The stocks that will lead the recovery

Chief Investment Officer and founder of Aitken Investment Management
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I drove a couple of laps at Mt Panorama, Bathurst last weekend and this is the view down Conrod Straight. There’s nothing like a clear track ahead.

Conrod Straight, Bathurst. Switzer Super Report.But why on earth am I starting an equity strategy note with this photo? Because, in my view there are times when the market track is clear ahead and it’s safe to put the investing foot flat to the floor.

I believe there is a very large gap between what equities are discounting based on economic predictions and what the economic reality will be, particularly in companies that deal with China.

Similarly, in terms of equity liquidity, there is also a very large gap between the prices of stocks short-sellers have been shorting compared with where a long-only fund would value a stock. This was evident this week in all things China related, where the China macro bears simply got destroyed.

Short-selling is when an investor aims to make money on a stock’s price decline. This is done by borrowing shares in that company from a third party, selling them, and then after the price falls, buying the shares back at a cheaper price and returning them to the owner – profiting from the decline. Those who are ‘long’ own the stock.

I believe when short-covering starts in earnest in Australia (that is, when shorters start to buy the shares back to close out their short positions), and it hasn’t yet, that price gains in the most shorted stocks will be much larger than anyone currently forecasts. Just look how easily the ASX 200 “melted up” 113 points on Monday on low volumes.

Volumes are low because shorters and sellers are exhausted. Private investors are also very cashed up after selling at the bottom and switching to cash and fixed interest.

The ASX 200 is now up 23% off its recent lows in US dollar terms, which means huge losses for those who have shorted both Australian equities and the Australian dollar on the view that China’s economy was headed for a ‘hard landing’.

It’s also worth noting the most shorted stocks led the rally, which will be exactly how this unfolds into year-end.

I believe total short positions in Australian equities are grossly underestimated.

The ASX 200 has reached a very critical technical level. The downtrend from the April highs of 4,255, and once we break through, stocks will head up to the next technical level of 4,477, where we will reassess our risk on our trading strategy.

I’ve argued that predatory shorters had been targeting any company with a pending debt roll on the view that corporate debt markets were closed. Yet in the last week we have seen Seven West Media (SWM), Primary Healthcare (PRY) and Asciano (AIO) all refinance substantial debt facilities at lower rates. Debt markets are well and truly open with last week seeing $3.2 billion of weekly inflows to high yield funds – the largest inflows since 2003 as a percentage of assets under management.

These US corporate debt markets are well and truly open, which makes predatory shorting of Fortescue (FMG) on debt issuance concerns look ridiculous. I remain of the view that Fortescue will launch a debt issue after ‘Euromess’ comes to an end, and once that’s confirmed, you will see a massive ‘short-cover the fact’ rally in Fortescue, just as you have in Seven West Media and Primary Healthcare. Fortescue will get a debt issue away right as the spot iron ore price bottoms, which will lead to an explosive short-covering rally.

The other sector where short positions remain enormous, yet fundamental, and technical momentum is improving is discretionary retailers. The two major shorts – Myer and JB Hi-Fi – continue to rally and there simply isn’t any real stock supply around.

Inflation is in the Reserve Bank of Australia’s target range, giving the big green light to rate cuts. And there is no industrial cyclical sector with greater leverage to rate cuts than discretionary retail, yet it’s the industrial sector with the biggest short positions. Again, that is an explosive upside combination and we maintain a very bullish stance on Australian discretionary retail stocks.

Forge Group (ASX:FGE) – Buy

We’ve reinstated our buy rating for Forge. Revenue coverage in fiscal 2012 has improved significantly (+90%) since June and with the scope for further improvements. We see the downside risk abating. Forge generates an exceptional return on equity (ROE), sits in a net cash position with very high operating cash conversion. Average contract sizes continue to grow and there is a developing thematic in West African investment that the stock is leveraged to. Trading at 5.1 times fiscal 2012 EBITDA (earnings before interest, tax, depreciation and amortisation) valuation is relatively undemanding and we retain our Buy rating and target price of $6.50 per share.

Webjet (ASX:WEB) – Buy

We think it is rare for a mature company to have an organic opportunity as good as this: Webjet is about to embark on a major initiative targeting the online accommodation segment. The scale of the opportunity is amplified by the fact that if successful, it is likely to deliver margin improvement given hotels and accommodation margins are almost twice as high as flights. Our underlying thesis is that Webjet appears well positioned to gradually increase its share of the domestic online accommodation market from 0.65% in fiscal 2012 to 9.5% in fiscal 2023. Our target price is $4.92.

Woodside Petroleum (ASX:WPL) – Buy

Woodside remains attractive buying in our view. It is the only major LNG producer in Australia for the next three years, with a near-term step change through the Pluto Foundation Project due to start in less than six months. The market is not factoring in any Pluto expansion or the upside potential at the Browse LNG or Sunrise LNG projects, despite progress at all three. The likely sell-down of Shell’s remaining 24% stake in Woodside is acting as an overhang, but if this is removed the stock will re-rate, particularly if another LNG project is announced. Our share price target is $40.

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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