Stocks to buy in a sinking market

Chief Investment Officer and founder of Aitken Investment Management
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Last Friday night I experienced the West Australian skills shortage first hand when trying to get a taxi from the packed Burswood Entertainment Complex to Cottesloe Beach. Now, don’t get me wrong – Perth has always been a taxi nightmare, but the problem gets even worse in a mining boom because the skilled taxi drivers move to the Pilbara to drive 200 tonne iron ore trucks for $200,000 a year.

The most interesting aspect of my conversations while in Perth is that large scale, long duration projects are moving into the spend stage and that is starting to have a multiplier effect on the WA service economy. We have all known that about $120 billion-plus of new resource projects have been announced in WA, yet there is always a 12 to 18 month lag between major project announcements, approvals, contract awards, and then finally capital expenditure (capex) starting. What’s interesting for us now is that capex intentions are becoming capex spend.

The point is that BHP Billiton, Rio Tinto, Fortescue, Hancock, Chevron, Shell, Apache, and Woodside have started physically deploying large chunks of capex, which is finding its way into the WA engineering, contracting and mining service sectors, and then down into the transport, fabrication, heavy equipment, labour hire, accommodation, and logistics sub-contractors. The capex starting gun has been fired and the WA economy can look forward to at least three more years of unprecedented resources sector capex spend.

This was confirmed at a stock specific level this week, where engineering leader Monadelphous (MND) gave a very upbeat earnings guidance. Monadelphous expects revenue growth of “at least 15%” in the first half of fiscal 2012, which is very bullish considering the company is conservative. The fact Monadelphous has such forward transparency in their business is a clear confirmation that the capex gun has been fired in WA. We forecast Monadelphous to grow its earnings per share (EPS) by a cumulative 50% over the next three years.

Similarly, down the market cap chain a little, the capex spend theme was confirmed by contractor NRW Holdings (NWH) Wednesday, who forecast a 100% increase in net profit after tax in the first half of 2011/12. The market was ‘surprised’ by this yesterday, sending NHW’s shares up 13%.

Yes, we can all fret about Italian or Spanish bond yields, but we are all missing a huge structural growth story right under our noses. I couldn’t be more bullish on Western Australia, but this is not just about owning mining companies, it’s about owning every derivative of the mining investment cycle and every direct and indirect play on WA economic outperformance as the money really starts flowing inside the state.

Perth Airport traffic is up 7% from a year ago, every hotel is full, the casino is full, every decent restaurant is now full, property prices are bottoming and office rents are rising.

Our number one recommendation remains to come out of the euromess with a heavily east-facing portfolio of structural growth stocks, that is, companies set to benefit from Asian demand. In Australia that means mining and mining service stocks, but I would also extend that strategy to companies that benefit from broader WA economic growth, consumer confidence, and broader discretionary spending.

In my view there is a total disconnect between what the equity market is discounting and what is actually happening in WA; that won’t last, stocks exposed to this growth will soon attract a premium. That is why at a strategy level I am banging the table on this theme.

Here are some other stock recommendations:

Iluka Resources Ltd (ILU) – Buy

We continue to rate Iluka as a ‘buy’. We expect continued tightness in the zircon and the titanium dioxide pigment (TiO2) feedstock markets driven by strong demand from China, India, Middle East, Asia and South America. We expect Iluka’s share price to continue its upward trend as attention is focused on the short- to medium-term earnings, TiO2 pricing announcements (due early Dec/Jan), and its strong balance sheet.

Target Price: $20.05

Wednesday’s closing price: $14.50

The Reject Shop (TRS) – Buy

We remain attracted to The Reject Shop based on a strong store rollout profile and margin upside from positive operating leverage. This supports our 20% EPS compound annual growth rate for 2012 to 2015. The Reject Shop is well positioned to recover from the setbacks in fiscal 2011 and subsequently re-rated by the market, with fiscal 2013 shaping up to be a more normalised year for the business. With the business trading on price to earnings ratio of 8.9 times for fiscal 2013 and an enterprise value/EBITDA of 4.9 times, we maintain a ‘buy’ recommendation.

Target Price: $12.26

Wednesday’s closing price: $9.92

IOOF Holdings (IFL) – Buy

We’ve downgraded our fiscal 2012 earnings for IOOF by 7.5%. Where previously we estimated 3% growth for the year, our revised forecast is for negative 5% underlying cash EPS growth. Despite the negative adjustment, our investment view remains positive as we believe IOOF is in a unique position as the only middle-sized, fully-integrated wealth manager, providing differentiation from the major banks and AMP. IOOF remains attractive for any would-be acquirer, while on the other hand, has balance sheet strength to embark on accretive acquisitions itself. The company has steady recurring earnings, a diversified model with 8% fully-franked yield to support the share price. We retain our ‘buy’ rating with a lower price target of $7 based on earnings revisions, down from $7.30 previously.

Target Price: $7

Wednesday’s closing price: $5.37

Charlie Aitken is the managing director of Bell Potter Securities.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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