high yielding, defensive stocks and is proving an island in the storm. China is very important. Internal infrastructure investment is likely to be boosted in 2012 and will continue to dominate and underpin commodities demand. Much publicity goes to the residential real estate downturn in the upmarket areas where private developers are allowed to work. Little publicity is given to the more important building of affordable housing a rate of 10 million a year as part of the current five year plan. A soft Europe slows Chinas exports as that is its largest market. Also a slowing Europe itself will absorb less commodities. But overall I cannot get too bothered, no hard landing, still not looking for a downturn anything like the scale of the GFC... no major credit squeeze! No significant inflation! Continued on page 2
Australias Leading Independent Investment Newsletter Since 1973

Ian Huntley Editor

Sector Overview 6 Equity prices looking attractive for the long-term, patient investor Resources Not all gloom and doom

Banking Sector 12 Risks becoming increasingly complex Mining Services 14 Riding the capital spending wave Telecommunications Dial in Get on line! Retail For now, safety first

15 16

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Overview continued from Page 1

Key Terms Buy: Substantially undervalued. Accumulate: Modestly undervalued. Hold: Appropriately priced, neither buy nor sell. Reduce: Sell part holding. Sell: Sell all holdings now. Avoid: Not investment grade. Moat Rating: 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. Business Risk and Share price risk: The analysts opinion of a companys 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).
Investment Style

Table 1: Top 20, Top 50 indexes weighted EPS growth and Dividend yield forecast
TOP 20 Table FY11* FY12* FY13*

PE NPAT Growth EPS Growth Div Yield Price/Intrinsic Value


TOP 50 Table

12.5 19.7% 14.9% 4.9% 75.7%


FY11*

10.0 13.2% 12.3% 5.8%


FY12*

9.6 5.7% 5.0% 6.2%


FY13*

But banks sell on a low PE as they are highly leveraged. The resource stocks are currently selling on low PEs because commodity prices are perceived as high and falling. The market is preparing for a commodities downturn as world growth contracts through 2012/2013. We are more positive on our resource majors despite our Commodity Forecast Table 3 pointing to most prices gradually declining including iron ore at $80 a tonne by 2016 and copper at $3.13. These are still good prices for our majors BHP and RIO. We have oil steady at $100 a barrel, sufficient to support the current immense investment in LNG, shale gas, and liquids from tar sands, coal, biomass and gas. The US S&P 500 is on a 12.3 PE against consensus 2012 earnings, not expensive. The major bottoms over the last 15/20 years have often been at a PE of 15! In the latest year dividend yield on the S&P 500 is up 12.7%, and the S&P has gone sideways. According to Standard and Poors, of the 78% of index stocks that pay dividends 56% lifted them in the latest year for a 16.7% overall gain for the dividend payers. While EPS and DPS for the index increased, the index PE was dragged down largely by the financials. Forecasts of global growth are now consistently falling with the latest bearish one I noted calling 2012 and 2013 global growth at half the 2010 level of 5.1%, and China to run in the low 7% range with downside risk. Thats on a rapidly expanding base and you will see how big that is from Figure 1, a great read. More notice needs to be taken of a slowly improving United States, though the main issue is the onset of recession in Europe and potential for nasty downside if they cant handle the situation, and a growth slowdown in Asia.
Declaration Declaration of all equities analysts' personal shareholdings, disclosure list for Forecast 2012. These positions can change at any time and are not additional recommendations. AAO, ABC, ACG, ACL, ACR, AEU, AFI, AGK, AGS, AGX, AIX, AKF, ALL, ALS, AMP, ANO, ANP, ANZ, APA, APN, ARD, ARG, ARU, ASB, ASX, ASZ, ATI, AUN, AVX, BEN, BFG, BHP, BKI, BKN, BLY, BND, BNO, BOQ, BSL, BTU, BXB, CAB, CBA, CDD, CGS, CIF, CND, COH, CPA, CPB, CQO, CRK, CRZ, CSL, CSS, CTN, DJS, DOW, DTE, DUE, DVN, EGL, EGP, EQT, ERA, ESV, EVZ, FMG, FXJ, GBG, GCL, GFF, GMG, GPT, GWA, HIL, HSN, HST, IAG, IFL, IGR, IIN, ILF, IPD, JMB, KAR, KBC, KCN, KEY, KMD, LEG, LEI, LLC, MBN, MCR, MFF, MIO, MPO, MQG, MSB, MSF, MTS, MUN, MYR, NAB, NEU, NHC, NMS, NUF, NUP, NVT, NWS, OSH, OST, PBG, PBT, PGA, PGM, PMV, PNR, PPT, PRE, PRG, PRY, PTS, QBE, QFX, QUB, RCR, REX, RFE, RHC, RHG, RIO, RKN, ROK, RQL, RWH, SAKHA, SEK, SGP, SGT, SHV, SMX, SOL, SRH, SRX, STS, STW, SUN, SVW, TAH, TCL, TEN, TLS, TOL, TPM, TRF, TRS, TSE, UGL, UXC, WAL, WAM, WBB, WBC, WCB, WDC, WES, WHC, WHG, WOW, WPL, WRT, ZGL.

PE NPAT Growth EPS Growth Div Yield Price/Intrinsic Value


result dramatically.

13.4 8.0% 17.3% 4.5% 79.4%

10.7 20.7% 20.6% 5.4%

10.1 7.0% 6.4% 5.9%

* Oil Search Ltd and Iluka Resources Ltd growth changes the top 50s

Value

Blend

Growth

Mkt Cap

Large Medium Small

Top 20, 50 Index EPS and dividend return forecasts Table 1 provides our estimates of Top 20 Index growth in EPS and dividend for 2012 and 2013 and similarly for the Top 50. As the Top 20 goes, so does the market. Our estimates for the Top 20 give 12.3% upside for 2012 EPS and a further 5.0% for 2013 while our dividend forecast sees the yield increase from 4.9% in 2011 to 5.8% in 2012 and 6.2% in 2013. Those numbers support a potential rise in our Index, possibly to that 20% chance of 5500. But I expect offshore generated fear to keep the indices down and give investors wonderful dividend yields... something I have stressed for some months together with my successful forecast of two 0.25% interest cuts before Christmas.

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.

We kick off with the Top 20 index at a 25% discount to our estimate of Fair Value with the All Ordinaries in the mid 4200s. The market appears cheap, a 25% discount broadly equating to a buy. That discount also tallies with the low market PE.
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:95 090 665 544, AFSL:240892 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 www.morningstar.com.au/fsg Contact Details Tel: 1800 03 44 55 Email: help.au@morningstar.com www.morningstar.com.au

Huntleys Your Money Weekly

15 December 2011

Table 2: Top 20 earnings and dividend forecasts


Actual F'cast Y1 F'cast Y2 1 BHP EPS 396.2 510.1 471.7 Price 36.99 EPS growth 56.30% 28.70% -7.50% 98 126.8 166.2 Fair Value 57.65 Dividend Franking 100% 100% 100% Grossed up Dividend 140 181.1 237.4 Grossed up yield 3.80% 4.90% 6.40% Dividend Yield 2.60% 3.40% 4.50% PE 9.34 7.25 7.84 2 CBA EPS 426.8 456.3 482.9 Price 49.68 EPS growth 9.60% 6.90% 5.80% 320 329.4 348.6 Fair Value 62.40 Dividend Franking 100% 100% 100% Grossed up Dividend 457.1 470.6 498 Grossed up yield 9.20% 9.50% 10.00% Dividend Yield 6.40% 6.60% 7.00% PE 11.64 10.89 10.29 3 WBC EPS 209.3 222.5 234.5 Price 21.53 EPS growth 5.80% 6.30% 5.40% 156 160 167 Fair Value 30.42 Dividend Franking 100% 100% 100% Grossed up Dividend 222.9 228.6 238.6 Grossed up yield 10.40% 10.60% 11.10% Dividend Yield 7.20% 7.40% 7.80% PE 10.29 9.68 9.18 4 ANZ EPS 214.5 216.6 227.6 Price 21.13 EPS growth 7.70% 1.00% 5.10% 140 143 150 Fair Value 31.00 Dividend Franking 100% 100% 100% Grossed up Dividend 200 204.3 214.3 Grossed up yield 9.50% 9.70% 10.10% Dividend Yield 6.60% 6.80% 7.10% PE 9.85 9.76 9.28 5 NAB EPS 245.1 270.7 290.3 Price 24.61 EPS growth 16.10% 10.40% 7.20% 172 189 203 Fair Value 32.50 Dividend Franking 100% 100% 100% Grossed up Dividend 245.7 270 290 Grossed up yield 10.00% 11.00% 11.80% Dividend Yield 7.00% 7.70% 8.20% PE 10.04 9.09 8.48 6 TLS EPS 26 29.3 32.9 Price 3.27 EPS growth -16.80% 12.70% 12.30% 28 28 28 Fair Value 3.60 Dividend Franking 100% 100% 100% Grossed up Dividend 40 40 40 Grossed up yield 12.20% 12.20% 12.20% Dividend Yield 8.60% 8.60% 8.60% PE 12.58 11.16 9.94 7 WES EPS 166.1 230.8 250.2 Price 31.91 EPS growth 12.70% 39.00% 8.40% 150 200 210 Fair Value 36.90 Dividend Franking 100% 100% 100% Grossed up Dividend 214.3 285.7 300 Grossed up yield 6.70% 9.00% 9.40% Dividend Yield 4.70% 6.30% 6.60% PE 19.21 13.83 12.75 8 WOW EPS Price 25.68 EPS growth Fair Value 29.05 Dividend Franking Grossed up Dividend Grossed up yield Dividend Yield PE 9 RIO* EPS Price 66.09 EPS growth Fair Value 97.55 Dividend Franking Grossed up Dividend Grossed up yield Dividend Yield PE 10 NCM EPS Price 33.50 EPS growth Fair Value 42.85 Dividend Franking Grossed up Dividend Grossed up yield Dividend Yield PE 11 WPL* EPS Price 32.90 EPS growth Fair Value 64.90 Dividend Franking Grossed up Dividend Grossed up yield Dividend Yield PE 12 WDC* EPS Price 8.20 EPS growth Fair Value 9.95 Dividend Franking Grossed up Dividend Grossed up yield Dividend Yield PE 13 CSL EPS Price 32.39 EPS growth Fair Value 34.40 Dividend Franking Grossed up Dividend Grossed up yield Dividend Yield PE 14 ORG EPS Price 14.45 EPS growth Fair Value 19.10 Dividend Franking Grossed up Dividend Grossed up yield Dividend Yield PE Actual F'cast Y1 F'cast Y2 173.6 181.6 196 6.40% 4.60% 7.90% 122 127 135 100% 100% 100% 174.3 181.4 192.9 6.80% 7.10% 7.50% 4.80% 4.90% 5.30% 14.79 14.14 13.1 784.4 862.4 900.9 75.60% 9.90% 4.50% 117.5 116 128.6 100% 100% 100% 167.9 165.7 183.7 2.50% 2.50% 2.80% 1.80% 1.80% 1.90% 8.43 7.66 7.34 147.1 149.1 171.7 -6.60% 1.40% 15.20% 50 40 50 0% 0% 100% 50 40 71.4 1.50% 1.20% 2.10% 1.50% 1.20% 1.50% 22.77 22.47 19.51 198 198.5 186.1 3.90% 0.30% -6.20% 114.2 111.7 121 100% 100% 100% 163.1 159.6 172.9 5.00% 4.90% 5.30% 3.50% 3.40% 3.70% 16.62 16.57 17.68 90.5 62.5 63.3 2.40% -30.90% 1.30% 63.6 48.4 50.6 0% 0% 0% 63.6 48.4 50.6 7.80% 5.90% 6.20% 7.80% 5.90% 6.20% 9.06 13.12 12.95 173.6 195.6 211.1 -6.30% 12.70% 7.90% 80 87 91 6% 6% 6% 82.1 89.3 93.4 2.50% 2.80% 2.90% 2.50% 2.70% 2.80% 18.66 16.56 15.34 68.5 79.1 81.3 3.80% 15.50% 2.80% 50 50 50 100% 100% 100% 71.4 71.4 71.4 4.90% 4.90% 4.90% 3.50% 3.50% 3.50% 21.09 18.27 17.77 Actual F'cast Y1 F'cast Y2 15 QBE* EPS 124.4 124.7 157.5 Price 14.05 EPS growth -34.60% 0.20% 26.30% 128 128 130 Fair Value 21.10 Dividend Franking 12% 10% 15% Grossed up Dividend 134.8 133.5 138.4 Grossed up yield 9.60% 9.50% 9.80% Dividend Yield 9.10% 9.10% 9.30% PE 11.29 11.27 8.92 16 STO* EPS 44 55.8 52.9 Price 13.00 EPS growth 36.80% 26.80% -5.20% 37 24 30 Fair Value 14.75 Dividend Franking 100% 100% 100% Grossed up Dividend 52.9 34.3 42.9 Grossed up yield 4.10% 2.60% 3.30% Dividend Yield 2.80% 1.80% 2.30% PE 29.55 23.3 24.57 17 AMP* EPS 34.3 36.3 39 Price 4.32 EPS growth -2.00% 5.80% 7.40% 30 31.3 33 Fair Value 6.30 Dividend Franking 60% 30% 30% Grossed up Dividend 37.7 35.3 37.2 Grossed up yield 8.70% 8.20% 8.60% Dividend Yield 6.90% 7.20% 7.60% PE 12.59 11.9 11.08 18 SUN EPS 49.1 80 91.4 Price 8.48 EPS growth -18.30% 62.90% 14.30% 35 48 54.8 Fair Value 9.40 Dividend Franking 100% 100% 100% Grossed up Dividend 50 68.6 78.3 Grossed up yield 5.90% 8.10% 9.20% Dividend Yield 4.10% 5.70% 6.50% PE 17.27 10.6 9.28 19 BXB EPS 35.4 42.6 47.1 Price 7.22 EPS growth 0.40% 20.30% 10.60% 26 30 32 Fair Value 7.38 Dividend Franking 20% 20% 20% Grossed up Dividend 28.2 32.6 34.7 Grossed up yield 3.90% 4.50% 4.80% Dividend Yield 3.60% 4.20% 4.40% PE 20.4 16.95 15.33 20 ORI EPS 173.1 190.4 215.1 Price 25.83 EPS growth 2.50% 10.00% 13.00% 90 98 112 Fair Value 29.70 Dividend Franking 79% 40% 40% Grossed up Dividend 120.4 114.8 131.2 Grossed up yield 4.70% 4.40% 5.10% Dividend Yield 3.50% 3.80% 4.30% PE 14.92 13.57 12.01

* Stocks with a December balance date. Actual is FY10 Source: Morningstar Analysts

Notes for Table 1


For this index replication purpose only, the dividend yield, EPS growth and price/intrinsic value are the market cap weighted averages of the respective stock statistics as per the S&P index methodology. This includes major shareholdings such as the Murdoch holding in News Corp but not offshore listing such as the London stock of BHP Billiton. NPAT growth is the sum of the index weighted growth rate of each company. The PE is sum of the inverse (earnings yield) of each company by market weight. Inversed again to calculate the correct weighted PE.

Resource and bank stocks dominate the Top 20 and its easy to understand why a cynical friend styles our index as a Resource/Bank hedge fund! In our Bank section you will see why we continue to love the bank stocks for their dividends, and in the Resource Section, the resource stocks for their medium term value! My view continues that many Australian companies will continue to do well in a reasonable economy including the banks and resource stocks. But overseas selling may drive prices down due to the European flutters. The gift: better dividend yields for Australian investors. And I just love fully franked dividends and say thank you Paul Keating, many a day!

What is driving this market? Europe In 1988 the Bank of International Settlements said OECD sovereign debt could be purchased by banks with zero risk weighting. The Basel Bankers forgot that wonderful Walter Wriston quote while CEO of CitiBank in the 70s: "Countries can't go bankrupt. Citibank has never lost a dime on sovereign loans and it will not ever!" Shortly after, Mr. Wristons bank lost heaps on Latin American debt. The European banks loaded up on Euro sovereign debt, and now pay the price as Greece defaults and bond rates zoom in Italy and Spain in particular. But German Bunds would have given strong capital gains in recent years.

The bears now point to Mario Draghi, head of the European Central Bank stating the ECB will give no

Table 3: Morningstar Commodity Forecasts


CY06(a) CY07(a) CY08(a) CY09(a) CY10(a) CY11(e) CY12(e) CY13(e) CY14(e) CY15(e) CY16(e) CY17(e) CY18(e) LT(e)

Aluminium (A$/lb) Copper (A$/lb) Nickel (A$/lb) Gold (A$/oz) Oil (A$/bbl) Uranium (A$/lb) Iron Ore Fines (A$/t FOB) Coking Coal (A$/t) Thermal Coal (A$/t)

1.56 4.06 14.60 802 88.02 64.40 60.43 152.6 69.0

1.43 3.87 20.14 832 83.15 117.31 59.54 117.0 65.7

1.37 3.71 11.26 1024 116.94 71.62 105.30 352.22 146.76

0.95 2.96 8.40 1228 77.92 58.69 75.90 157.76 88.35

1.07 3.72 10.76 1334 86.47 50.86 108.47 205.06 96.55

1.11 3.97 10.03 1436 89.56 57.84 151.74 277.98 117.75

1.24 3.81 9.05 1429 100.00 61.90 119.05 238.10 120.24

1.30 3.75 10.25 1400 100.00 70.00 105.00 225.00 121.25

1.37 3.68 10.53 1368 100.00 78.95 92.11 210.53 118.42

1.44 3.61 10.56 1333 100.00 77.78 86.11 200.00 113.89

1.53 3.53 10.59 1294 100.00 76.47 79.41 188.24 108.82

1.63 3.44 10.63 1250 100.00 81.25 81.25 175.00 107.81

1.63 3.13 10.00 1125 100.00 81.25 81.25 162.50 101.56

1.63 3.13 10.00 1000 100.00 81.25 81.25 150.00 87.50

major support to sovereign debt. But he does say the ECB will provide major liquidity for up to three years to the banks at 1%. The bears miss this, a major mistake. The risk to the 17 sovereigns in the European Monetary Union (EMU) is they might need to semi nationalise their banks and thus trash their sovereign debt rating. The ECBs major support sure helps the sovereigns! In my overview of 18/11/2011, I pointed to the ECB instructing member country central banks to drive the printing press and buy sovereign debt. This appeared a limited, so fruitless exercise. The process is now into a far higher gear to support the individual banks in each country and thus their ability to hold or even buy more sovereign debt. This is also a method of alleviating the market based credit squeeze developing in Europe as the banks reduce activity to build their own liquidity. This is part of a central banks role and may boost European money supply is the printing press finally at work? Theres more! Early December the US Federal Reserve announced a further buttressing measure for global liquidity against the European Crisis. Together with four other Central Banks the Fed cut the rate 50 basis points to 50 basis points on the premium banks pay to borrow dollars overnight from central banks. Dollar swap lines were extended by six months to 1 February 2013. The Fed coordinated the move with the ECB and the central banks of Canada, Switzerland, Japan and the U.K. The six central banks agreed on temporary bilateral swap programs so funding can be provided in any of the currencies should market conditions warrant. The governments of Spain, Italy and Greece certainly seem set on austerity programs which in a Keynesian sense should drive their economies into recession, though if coupled with expanding money supply and lower interest rates, the result may be better. Austerity should also be supportive of these PIIGS bond markets.

The 17 countries of the EMU will take until March to legislate the proposed fiscal reforms of early December. But more important is that the PIIGS are making significant steps in cleaning their sties already!
Sovereign Debt refinancing. Significant Euro sovereign debt refinancing takes place in the first quarter, particularly Italy, which will be watched closely. If it goes well upside surprise if it goes badly the bears will have expectations fulfilled. Given the way the refinancing is staged over the next three years, the costs to the Italian budget only edge up in the early years, not a big bang. Euro Bank equity raisings. This is the big one...but! First there is several hundred billion Euros in topping up to meet the latest Basel agreement for banking capital requirements. But that pales beside the mooted 1trillion or so in equity raisings some say are necessary to clean out the mounting bad debts within the system, most of which relate to sovereign debt. That seems a worst case prognostication. If Italy or Spain leave the Euro and their currencies crash, it will crystallise those types of sovereign bond losses for banks exposed who remain within the EMU. But if as is more likely Italy and Spain remain in the Euro and the bonds are held to maturity the losses will be a lot less. There could be other bad debts lurking as well. This could be a major bear influence during the year or it could be an upside surprise as dismal expectations are not met. (1) It is hardly coming as a shock (2) it can be seriously debated as above and (3) one would think liquidity has been built in various institutions ahead of the possibility of buying very cheap Euro bank stock. Bottom Line Europe...muddle through case! Germany must be cheering for the Euro is now falling versus the US dollar, exactly what the worlds second largest exporter wants. I have been largely in the camp that following the GFC, the central banks and Governments would understand

Huntleys Your Money Weekly

15 December 2011

how to avoid another severe market based credit crunch and it appears thats the case. It is much easier in 2011/2012 for them to achieve this as the spectre of inflation is just not rearing its ugly head as it did in 2007/2008. The ECB has now cut interest rates twice by 0.25% pre Christmas. So the major countries of Europe, particularly the German powerhouse, are rapidly becoming a very low interest rate zone, just like the US. This chart shows the powerful growth in GDP per person in the BRIIC economies since 2007 but particularly China, India, and Indonesia. Indonesia is the extra i, important as it is our nearest neighbour. The weakness in the developed world stands out. It also puts in context the suggested slow down in the developing world for it comes on a significantly larger base and after powerful growth. The developing world may be cash rich but it needs this to develop infrastructure where there is a long way to go. Thats resource intensive, good for Australian exports. The developed world already has that infrastructure, just needs to put it to better use and sell like crazy to these fast developing markets in the BRIICs! That will be the story of the next 20 years as the Kondratieff long wave develops its next fully fledged upswing.
Figure 1: Real GDP per person, 4Q07 to 2Q11 (% change)
Poland* Taiwan Brazil* South Korea Argentina* Indonesia India* China

Greece* Ireland*

Belgium* Mexico* Canada* Netherlands France Portugal United States Spain Japan Britain Italy

Russia Australia* Germany South Africa* Switzerland* Sweden

Turkey*

The USA on a very slow improve The US is making steady but slow progress, very much slower than previous post war cycles. Employment has hardly grown at all and underemployment stands at 1517%. Employment in recent months is growing. These statistics can be subject to incredible revisions possibly upward! There are green shoots popping up. It may be somewhat overstated but the Americans showed their wonderful powers of innovation again in the exploitation of shale gas resources, which promises to make them self sufficient in gas and an exporter of LNG. Financial services innovation in the last 20 years ended up in the GFC big bang, but true to form they are working out of the hole. Their major banks are recapitalised but face a liquidity trap as the populace deleverages with some years to go. Corporates are in very good financial shape. The national balance sheet is stretched and budget deficits run at $1.5trillion, promising to stretch it further, though the current drive to security of capital makes the deficits easy to finance. If you look at segments of the population, it is not dissimilar to Australia 33% renters, 33% in mortgage debt, 33% no debt. There are large groups doing well, large groups not doing so well particularly the lower income earners. So it is understandable with very low interest rates that a number of US companies are doing well indeed, dependent on the population segments they service. The current strengthening of the US dollar versus the Euro takes the shine off the significant US corporate earnings from Europe.

-10

-5

10

15

20

25

30

35

* 2Q11 estimate. Source: Barrick Gold presentation, September 2011

Figure 2: The Financial Services Boom that led to the troubles


US (18502009)
12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

These charts show the large increase in financial services, particularly for Australia from the 90s on, as our interest rates began a long decline, luring the populace to take on more and more debt. The period 20032007 in Australia saw an explosion in these services with Macquarie Bank, the millionaires factory, the iconic emblem of the era. The result was residential property booms around financial centres such as London, New York, Sydney and so on. In at least the next few years, deleveraging of household debt continues as the key theme, so I look to a continuing downturn in these graphs to be mirrored in weak up-market residential areas, and the retailers such as David Jones who service them. Not all members by a long way in this sector are investment bankers/financial market participants down on their luck. But there is significant deflation of that bubble going on and its likely to continue for some time. K

Australia (19742011) Financial sector as percentage of GDP: US vs Australia

Source: Ewing Marion Kauffman Foundation/ABS

Sector Overview Equity prices looking attractive for the long-term, patient investor
Ross Bird Head of Equities Strategy

only 3.4%, possibly reflecting indirect UK membership of the eurozone. Japan experienced its own left field tragedy in 2011, contributing to its market falling 17.5%. Within the Australian market sector performance has varied highlighting the importance of diversification within portfolios to reduce volatility. Our preference for defensive style industrial sectors over the course of 2011 has certainly been vindicated. The performance of resource stocks in comparison has been disappointing. Nevertheless the risk averse investment climate is presenting high quality resource stocks at deep discounts to fair value - very good buying for the patient, medium term investor. The relative sector performance also highlights investor preference for sustainable, high yields as seen in Chart 1, a theme consistent with our strategy and one we expect to continue into 2012. The Telecommunications Accumulation Index, largely driven by Telstra, saw a 27.8% rise. Telstra is in recovery mode after disappointing from 2008 to 2010. A welcome management change and greater clarity over the NBN portends an environment in which investors can be more confident. Other high yielding, defensive sectors to outperform include Utilities (8.6%), Consumer Staples (3.5%) and A-REITs (1.2%). Within the context of challenging macro-economic events and weak performances of many global banks, Financials excluding A-REITs also performed well, down a modest 1.3% over the year. The worse performing sectors for 2011 had lower dividend yields despite some very strong profit growth especially in resource stocks. It highlights the role of dividends as an important component to overall returns in a risk-averse, low to falling interest rate environment and suggests these sectors should continue to form a significant part of a balanced equity portfolio into 2012. Especially as they remain priced at a discount to assessed fair value. Lacklustre short term market performance by resource stocks, as overall earnings are rising and supporting valuations, sees current overall market pricing at a significant 22% discount to our assessed fair value as outlined in Chart 2. This compares to a 17% discount in June 2011. Energy (-32%), Materials (-32%), Banking (-28%) and Insurance (-26%) are at greatest discounts to

Without question 2011 has been a challenging year for investors. To end November, major global equity markets have seen negative to slightly positive returns with weakness in the US$ assisting the relative performance of US indices. Even here, investor risk aversion reflects in the large cap Dow Jones index rising 6.7% while the broader based S&P500 eked just 1.1% and the technology driven NASDAQ fell 0.3% on a total return basis. The Australian market fared worse, the S&P/ASX 200 Accumulation index down 9.3%, primarily Resources down 21.0%, tempered by Industrials down a modest 3.5%. The strength of the A$ in 2011, consolidating strong rises seen in the previous two years, has acted as a handbrake on profit growth for many companies while American counterparts enjoyed a depreciating greenback. Most European equity markets endured even more challenges with weak economic growth and ongoing concern over the state of public sector finances. Germanys DAX declined 11.9% and Frances CAC 40 fell 14.6%. The FTSE 100 is down

Chart 1: Sector performances this year (including dividends to 12 Dec 2011)


30 25 20 15 10 5 0 -5 -10 -15 Info Tech Materials Energy Consumer Disc. Health Care S&P/ASX 200 Industrials Financials x A-REITs Financials A-REIT Consumer Staples Utilities Telecom Services -20

Source: Morningstar Analysts

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15 December 2011

Chart 2: Sector price to fair value


1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 Morningstar Universe Energy Materials Banks Real Estate Utilities Info Technology Telco. Services Health Care Consumer Discr. Consumer Staple Industrials Insurance 0.60

investments generating steady returns even in tough conditions. High quality retail A-REITs are defensive in the short term but conservative spending patterns post GFC and growth in online shopping are headwinds. Higher geared trusts and those with cyclical earnings such as developers face greater uncertainty and are not suitable for most typical income investors. While we recommend some exposure to Utilities (-7%) and Health Care (-4%) for defensive properties, these sectors are close to fair value and are given Neutral sector weights. Industrials (-1%) and Consumer Discretionary (-11%) retain Underweight ratings due to higher risk and modest discounts to fair value. For the Morningstar universe of stocks researched, we forecast dividend yield of 5.2% for FY12 and 5.7% for FY13. For income seekers, we provide our two years yield forecasts below. K
Table 2: Forecast dividend yields

Source: Morningstar Analysts

fair value and are recommended as Overweight for portfolios. Consumer Staples (-10%) and Telecommunications (-11%) are also Overweight due to their strong defensive characteristics. Within the A-REITs we recommend a neutral weighting and encourage investor focus on good quality trusts with secure, growing earnings and conservative balance sheets. These include Commonwealth Property Office Fund (CPA), BWP Trust (BWP) and Dexus Property Group (DXS) which should behave like traditional defensive

FY12

FY13

Banks Consumer Staples Insurance Real Estate Telecommunications Utilities

7.5% 5.8% 7.4% 6.6% 8.3% 6.3%

8.0% 6.1% 7.8% 6.9% 8.4% 6.4%

Table 1: Sector weightings and recommended stocks


Sector Weighting Recommended stocks with Moat and company business risk ratings

Energy Financials Banks / Insurance Financials A-REITs / Property Information Technology Materials Consumer Staple Health Care Utilities Telecommunication Services Industrials* Consumer Discretionary

Overweight Overweight Neutral Neutral Overweight Overweight Neutral Neutral Overweight Underweight* Underweight

ORG (none, medium), WPL (narrow, high) NAB (narrow, medium), CBA (narrow, low), ANZ (narrow, medium), WBC (narrow, low), QBE (narrow, medium), CGF (none, medium) DXS (narrow, medium), BWP (narrow, low), CPA (none, low-medium) CPU (narrow, medium), CRZ (none, medium) BHP (narrow, medium), RIO (narrow, medium), NCM (none, medium), ILU (none, high) WOW (wide, low), WES (narrow, medium), MTS (narrow, medium) RHC (narrow, low) AGK (narrow, medium), APA (narrow, medium), SPN (narrow, medium) TLS (narrow, medium), IIN (none, medium) TOL (narrow, medium), ORI (narrow, medium), IPL (none, high) CWN (narrow, medium-high)

*A diverse range of business types within the Industrials sector. We emphasis an overweight position to mining linked services and support companies.

Resources Not all gloom and doom

The full sze charts that accompany this article are available at www.morningstar.com.au

Global GDP growth rate


(% per annum)

Introduction The uncertain short term global economic outlook sees an elevated level of fear in the market. It also presents value opportunities. Both BHP and RIO recently re-iterated their view of a strong long term outlook underpinned by increasing supply challenges and developing world demand growth. Other global majors Anglo American, Vale and Xstrata made similar statements.

consumption is less than a quarter of Australia, the US and Canada, about a third of Japan and South Korea and less than half the EU. India is emerging and has per capita energy consumption at just 20% of China, and less than one tenth the EU. India is not particularly energy rich and coal is generally low quality. This bodes well for Australian exports of thermal coal and LNG. Ultimately declining population growth rates and increasing efficiency will see the demand for primary energy flat line, but that point is decades away. At the moment the key driver of increasing demand is the rise in incomes in the developing world.
Oil There has now effectively been no growth in global oil production for the last six years. We use oil here in the near catch-all sense for crude, shale oil, oil sands and non-gas liquids. Combined output of product falling within this definition has hovered between 8082 million barrels per day (mmbopd) since 2004. Worth considering is that oil prices during this period more than tripled from US$30/bbl to US$100/bbl, making any argument that price suppressed supply invalid. Further global liquids consumption actually rose by 5.5% to 87mmbopd over the same eight years with ethanol and other sources including coal derivatives making up the shortfall.

Source: BHP Billiton

Capital equipment lead time in 2011

Source: Rio Tinto

Nearer term the chance of another GFC type credit freeze has raised its ugly head. Its a low probability but high impact scenario which could severely wound a number of companies and those with debt and/or low margins may not make it. Thankfully the likes of BHP and RIO are well placed to survive and prosper should we have another sharp downturn. The combination of quality operations, long life assets, high margins and relatively low PEs make an attractive combination. These companies are not even priced for gradual commodity market decline let alone growth. There is the potential for the strong to get stronger and the weak weaker. High margin miners with solid balance sheets are positioned to acquire those with good assets but temporary cash flow and balance sheet issues. We explored this issue in last weeks YMW. The large diversified miners, plus perhaps a few of the high quality mid caps, are in position to benefit if there is a near term downturn. Long term supply challenges coupled with developing world demand for raw materials makes for relatively attractive investment. Over-investment in the processing and industrial segments in China, leveraging off low labour costs and depressed exchange rates makes for a generally tough environment for downstream processors and industry in competition with China. Warren Buffett and Charlie Munger go out of their way to avoid direct competition with China. Steel is the classic example.
Energy The boom in energy is still in its infancy and has longer to run than steel. China now consumes steel at the same rate per capita as the Western World but is behind in energy. Chinese per capita electricity

Energy Consumption per Capita (toe)

Source: Xstrata

Interesting to note is that key Middle East oil production remained steady at 25mmbopd over the eight years to 2010 but consumption rose by one-third to 8mmbopd, meaning a net decline in exportable oil of 12% to 17mmbopd. This is important with the Middle East accounting for 30% of global oil supply. And all this has occurred against a back-drop of a continuation in strong overall growth in global primary energy demand. The six years to 2010 saw a rise at around the historical cumulative annual average rate of 2.3%. Coal grew fastest at 4.3%pa followed by natural gas at 2.9%pa. The evidence for peak conventional oil supply would seem to be firming. This year oil prices continued the recovery from GFC depths, up 30% to US$100/bbl. A rise in Saudi output to over 10mmbopd in November aims to relieve the pressure of low stockpiles due to weaker non-OPEC production. But longer term, strong demand growth from China, already the worlds second largest oil importer, will be the true test of the globes production potential. Even with non-conventional sources, we foresee difficulty in supply keeping up with demand. Oil futures at the

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Impact of Fukushima on uranium demand

present concur, at over US$95/bbl out to 2015. Our long term oil price forecast remains A$100/bbl, equivalent to US$80/bbl at an A$/US$ exchange rate of 0.80 or US$100/bbl at parity.
Gas Natural gas demand has grown at almost 3%pa over the last six years, but the fraction traded has grown faster at around 10% including the LNG component. Australian LNG exports doubled over this period, a six year cumulative annual growth rate of 12.7% to 22.9 billion cubic metres. LNG prices also doubled from US$5.2mmBtu to US$10.90/mmBtu though considerably less than for oil. The LNG price is 65% of the oil price in energy equivalence. Our long term LNG price forecast is unchanged at US$10.70/mmBtu assuming US$80/ bbl oil and LNG achieving 80% oil price parity in energy equivalence. We expect the rise in parity pricing to result from increased gas utility as infrastructure expands. Oils comparative scarcity could see its utility begin to decline.

Source: Cameco

Chinese iron ore requirements


(Million tonnes, per cent)

comparatively low cost energy source is great. Talk of coals death is premature with its share of primary energy growing faster than any other segment despite carbon concerns. BP anticipates a demand plateau in 2030 under the weight of carbon regulation. But Australian coal exports may continue to do well. Dwindling domestic output and growing reliance on imported coal in China and India could well drive our market far longer. Global coal consumption grew 7.6% in 2010 but the traded fraction grew much faster at 17.5%. Export markets are typically much smaller than the total and outsized volume growth can be fuelled by high prices to incentivise new mines.
Uranium Developing world energy consumption recently surpassed the OECD though per capita consumption is still only around a quarter. BP in its Energy Outlook 2030 expects uranium to play a more important role in meeting global energy demand over the next 20 years. Nuclear is expected to gain market share, but slowly.

Source: Rio Tinto

Steel intensity and GDP 19002010


(Kg/capita crude steel production)

Source: Rio Tinto

Much has been made of the prolific growth slated for Australian LNG exports both from conventional North West Shelf gas fields and less conventional East Coast coal seam gas. Some perspective has to be put here. Ignoring depletion, a continuation in that 10% global LNG demand growth rate would require construction of over 30 new standard 4.3Mtpa LNG trains by mid this decade alone. Australia currently has the equivalent of five taking the best part of 25 years to build. We will be lucky to have the equivalent of 15 in place by mid decade including one in Pluto T2, two at Curtis Is., three at Gorgon, two at Gladstone and 1.5 in PNG. Then over 40 more new trains would be required in the back half of the decade. Even if the growth rate halved we just dont see over-supply being a problem projects are never built that smoothly ask Woodside.
Thermal Coal Coal is a key primary energy source accounting for 30% in 2010. In Asia Pacific where China dominates but India, Japan and Korea are also meaningful, coal accounts for over 52% of energy consumed, 70% in China. Asia Pacific is the growth engine of the world and this outsized reliance on coal is driving strong demand for exports. It has been responsible for all the growth in coal production and consumption in the last decade.

The Fukushima incident caused a near term slowdown with lower demand from Japan, the likely early shut downs in Germany and a slowing of new construction. Long term ERA suggests demand may surprise on the upside. It cites China, India, Russia and the UAE as key emerging economies expected to support nuclear with China expected to account for the bulk of growth. Canadas Cameco expects an additional 86 reactors to be built by 2020, net of closures, down from the pre-Fukushima estimate of 103. The reduction is the result of project delays, not cancellations of which there has only been one by Japan's Tepco, the owner of Fukushima. Cameco sees these reducing 2020 demand by 8% to over 240Mlbs a year, up from 180Mlbs in 2011 a 3% annual growth rate. There is evidence reduced near term demand and price is having an impact on supply. New mines will be challenged by lower near term prices and weak sentiment. Financing and securing offtake will be more difficult, particularly for smaller companies. ERA has already decided not to proceed with a proposed heap leach which was to add up to 44Mlbs of uranium supply over its life. Renewed corporate activity with a Chinese bid for Extract Resources (EXT) and RIOs recent successful bid for Canadas Hathor Exploration points to confidence in the long term outlook.

China and India are buying coal, coal deposits and investing in miners. The attraction to a

10

China and India copper consumption forecast

Source: Rio Tinto

Annual change in global mined copper output ('000t)

Source: Xstrata

Primary copper head grades (%)

Steel Making Materials Iron Ore The rapid correction in the iron ore fines price to below US$110/t in October was unsustainable and would have cut a swathe through high cost Chinese miners. As quickly as it fell price recovered to near US$140/t delivered China. Expect high cost Chinese domestic iron ore to support favourable prices at least until the middle of the decade. Ultimately it will be pushed off the end of the curve as lower cost capacity is built in the Pilbara, Brazil and perhaps West Africa later in the decade. Following the rebound, we expect a gradual decline in the iron ore fines price to our long term average of A$81.25/t in about five years. At this price, BHP, RIO and Brazils Vale will still be incentivised with post tax returns on new investment well over 10%.

domestic coking coal in China is a huge move for the much smaller export market. Indian companies are already investing heavily in Australian coal deposits. In China, major population centres are near the coast which bodes well for imports versus domestic production which faces costly overland transport and increasing depths. Large growth increments place enormous stresses on suppliers. Capital costs are rising rapidly steel for mines and infrastructure, large mining equipment, skilled labour, engineering and design services. Recent BHP investments in the Bowen Basin imply pre-tax coking coal margins of US$100/t are required to support a 10% after tax return. Not long ago coking coal prices were less than US$100/t and thermal coal is not much more than US$100/t now yet faces a similar cost burden. Assets already in production are at a big advantage and the gap between producers and wannabe miners continues to grow. Barriers to entry capital costs, access to infrastructure and regulation are rising. The difficulty in bringing on new mines means the much heralded wall of supply is unlikely to prick boom prices.
Base & Precious Metals Aluminium LME aluminium stocks remain stubbornly high around 4.6Mt. And after recovering to post GFC highs of US$1.20/lb in April 2011, the aluminium price has since drifted 25% to US$0.90/lb levels. This doesnt so much concern us for the longer term where our aluminium price forecast remains US$1.30/lb at an A$/US$ exchange rate of 0.80. Our confidence stems from the ongoing de-linking of alumina prices from LME aluminium.

Source: Xstrata

Chinese metallurgical coal imports (million tonnes)

BHP continues to see higher growth for exported iron ore than the total market 5% versus 4% a year to 2020. This is slower than 8% average growth between 2000 and 2010 but off an expanded base, now double the size. This will require similarly large tonnage increases roughly 100Mt a year. Were external conditions to deteriorate and iron ore fall to US$100/t, the trend of exports from Brazil and Australia taking market share would accelerate. RIO believes the long term demand outlook is unchanged and worsening delays continue to challenge supply. It cites lead times of more than two years for crushers, grinding mills, ship loaders, locomotives and gas generators, and a year and a half for tyres and large trucks. Large miners with high margins, good cash flow and solid balance sheets are at an advantage when suppliers can pick and choose customers. Continued convergence of iron ore prices to spot is a negative for steel makers and a positive for miners. Spot exposes the relative pricing power of the two groups and miners are well in the ascendancy. Coking coal and iron ore supply is consolidated and barriers to entry are high relative to steel making. Miners strong position should moderate towards the middle of the decade as supply catches up with slowing growth in China. Regardless we are not convinced steel makers will be advantaged.
Coking Coal Growing Chinese and Indian reliance on imported coal has only just begun. A small shift away from

Source: BHP Billiton

Historically contract alumina prices have been set at around 15% of the aluminium price regardless of aluminas specific fundamentals. That contract system is being dismantled and is 20% of the way through the process with four years to run. Since spot alumina prices were first quoted in August 2010, they have on average traded at a 10% premium to contract. This is less than expected but may reflect ongoing purchases via legacy contracts which are then sold into spot. This suppressing activity can only last as long as contracts do. We think the ability of high cost Chinese smelters to oversupply the market with aluminium will gradually be eroded as alumina moves to spot and returns befitting such a capital and energy intensive industry can be expected to recur. In the meantime

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11

Gold and FX Reserves (1Q11)

players will have to grin and bare it, the lowest cost producers as always are best placed!
Copper Persistent global growth concerns and an easing in the demand-supply balance brought an end to coppers bull run in 2011. The spot price fell 21% year to date but at US$3.44/lb remains historically high and well above the marginal cost of production. China continues to dominate global demand with a 39% share in 2011. Urbanisation and industrialisation are key drivers with copper critical to the electrification of the developing world. Growing personal income in China and India boosts consumption with electrical use a key component. Investment demand has also grown and may add to volatility at the margin. It remains a small part of the market overall.

Low grade lateritic ores require significant capital expenditure and generally attract higher cash costs. Xstrata questions the long term viability of nickel pig iron due to high costs and ore availability. It sees continued strong demand in China and India underpinned by growth in industrial production. There is also a kicker as both countries move up the food chain to use better quality stainless with higher nickel grades. But demand for nickel in the US, Japan and Europe is expected to remain weak in 2012.
Gold Gold has retreated from August US$1,900/oz highs but is still 20% up on a year ago. Reasons for buying gold stand a store of value, diversification and general insurance against uncertainty. The US experiences tough economic conditions but there are signs of life the focal point for global economic concern has shifted to Europe. Its difficult to see a scenario where the allure of the printing press is resisted, a positive for gold in 2012. Expect loose monetary policy with near zero interest rates and potential for further quantitative easing to provide support at least in US$ terms. For the moment golds currency attributes still rule, driven by sentiment and investment demand. Central bank holdings peaked at about 60% of all gold mined in 1945 and since declined to less than 20%. Chinas gold holdings make up just 1.7% of foreign exchange reserves compared to 73.9% for the US and 60.7% for Europe.

Source: AngloGold

Net Official Sector Gold Buying

Source: Barrick

Mine Supply vs Gold Price

Supply is increasingly constrained in the long term. Many large mines approach maturity and new finds are rare, deep and often in high sovereign risk locales. Production suffers from declining grades and lower recoveries. New supply is impeded by project delays, industrial action and extreme weather events. Coppers substitution including plastic for tube production, aluminium for highvoltage energy cables and fibre optics for communications cabling is a feature. In the near term, we forecast prices of US$4.00/lb in 2012 and US$3.75 in 2013. Then a decline to US$2.50/lb by 2018, 27% below spot prices. Expect Chinese economic growth and investor sentiment to remain key price drivers.
Nickel A tough year for nickel miners with the price down over 35% since Februarys US$13/lb peak. This despite a rapid draw down in LME stocks from +135,000t to 90,000t. Usually declining stocks indicate a tightening market, a positive for price, but the growing influence of high cost nickel pig iron from China proves a dampener. Panoramic (PAN) says pig iron provides over 400,000t of nickel a year, one quarter of the 1.6Mt market. A concern is nickel going the way of steel where low barriers to the addition of new supply belted margins. Our view is that the industry is going through a disruptive period of lower than average margins. Higher prices will be required to incentivise new large scale, high cost laterite production which is expected to make up the bulk of new supply.

Source: Barrick

Gold production rose from 2,400t in 2008 to 2,700t in 2010, incentivised by higher prices. And global majors plan to grow output over the next five years. Goldcorp forecasts 10% a year, Newcrest 8%, Newmont 6%, AngloGold nearly 4% and Barrick 3%. Perhaps we are finally facing a supply response. New mines though will still be challenged by capital costs and tight construction capacity. Our conservative long term A$1,000/oz forecast assumes commodity characteristics return with the cost curve to reclaim a say in pricing. A small exposure to gold or gold stocks makes sense for diversification and insurance purposes. Newcrest is our preferred quality gold miner, particularly in light of recent exploration success and price weakness. The risk of resource nationalism and increased taxation on mining assets is limiting price action and compressing the PE premiums gold stocks typically enjoy. K

The long term challenge to supply is the falling proportion of generally lower cost nickel sulphides.

12

Banking Sector Risks becoming increasingly complex

bailouts wiped out bank shareholders and tipped countries with massively high government debt levels and budget deficits over the edge, causing devastation and long-term hardship. The US has not escaped unscathed, with the economy struggling to recover from recession, and burdened with massive government debt and an ineffective government decision-making process. The love/hate relationship with the major banks tends to focus on the hate rather than the love, despite our banking system being ranked the third-safest in the world by both S&P and Moodys. A surprisingly high level of bank customer satisfaction, as reported by Roy Morgan Research, sits oddly with the widespread belief that the general public despise their banks. Consumers hate the big banks as a whole, but like their individual banks, creating a disparity in the hatred. A classic case of generalisation versus particular resulting in the love/hate relationship We believe the investment argument in favour of banks continues to strengthen, underpinned by solid economic growth, low government debt, an effective and independent central bank, low unemployment, and increasing bank profitability and balance sheet strength. Most importantly, we believe an effective banking regulator, strong bank management and risk management support our view. Australians should genuinely be proud of the fact our banks were, for the most part, not significantly impacted by the financial crisis. Large profits generated by our four major banks create public resentment, but we proudly have one of the safest and most stable financial systems in the world. Despite our positive view, share price recovery is hampered by widespread perceptions Australian banks are overvalued and face earnings pressure due to slower economic growth, household and business deleveraging reducing loan growth, higher funding costs, increasing bad debts, and softer consumer and business confidence eroding earnings power. While many northern hemisphere banks are stressed, Australian banks are increasingly more robust and profitable. The international view of banks generally is extremely negative, due to very serious concerns about bank liquidity and solvency. But given the low level of short-selling in the Australian major banks, it seems a lack of confidence by domestic investors is a larger headwind than international opinion. We argue the best stocks to sell or avoid are

ANZ Bank ANZ $20.74 Price Buy Recommendation 27.90 Accumulate Below ($) 23.25 Buy Below ($) Last Review 24/11/11 (YMW45) Medium Business Risk Medium Price Risk Narrow Moat Rating 31.00 Fair Value ($) Commonwealth Bank CBA $49.35 Price Recommendation Accumulate 57.40 Accumulate Below ($) 48.15 Buy Below ($) Last Review 17/11/11 (YMW44) Low Business Risk Medium Price Risk Narrow Moat Rating 62.40 Fair Value ($) National Aust. Bank NAB $23.75 Price Buy Recommendation 27.70 Accumulate Below ($) 26.20 Buy Below ($) Last Review 27/10/11 (YMW41) Medium Business Risk Medium Price Risk Narrow Moat Rating 32.50 Fair Value ($)

The major bank investment decision process is becoming more complex as a wide range of risks continue to test our positive view on bank valuations and earnings. The multitude of risks include those relating to funding, as well as economic, business, regulatory, financial and political matters, with the majority outside the direct control of management. The economic and social advantages provided by the dominant market positions of major banks, balance sheet strength and operational effectiveness are not clearly understood and appreciated by market commentators, the media and certain investors. The banks are easy targets for criticism and ridicule due to their size, oligopolistic power, substantial profits and relatively high executive salaries. Most importantly, Australian banks continue to take deposits and extend credit, providing the lifeblood required for a functioning economy. This also enables Australia to avoid the social unrest experienced in certain European countries as credit dries up and austerity measures are introduced. In contrast, European banks need to raise very substantial amounts of capital and sell significant amounts of assets in order to survive. Consequently, a European credit crunch seems unavoidable and is likely to push the Eurozone into recession in 2012. But the European Central Bank is supporting Eurozone banks for up to three years, and will be working hard to avoid a market induced severe credit squeeze. Politicians and media are quick to criticise, but there is a lot to be said for a strong and stable banking system. The Australian government has not had to bail out the banks to anywhere near the extent of UK, European and US counterparts. These

Table 1: Bank Profit Summary - Actual NPAT and Morningstar Forecasts


Current Reco. Balance Date NPAT FY10(A) NPAT FY11(A) NPAT FY12 F'cast FY12(F) v FY11(A)

ANZ CBA NAB WBC BEN BOQ

Buy Accumulate Buy Buy Accumulate Accumulate

30-Sep 30-Jun 30-Sep 30-Sep 30-Jun 31-Aug

$5,025m $5,964m $4,581m $5,879m $291m $197m

$5,262m $6,652m $5,460m $6,301m $336m $177m

$5,850m $7,112m $6,166m $6,810m $373m $240m

11.2% 6.9% 12.9% 8.1% 10.8% 35.7%

Source: Company Accounts/Morningstar Forecasts

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13

Westpac WBC $20.83 Price Buy Recommendation 25.10 Accumulate Below ($) 23.75 Buy Below ($) Last Review 03/11/11 (YMW42) Low Business Risk Medium Price Risk Narrow Moat Rating 30.42 Fair Value ($) Bank of Queensland BOQ $7.84 Price Recommendation Accumulate 8.60 Accumulate Below ($) 6.70 Buy Below ($) Last Review 20/10/11 (YMW40) Medium Business Risk Medium Price Risk None Moat Rating 9.53 Fair Value ($) Bendigo Adelaide Bank BEN $9.14 Price Recommendation Accumulate 9.90 Accumulate Below ($) 7.70 Buy Below ($) Last Review 29/09/11 (YMW37) Medium Business Risk Medium Price Risk None Moat Rating 10.95 Fair Value ($)

structurally weak, lack competitive advantage and are fundamentally doubtful. In contrast, Australian major banks are highly profitable, benefit from a highly regulated oligopoly, are well capitalised and possess high credit ratings. Investors focusing on capital appreciation only, who are discounting the attractiveness of the high, sustainable, fully-franked dividends offered by the Australian banks, are missing an important opportunity. We argue Australian investors will benefit from both a re-rating in share price and very attractive dividends, but near-term political and economic uncertainty continues to plague investor confidence. Bank term deposit rates are declining, and combined with share price weakness, this means bank dividend yields are more attractive for investors than bank term deposits although capital preservation must be acknowledged. Tougher political and regulatory oversight is intended to force global banks to operate with substantially less risk and look more like low-growth utilities trading on regulated utility multiples of 8-9x, rather than Australian banks' long-term historical levels around 12x. Based on our earnings forecasts and current share prices, the simple average PE for the four major banks is 10x. A contraction of the PE multiple to 9x equates to shares prices about 10%

lower than current levels, and conversely, PE expansion to 11x boosts share prices 10%. The current negative global macro environment for banks weighs heavily on major bank share prices restricitng price recovery. The majority of retail and institutional investors in Australia have exposure to the major banks, as the sector accounts for 24% of total market capitalisation. So, despite share price weakness, domestic investors already holding market weightings in banks have limited buying capacity, despite the very attractive fully-franked yields on offer. NAB is our preferred bank on a risk-return basis, but we acknowledge its higher risk profile. The clearly differentiated retail banking strategy is delivering strong volume growth, improved market share in mortgages, and higher customer satisfaction. Strong loan growth in both mortgages and business banking has supported top-line revenue growth and net earnings outperformance. NAB is the cheapest with a 8.6x one-year forward PE and 8.1% fully-franked dividend yield. ROE is improving and the bank is a strong turnaround situation. Trading at a discount to peers, the multiple growth options provide an attractive investment. Strong loan growth is struggling to keep up with customer deposit growth so NAB's reliance on wholesale funding is not decreasing, unlike its peers. Resolving the UK banking operations and troublesome off-balance-sheet exposures will release substantial amounts of capital, but timing remains uncertain. Risks include earnings and bad debt consequences from the price led growth strategy, further deterioration in the UK banks and increased losses from the off-balance-sheet exposures. CBA is our preferred major bank for more conservative investors. Potential upside is lower than NAB, as CBA trades at a premium to peers with a 10.4x one-year forward PE and 6.9% fully-franked dividend yield. Going forward we see less volatility in earnings and dividends, making CBA attractive for investors seeking a sustainable dividend stream. Australias biggest bank benefits from the highest market share in mortgages, retail deposits, credit cards and online broking. The large exposure to wealth and a growing presence in business banking underpins CBAs sector-high ROE of 19.5%. The core banking system rollout will deliver increased revenue opportunities and a lower cost base, further improving shareholder returns. New CEO Ian Narev will be closely watched and we expect further bolt-on acquisitions in wealth and limited low-profile expansion across Asia. K Analysts: David Ellis, David Walker, Michael Higgins

Figure 1: NAB Net Profits after tax Base Case vs Bear case ($m)
7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 FY09A FY10A FY11A FY12F FY13F $3,841m Base (80%*) $6,166m Base (80%*) $6,758m

$5,581m $5,460m Bear (10%*) $4,907m Bear (10%*) $4,999m

Source: Company Accounts/Morningstar Forecasts for FY12 and FY13 (* scenario probability)

Figure 2: CBA Net Profits after tax Base Case vs Bear Case ($m)
8,000 7,500 7,000 6,500 6,000 5,500 $4,292m 5,000 4,500 4,000 FY09A FY10A FY11A Bear (10%*) $5,383m FY12F Bear (10%*) $5,475m $6,652m $5,964m Base (80%*) $7,112m Base (80%*) $7,527m

FY13F

Source: Company Accounts/Morningstar Forecasts for FY12 and FY13 (* scenario probability)

14

Mining Services Riding the capital spending wave

recent wins in non-mining sectors. Following the large losses of FY11, earnings should stage a strong turnaround in FY12.
Orica (ORI) offers good exposure to increases in resources activity through the provision of explosives, chemicals and other products. It has a dominant position, particularly in Australia, which ensures a narrow economic moat. Operations are more sensitive to commodity volumes than prices. We expect solid growth over the next two years due to increased demand for explosives and expansion of production capacity. Monadelphous (MND) has secured $870m in new contract work since the start of FY12. Based on contract wins and continuing strong demand, it expects at least 15% revenue growth in 1H12, with margins maintained, and similar full-year revenue growth. NRW Holdings' (NWH) guidance is for earnings to double in 1H12, with a similarly strong result expected in 2H12. The strong growth is driven by margin improvements, buoyant industry conditions and diversification from its traditional WA iron ore base. With near-term tender opportunities of $11bn and $1.6bn in current active tenders, the order book will continue to increase and lengthen.

Ausdrill ASL $2.93 Price Recommendation Accumulate 3.15 Accumulate Below ($) 2.90 Buy Below ($) Last Review 01/12/11 (YMW46) High Business Risk High Price Risk None Moat Rating 3.60 Fair Value ($) Leighton LEI $20.61 Price Hold Recommendation 18.65 Accumulate Below ($) 13.20 Buy Below ($) Last Review 10/11/11 (YMW43) High Business Risk High Price Risk Narrow Moat Rating 21.95 Fair Value ($) NRW Holdings NWH $2.77 Price Buy Recommendation 3.05 Accumulate Below ($) 2.80 Buy Below ($) Last Review 24/11/11 (YMW45) High Business Risk High Price Risk None Moat Rating 3.45 Fair Value ($) Orica ORI $25.47 Price Recommendation Accumulate 27.00 Accumulate Below ($) 25.00 Buy Below ($) Last Review 24/11/11 (YMW45) Medium Business Risk Medium Price Risk Narrow Moat Rating 29.70 Fair Value ($)

The October 2011 Mining Industry Major Projects report from the Bureau of Resources and Energy Economics indicates 102 projects are at an advanced stage of development, with capital expenditure up 34% from April 2011 to $232bn. Liquefied natural gas (LNG) projects account for 67% of the total, but there are also significant plans for other resources such as coal and iron ore, as well as resources infrastructure. There is also a potential $224bn relating to less advanced projects. This massive capital expenditure underpins a very favourable outlook for mining services. But there are also a number of issues and risks investors need to take heed of. While there is no apparent slowing in present activity, continued global economic uncertainty could lead to delays or cancellations in some projects - possibly a mini-panic in mid to late 2012. While the extent is difficult to predict, it is highly unlikely to spiral into the depths witnessed in the GFC. Asian demand for our minerals and resources, particularly from China and India, is expected to remain strong for many years, particularly for energy. Apart from project delays, increased industrial action, a shortage of skilled labour and a return to owner-operator mining are the main threats to the sector. Increased employee claims and threats of industrial action are on the rise and have the potential to become a major issue in 2012. A couple of headline cancellations would do wonders for industrial relations! In-sourcing remains a growing risk to the industry and moves to an owner-operator model would restrict growth for contract miners. Most of the smaller mining services companies are highly leveraged to the resources sector and earnings can fall rapidly in a downturn. Rising costs, project deferrals and weather interruptions can also hurt margins. As such, the sector only suits investors with a higher risk tolerance.
Leighton Holdings (LEI) sold its HWE iron ore business but still has a strong exposure to resources. The John Holland division recently won a $370m contract to construct a 3,800-bed village for the Wheatstone project. This adds to a series of

Earth moving equipment rental company Emeco Holdings (EHL) achieved an average utilisation rate of 84% for the first four months of FY12, with the current rate an impressive 90%. 1H12 is expected to be relatively subdued as new fleet costs are absorbed, with a significant ramp up in 2H12 as the fleet becomes fully deployed. We forecast 26% growth in FY12 EPS, with further strong growth in FY13. At the recent AGM, Ausdrill (ASL) reaffirmed continuing robust revenue and earnings for FY12. Revenue growth of 1920% is expected due to buoyant demand from the gold and iron ore sectors, with margins maintained at FY11 levels.
Boart Longyear (BLY) reaffirmed a strong FY11 result, with guidance for 48% growth in EBITDA. But the company notes the actual result may be higher due to the current strength of demand.

In late November, Bradken (BKN) reiterated FY12 guidance for EBITDA growth of 2530% and NPAT growth of 3540%. BKN offers good exposure to the resources boom as a manufacturer and supplier of consumable mining products. K Analysts: Ross MacMillan, Peter Rae

Huntleys Your Money Weekly

15 December 2011

15

Telecommunications Dial in Get on line!

positive performance. Our preferred companies include iiNet (IIN) and TPG Telecom (TPM) in the medium caps and Amcom Telecommunications (AMM) in the small cap space. IIN and TPM should benefit from the NBN rollout as all telcos become resellers in the fixed broadband market. The rollout is focused on the most underserved area of Australia, creating opportunities for ongoing investments in ADSL 2+ infrastructure in the short term. ISPs will invest at selective sites where they can earn a meaningful return. Over the longer term, the reseller model will free up capital for telcos to redeploy to other parts of their business. This includes widening of products such as reselling mobile and wireless broadband services, acquisition of content and improvement in support services. While TPMs buying in IIN may suggest consolidation between the two junior telcos, we see this as a passive investment. We expect cost savings to be generated from the rationalisation of infrastructure, billing systems and overheads plus operational benefits from greater scale. But the different strategies see a lack of synergies. TPM is a price leader while IINs focus is on value and customer experience. IIN subscribers have high regard for superior customer service. Any deterioration in service quality resulting from a TPM acquisition could see customers leave the combined network, eliminating any benefits in scale. In the small cap space, we remain positive on AMM. AMM delivered FY11 revenue and EBITDA growth of 38% and 29% and we expect strong growth to continue in FY12, underpinned by increased data capacity demand from corporates and government sectors. With an existing fibre infrastructure in the ground, AMM will leverage its network and cross sell voice services and cloud computing services to existing customer base. K Analysts: Peter Warnes, Michael Wu
Morningstar Recommendations
Code Recommendation SP ($) FV ($) Moat Rating

Forecast EPS
Code FY10 (a) FY11(e) FY12(e)

AMM CNU IIN SGT TEL TLS TPM

9.0 63.5 25.7 18.4 10.0 26.0 10.1

7.1 41.4 33.7 19.8 12.7 29.3 14.3

8.8 40.5 38.5 21.0 13.1 32.9 16.6

Forecast PE (x)
Code FY10 (a) FY11(e) FY12(e)

The Australian telecommunications landscape will change dramatically in 2012. After taking nine years to complete the privatisation of Telstra between 1997 and 2006 the Commonwealth Government returns to the industry. The establishment of the National Broadband Network (NBN) sees the government owing the monopoly infrastructure network focused on providing wholesale fixed broadband services. We still consider the private sector was best placed to satisfy the national demand for broadband services. The ASX Telecommunications (Telco) Index was one of the market features in 2011 driven by the significant out performance of Telstra, which accounts for 93.5% of the Telco index. For the period 1 January to 12 December the Telco Index is up 16.8% and the Telco Accumulation Index 27.8% against a 10.4% decline in the ASX/S&P 200 and a 6.4% fall in the ASX/S&P 200 Accumulation Index. This is some out performance justifying our consistent positive recommendation throughout the year. For 2012 we remain positive on the sector against a difficult outlook for the market as a whole. Demand for communications services will comfortably outstrip GDP growth. Telstras outperformance is set to continue. The $11bn of net after tax net present value payments from NBN Co and the Commonwealth Government will underpin earnings, free cash flow and dividends for several years. Telstra retains a strong but not dominant position in the wireless space where a clear preference for mobility and connectivity will drive demand at rates far in excess of those for fixed broadband services. Demand for data is growing exponentially while the number of mobile services in operations accelerates. Telstra is in a sweet spot owning the premier wireless network with the launch the Long Term Evolution (LTE) or 4G network widening the competitive gap based on speed, coverage and efficiency. While Telstras performance drove index out performance several smaller telcos achieved strong

AMM CNU IIN SGT TEL TLS TPM

7.9 na 10.7 12.5 16.4 11.0 15.8

11.8 5.9 7.6 12.1 11.5 10.8 10.0

9.6 6.0 6.6 11.4 11.1 9.6 8.6

Forecast Dividend Yield (%)


Code FY10 (a) FY11(e) FY12(e)

AMM CNU IIN SGT TEL TLS TPM

2.0% na 4.4% 5.4% 11.3% 9.8% 2.8%

4.2% 7.9% 5.5% 5.4% 7.9% 8.8% 4.0%

6.6% 7.9% 6.3% 5.7% 7.9% 8.8% 4.7%

AMM CNU IIN SGT TEL TLS TPM

Buy Acc Acc Acc Hold Acc Buy

0.88 2.24 2.83 2.40 1.58 3.27 1.36

1.15 3.07 3.33 2.78 1.73 3.60 1.90

None Narrow None None Narrow Narrow None

16

Retail For now, safety first

just over 50% offsetting the more volatile operations such as coal and fertilisers.
Woolworths (WOW) | $26.17 Accumulate below $27.50 New CEO Grant OBrien will not run WOW for short-term shareholder returns. A commitment to a strong level of capital investment to drive long-term growth and value creation is critical to ensure the footprint grows and future customer demands are satisfied. While near-term headwinds will likely see subdued trading through the remainder of FY12, long-term the target is high single-digit sales growth and 10% EPS growth assisted by bolt-on acquisitions and capital management. plans. Premier Investments (PMV) | $5.44 Accumulate below $5.55 Premier Investments (PMV), owner of the Just Group portfolio of brands, and has $300m in cash. We expect PMV to utilise its balance sheet for opportunistic acquisitions that complement its core brand portfolio, increase sales volume and drive scale cost benefits. Metcash (MTS) | $4.18 Accumulate below $4.30 Metcash (MTS) the largest and for some, only supplier of grocery, fresh produce, liquor and hardware to the independent retail channel represents a powerful monopolistic market position. Year on year mid-single digit profit growth seems pedestrian in a strong economic environment, but appeals in tougher times. Super Retail Group (SUL) | $5.67 Accumulate below $5.30 SUL operates in Australia and New Zealand retailing automotive accessories and tools through the SupercheapAuto chain, and a variety of outdoor lifestyle product through the BCF (Boating, Camping and Fishing) and Rays Outdoor chains and through sporting specialist Rebel Group. SUL has grown EPS and DPS at compound average rates of 22% and 29% respectively over the last five years. The $600m acquisition of the Rebel Group in October 2011 was a gutsy decision given its size and price. SUL sees a large opportunity to extract greater market share and we agree. K Analysts: James Cooper, Tim Montague-Jones, Peter Warnes

Metcash MTS $4.18 Price Recommendation Accumulate 4.30 Accumulate Below ($) 3.30 Buy Below ($) Last Review 01/12/11 (YMW46) Medium Business Risk Medium Price Risk Narrow Moat Rating 4.76 Fair Value ($) Premier Investments PMV $5.44 Price Recommendation Accumulate 5.55 Accumulate Below ($) 4.30 Buy Below ($) Last Review 22/09/11 (YMW36) Medium Business Risk Medium Price Risk None Moat Rating 6.16 Fair Value ($) Super Retail Group SUL $5.67 Price Hold Recommendation 5.30 Accumulate Below ($) 3.75 Buy Below ($) Last Review 08/12/11 (YMW47) High Business Risk High Price Risk None Moat Rating 6.05 Fair Value ($) Wesfarmers WES $30.73 Price Recommendation Accumulate 33.20 Accumulate Below ($) 25.85 Buy Below ($) Last Review 20/10/11 (YMW40) Medium Business Risk Medium Price Risk Narrow Moat Rating 36.90 Fair Value ($) Woolworths WOW $26.17 Price Recommendation Accumulate 27.50 Accumulate Below ($) 23.25 Buy Below ($) Last Review 03/11/11 (YMW42) Low Business Risk Medium Price Risk Wide Moat Rating 29.05 Fair Value ($)

For well publicised reasons consumers in the West are spending less and saving more. In Australia households are saving around 10% of disposable income, a level last seen in the late 1980s when debt was closer to 50% of household income than the current 150%. We expect similar savings levels to persist for the next three years at least as consumers focus on reducing debt-to-income ratios to below 100%. Beyond that we expect at least 5% of income to be saved as a more frugal attitude to personal finances is entrenched. At the same time retailers cost of goods are unlikely to continue falling as Chinese manufacturing costs rise. This may lead to higher priced consumer goods in Australia and resultant lower sales volumes and/or thinner margins. We believe it is still too early to take a significant contrarian position in unloved discretionary retailers. In addition to deleveraging pressures online competition will compound their woes. There are exceptions, including Premier Investments (PMV) and Super Retail Group (SUL) which are relatively better positioned than other discretionary retailers. In the current economic climate we prefer the safer businesses of the major supermarket retailers. After a period of underperformace Woolworths (WOW) looks inexpensive even if facing lower growth than historic levels. Wesfarmers (owners of Coles supermarkets) and Metcash (MTS), wholesaler of groceries to independent supermarkets, are also in Accumulate territory. All three feature in our YMW Income Portfolio.
Wesfarmers (WES) | $30.73 Accumulate below $33.20 We consider Wesfarmers shares modestly undervalued. Concerns over exposure to discretionary spending and the arrival of Woolworths as a competitor in home improvement are overblown. Coles has solid momentum in the oligopolistic supermarket space. The acquisition of Coles increased the percentage of more predictable revenue, cash flow and profits from supermarkets and hardware/home improvement to