Contrarian calls – BHP and IAG

Chief Investment Officer and founder of Aitken Investment Management
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Key points

  • Expect more volatility but not as much as recent weeks.
  • Iron ore price could have bottomed for the year and BHP offers good exposure.
  • IAG could also benefit from Medibank IPO hype.

What’s catching my eye?

1. The awful events in Ottawa ↓
2. AT&T downgrading revenue forecasts ↓
3. US oil inventories rising ↓
4. The EURO ↓
5. US dollar index ↑
6. VIX ↑
7. Gold ↓
8. Boeing ↓
9. Interest in the Medibank Private IPO ↑
10. The lack of inflation in the world ↔

There’s certainly no lack of volatility with the combination of strong bellwether US earnings and hopes of European Central Bank action driving the biggest percentage gain for the S&P500 all year, earlier this week. It was actually the biggest daily points gain since 2011. What a difference a week makes since the Dow’s – 460 point intraday swoon, which actually was the knife sticking.

Ebb and flow

While the VIX has pulled back to 16.2 from a panicky peak last week of 31, it remains elevated versus averages of the last few years and I believe we should position for further volatility, but volatility that is lesser than the wild swings we have seen in the last few weeks.

Markets are still going to ebb and flow in the short term between worrying about global economic growth and what central banks can and will do about it. Liquidity is not great in terms of risk asset markets as evidenced by the wild swings of the last two weeks.

In terms of Australia, I think the Aussie dollar/US dollar will consolidate the new lower trading range of 86.50 to 88.50, while the ASX200 is also consolidating in a lower range of 5100 to around 5450. With three of the major banks about to go cum final dividends, it’s fair to say the index, due to those bank weightings, will be supported on dips.

Importantly also for Australia, and I may well be on my own saying this, but I think the iron ore price has bottomed for the year and will track higher ($95t target) on seasonal restocking from China. It also appears spot oil prices have bottomed and will also edge higher. If I am right and our key commodity prices have stopped falling, and in fact start edging a little higher, you will see buying coming into the beaten up Australian resources sector.

You can ONLY make money in resources if the underlying commodities are rising, probably more accurately “not falling”, if the company in question has production growth. That is coming in Q4 for the Australian resource sector and I suspect we all need to be a touch braver and buy a beaten up resource name or two.

The options

For private investors, the best risk/reward/quality/diversity option remains BHP Billiton (BHP), which is effectively an ETF over iron ore, oil, copper and coal. BHP has fallen sharply due to a lack of capital management at the FY14 result, UK pension funds agitated that they won’t get a UK listing of spin-off co, and general weakness in commodity prices. However, those sentiment drives are now stabilizing, or reversing, and you can see in the chart below that the knife has stuck in BHP. After an -18.5% peak to trough fall since August, it’s time to buy a few more BHP.

BHP: knife sticks

For those wanting pure iron ore exposure, the answer is Fortescue Metals Group (FMG). Again, this doesn’t require over-analysis. FMG trades like a listed spot iron ore ETF. The 12-month correlation below confirms that. I think both spot iron ore and FMG have bottomed. If I am right and iron ore recovers to $95t, then if this correlation holds, FMG would bounce back to $4.50 a share.

FMG vs. spot iron ore

Another aspect of my constructive and opportunist Australian equity strategy is to identify large cap industrial names that now appear solid risk/adjusted value and offer solid potential total returns (inc franking credits).

For the brave

Clearly, it seems interest in the Medibank Private IPO from private investors is strong. Fair enough, I can fully understand that and I suspect Medibank is headed towards a very successful listing on the 25 November.

In the interim, I am looking for stocks that may be re-rated a little by Medibank’s successful listing.

While Medibank effectively creates its own private health insurance sector once listed, I have a feeling its successful listing and solid rating will make investors also look at the general insurance sector and consider whether there is relative value in that space.

No doubt general insurance is higher risk, less predictable, and doesn’t have the structural growth of the private health insurance sector. But there is a price for general insurance and I think general insurers are now looking cheap after the market correction.

I want to reiterate our BUY recommendation on ASX top 20 member IAG. IAG has just experienced a -10% correction and on our estimates now look compelling value.

Mike Wilkins is a high class CEO with a track record of successfully growing companies by acquisition and organically. The issue with IAG in the short-term is due to an acquisition, EPS goes backwards -14% this year. That is well known and consensus, but that is why you are getting a chance to buy IAG cheaply before double-digit EPS growth returns in FY16.

On 11.8x FY15 earnings and offering a 6.4% fully-franked yield, generated from an return on equity of 18.2% and insurance margin of 15.8%, IAG is buy.

100% of Charlie Aitken’s fees for writing for the Switzer Super Report are donated to The Sydney Children’s Hospital Foundation.

Important: 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. Consider the appropriateness of the information in regards to your circumstances.

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