Beware bargain-buy share predictions

The start of a new financial year often brings bold predictions from commentators who argue the sharemarket is “cheap” on traditional valuation metrics, only to watch it fall a bit more and get cheaper still. So I’ll add my top 10 small and mid-cap ideas for 2012-13, with a few caveats and an outline of my base-case scenario for shares over the next 12 months.

I still believe the Australian sharemarket will vacillate probably between 3800 and 4800 points on the S&P/ASX 200 index over the next 12 months. Technical analysts might call it a consolidation pattern as the market builds the base for the next bull market.

It would not take much for the market to slip below 4000 points, although recent support near that level seems reasonable. The big question is earnings risk. Analysts still have industrial companies in the Small Ordinaries index on low double-digit earnings growth in 2012-13.

Low single-digit growth is more likely, which would mean more downward earnings revisions and lower share prices.

The market’s 12-month forward price-earnings multiple is about 11 times on consensus analyst forecasts. That seems good value, given the market’s long-term average P/E ratio is near 14.

But you could argue the average P/E multiple should be lower to reflect higher global uncertainty and risk. Of course, the P/E ratio is only as good as the earnings forecasts from analysts, which still look too high.

If you assume fair value for Australian shares is probably a forecast P/E ratio of 12 or 13 times earnings, the market may have already priced in downgrades to earnings forecasts of 10 per cent to 20 per cent.

That implies the market is trading below fair value, but not ridiculously so. So those market-watchers who proclaim it is a screaming buy at these levels overlook the risk of further earnings downgrades. Aggregate earnings forecasts for small resource companies, in particular, look far too high.

Nevertheless, I still expect the market to rally after the traditionally weak September-October period and enter 2013 stronger. An end of calendar year target of 4500 for the S&P/ASX 200 is plausible if fears recede about a double-dip recession in the United States and so-called hard landing in China. Next year might see earnings downgrades slow further and more upgrades feature, in a slow, grinding market.

That is the theory. The reality is no one really knows how the market will fare amid such extreme global volatility. I do know that investors should stick with the highest-quality companies over the next 12 months. Paying a bit more for stocks with greater earnings certainty seems a much better bet that chasing fallen stocks with low earnings visibility and unreliable P/E ratios.

For most investors, that means buying blue chips with high yields, such as Telstra, the banks and some utilities. Those who dabble in small and mid-cap stocks should focus on star companies you have a chance to buy during market sell-offs.

Regular readers know a recurring column theme has been to buy the so-called online portal stocks during market corrections. REA Group, Carsales.com and Seek are the best, and the top three on my list of small and mid-cap stocks for 2012-13. Even if the domestic economy slows, these will grow by taking market share from their print advertising competitors.

My next three are column favourites: four-wheel-drive parts maker ARB Corporation, mining services provider Monadelphous and sharemarket information provider IRESS, which has fallen from a 52-week high of $9.41 to about $6.26. IRESS is a good example of opportunities that emerge during corrections to buy high-quality companies that usually trade on higher P/E multiples.

The final four stocks offer “defensive growth” because they are exposed to markets that are less economically sensitive and have more visible earnings. InvoCare is a good example: you can’t get more defensive than an operator of funeral homes and cemeteries.

Salary packager and car lease administrator McMillan Shakespeare has clients in defensive sectors such as health, charities and government. SAI Global provides information on business standards and other government rules and regulations – a growth industry if ever there was one and clients do not swap providers easily.

Education provider Navitas rounds out the list and I wish there were more options to invest in education businesses on the Australian Securities Exchange. Navitas is showing signs of stronger enrolments and has a terrific position in the market for international students. It’s not the cheapest on my list but has higher earnings visibility than many.

Others considered for the list are Domino’s Pizza Enterprises, Super Retail Group, TPG Telecom, OrotonGroup, NIB Holdings, Blackmores, DuluxGroup and Trade Me Group (51 per cent owned by Fairfax Media, publisher of BRW).

If a final washout hits shares in September or October and the market tumbles another 5 per cent to 10 per cent, investors will at least know they are holding the best-quality small and mid-cap stocks. Better still, they might buy them at lower prices in coming months if they watch and wait.

READ NEXT:

• Biotech sector shows promise but fails to fire
• Bluechiip bets on biobanking
• Three hot gold stocks

• Tweet