The Australian share market fell in March and continued declining in April, with resources and gold shares hit hardest. Commonwealth Bank's share price outperformed BHP Billiton's by over 40% in the last year due to investors seeking higher yields. However, CBA is becoming expensive while BHP remains cheap, trading at a forecast PE of 10 times and offering a 4.15% yield. While short term gyrations in iron ore prices are possible, BHP is well positioned for the long term as the lowest cost global iron ore producer.

1. March 2013 — Over the Horizon Market Commentary by David Offer
During March the Australian share market finally retraced some ground with the All Ordinaries Index falling 2.7% for the
month to close at 4,980. At the time of writing, this weakness has continued into April with the market off a further
1%. Resource and gold shares have incurred the brunt of the fall. With concerns over Cyprus and Southern European
countries, North Korean tensions and weaker than expected Chinese and US growth, it is perhaps surprising we have not
incurred more market weakness of late.
According to our research house Morningstar, our market is trading at fair value at the current time and we agree with
this assessment. However, within our market, there does appear to be a wide contrast in valuations, with some shares
now appearing to offer good value versus the majority of shares still appearing expensive. In our opinion, two household
names that typify this are Commonwealth Bank (being expensive), now Australia’s largest company by market valuation,
and BHP Billiton (being cheap), the world’s largest resource company.
As per the 20 year chart below, both companies have rewarded long term investors and, as at the beginning of 2012, had
both appreciated 600% over the previous 19 years.
However, over the last 12 months, the following chart tells a different story with Commonwealth Bank’s share price
outperforming the BHP share price by over 40%.

2. For both Commonwealth Bank (CBA) and BHP Billiton (BHP), it has been largely business as usual. External market
influences have had the majority of impact on respective share prices, particularly for this calendar year to date.
For CBA, the current global Central Bank money printing program is depressing global interest rates and has forced
investors into more ‘risky’ share market assets in the search for yield. Australian bank shares have been a major
beneficiary of this investor rotation. With bank balance sheets in pristine condition the mainstream view is that the
banks are a safe place for conservative investors to generate the yield they need from their investments. However, we
question the safety in buying any asset once it has become expensive and feel that, as an example, CBA is entering
expensive territory.
CBA is now trading on a forecast 2014 Price Earnings (PE) ratio of 14 times and will need to pay out 80% of forecast
profits to provide it’s expected 2014 dividend yield of 5.5%. In a tight and competitive lending environment, CBA’s
earnings growth is expected to only average 5% for the next three financial years. Limited earnings growth and a high
payout ratio will result in limited opportunity for CBA to materially raise its dividend into the future and any future
tightening of interest rates (granted this is probably at least 18 months away) will take the shine of high yielding
investments very quickly. To this end we support Morningstar’s fair value of $63.00 and believe there will be future
opportunities to buy CBA (and other bank shares) at lower prices.
The share market’s view of BHP (and other resource shares) contrasts sharply and is presently largely due to fears about
a potential oversupply of iron ore to China. A recent Financial Review article provided some interesting insights. The
article stated that China’s urbanisation level is presently approximately 50% of the population and China’s urbanisation
will continue for at least the next decade. As it does, steel demand will remain elevated and is expected to grow at an
undemanding 3% to 4% per annum. China currently produces 720 million tonnes of steel (the majority of which is for
domestic consumption) and this requires approximately 1,100 million tonnes of iron ore. Australia supplies around half
of this requirement with Rio Tinto producing 260 million tonnes, BHP at 200 million tonnes and Fortescue at 100 million
tonnes. Brazil’s Vale produces 300 million tonnes. The remaining 240 million tonnes come from Chinese producers, India
(though the 100 million tonnes India was exporting is now being redirected to its domestic market) and smaller
producers including from Australia.
The market’s concern is that an expected increase in production will flood the market. These fears may be
overstated. While the Australian majors do have major expansion plans for a combined additional annual increase of 180
million tonnes of iron ore production, this will take several years to completely come on stream. Away from the
Australian majors, it is very difficult for new iron ore producers to enter the market for various reasons including
prohibitive construction costs and a scarcity of project funding. Surprisingly, at the current time, Australia appears to be
the only country in an expansion phase in iron ore production. As mentioned, India is curbing exports, while Vale is
struggling to maintain production and African exporters are not coming on stream as expected. China, as a high cost
producer, appears to have finite iron ore reserves that are only expected to last another 15 years.

3. producer, appears to have finite iron ore reserves that are only expected to last another 15 years.
Accordingly, while there will be short term gyrations in the iron ore price, the longer term outlook may not be as dire as
expected. In any event, with Rio Tinto and BHP the lowest cost global producers of iron ore, they are well positioned to
ride out any downturns in the iron ore price and ultimately prosper as higher cost producers (particularly Chinese
producers) fold. The industry view is that for Chinese iron ore suppliers to remain viable, the iron ore price needs to
remain above $120 a tonne.
It is hard to reconcile the current market pessimism and BHP’s $32.00 share price with the current iron ore price at a
respectable $142 a tonne. The last time BHP traded at these levels, the iron ore price was under $90 a tonne.
It is worth mentioning that BHP is a genuinely diversified company. In broad terms, BHP’s revenue breaks down more or
less equally three ways: iron ore, other metals, and petroleum and coal. Geographically, China is the largest market,
supplying close to 30% of BHP’s revenue, but the remaining 70% comes from elsewhere. Accordingly, while the share
market focuses on the iron ore division, it ignores the rest of the BHP business. Importantly, BHP is a major player in the
shale gas revolution occurring in America at the current time.
At $31.80, BHP is presently trading on a prospective 2014 fully franked yield of 4.15% (a 5.9% grossed up yield) and an
undemanding forecast PE ratio of approximately 10 times. While we consider Morningstar’s fair value of $50.00 as
somewhat optimistic, we think that a 12 month price target of $40.00 is not unrealistic and, if achieved, would result in a
total return of 31%.
Accordingly, while out of favour, we are comfortable buying BHP at current prices.
On a different topic, in the face of mounting speculation and negative press, last week senior Federal Government
ministers locked themselves in a room for a couple of hours to work out the future of Australia’s superannuation system,
a summary of which is enclosed. As Parliament is unlikely to consider proposed changes until after the Federal election
in September there is a high probability the proposed changes will not see the light of day. We hope the next
government will provide a little more strategic thought to the Nation’s retirement savings.
If you would like to discuss the contents of this correspondence, the upcoming Westpac hybrid issue or your investment
portfolio in general, please do not hesitate to contact our office. We would welcome your call.
David Offer
AUTHORISED REPRESENTATIVE 259188
DIRECTOR
HORIZON INVESTMENT SOLUTIONS PTY LTD
SUITE 1, POST OFFICE PLAZA, 153 VICTORIA STREET, BUNBURY WA 6230
T. 08 9791 9188 F. 08 9791 9187
E.david.offer@horizonis.com.au www.horizoninvestmentsolutions.com.au
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