The following are excerpts from the panel discussion by members of the Morningstar equities team for the Morningstar Investor Conference in Sydney on June 11, 2008. The panellists were Ian Huntley (IH), Mark Taylor (MT), Peter Warnes (PW) and David Walker (DW). Andrew Doherty (AD) moderated the session.

AD: A year ago we had 85 Buy/Accumulate recommendations, now we have 150. Obviously a lot of value has opened up in the market. Where is that value?

PW: If value is the difference between a share price and the long-term worth of a company, and restricting our comments to the industrial sector at this point, then value has been created over the past year. We are experiencing a bear market in several sectors of the industrial market and the long-term value created has been more to do with the short-term decline in share prices rather than deterioration in long-term earnings potential.

The gap between share price and long-term worth has widened creating better long-term value. Market downturns create better long-term value hence the reason for more positive recommendations at this time.

In some cases there is compelling long-term value but at present it is overwhelmed by negative sentiment and economic news flow, whether domestic or international. For example, share prices of Australian banks are significantly affected by what happens to a UK mortgage lender or a US investment bank needing to raise more capital. These are totally unrelated but the negative sentiment and hedge fund activity drives share prices down.

Excluding banks and financials there is long-term value in defensive issues, companies servicing or having exposure to the resources and infrastructure sectors, cyclicals, retail and consumer-related issues. They include:

• Defensive - Fosters, Lion Nathan, Coca-Cola Amatil
• Resource/infrastructure related companies - Boart Longyear, Leighton, Orica, Transfield, The Mac Services Group, Worley Parsons
• Cyclicals - Alesco, Boral, CSR, Crane Group, GWA International, James Hardie
• Retail - David Jones, Harvey Norman, Just Group, Metcash, The Reject Shop, Wesfarmers and Woolworths
• Consumer - Billabong, Pacific Brands.

AD: Some commentators have observed that sell side analysts have been slow to cut their earnings forecasts and that the consensus is still too high. Have we been too slow in cutting our forecasts? Is this what is driving the increasing number of buy recommendations?

PW: There is always the possibility analysts have been too slow to cut near-term earnings forecasts hence throwing up perceived near-term value. But earnings downgrades affecting near-term earnings do not have a significant impact on longer-term value and that is what we concentrate upon. We take a long-term view so the next year's earnings have limited impact on valuations.

AD: We see resources as one of the strongest sectors currently, in the context of rising inflation, interest rates and commodity prices over the next 20 years. Where are the best opportunities in resources - amongst the big caps or small caps?

MT: We think there are opportunities in both big and small caps. Often there will be periods when the blue chips will skip ahead on issues like commodity price rises. Large caps have a higher proportion of producing assets and can quickly capitalise on price rises. Money flies to quality/liquidity first and then later to smaller caps after a lag.

At this particular point however I think you're seeing the large cap/small cap space similarly attractive. The commodities bull market has been running for a good number of years, plenty of time for money to filter its way around the full investment spectrum.

We have seen a bit of a pull back in base and precious metal prices, although not so in the bulk commodities like iron ore and coal or in oil & gas. Coal still has substantial upside as a cheap alternative to oil. The spot price is at about a 30% premium to the recent settlement.

There has been a modest pull-back in share prices with many companies off their recent highs. On the downside, money tends to exit both large and small caps simultaneously but sticks a little longer in the large caps. But I think large and small are equally flush with opportunity.

At the top-end we have active recommendations on BHP, RIO, Alumina and Woodside. While at the smaller end, in the oils we like Australian Worldwide Exploration, Roc Oil and Arc Energy. We like the smaller nickel stocks Sally Malay and Mincor. Western Areas is an exciting story but fairly priced. At the more speculative end, juniors like Compass Resources, Kingsgate Consolidated and Mosaic Oil are attractive.

We would stress that there is potential for a hiccup. An oil shock could impact even the seemingly bullet-proof resources sector. Our overriding preference is for the quality blue chip companies, particularly when they represent attractive value as at present, to best weather any downside

AD: Let's focus on BHP which is a widely held stock. What should investors do with their BHP shares?

MT: BHP is the premier diversified mining investment. It would be hard to imagine a balanced portfolio without BHP. Recent profit-taking after a strong share price run-up sees BHP favourably back within our Accumulate range. Strong price rises in the bulks - iron ore and coal - are favourable for the near-term earnings outlook. BHP's substantial oil & gas division sees it comfortably hedged against rising energy prices.

We think BHP is a win-win situation. If it is successful in its bid for RIO, the asset portfolio will be strengthened. If the bid fails, we think the company's strengths will shine when compared to rivals. Disciplined management, ie. not paying crazy prices, will be rewarded.

If you've got BHP shares, hang on to them. If you haven't, we think they are quite reasonable buying at the moment.

AD: A big part of our research process is to seek companies with sustainable competitive advantages that protect their profitability over the long term. Competitive advantages are skills or assets owned by the company that allows them to stay ahead of the competition. Does BHP have any competitive advantages?

MT: BHP has a competitive advantage but it is not as strong as might occur in other industries. While there has been considerable consolidation in the mining industry - something that is ongoing - mining companies are by and large still price takers, just demand is very good right now.

The exception is traded iron ore, where BHP is a member of the oligopoly along with RIO and Brazilian miner Vale. BHP and RIO are presently stalling on iron ore price-setting negotiations, in pursuit of a slice of the freight premium afforded by Australia's proximity to China. We don't think BHP and RIO want to get too cute on this front, a side issue.

For the most part BHP's competitive advantage is derived from its tier one assets - large, long-life and low-cost mines, followed by asset diversification, the quality of people it can attract and a low sovereign risk profile. Two thirds of its assets are in first world locations. It's cost advantage is a major attraction.

AD: One of the concerns with mining stocks is that commodity prices are so volatile. Commodity prices could easily correct after reaching such high levels. Will volume gains offset any price falls?

MT: In recent years, rising commodity prices have in the main dwarfed volume gains in respect of ballooning mining company profitability. Our company earnings forecasts and valuations commonly factor in a retreat in commodity prices over a five-year period.

Volume gains could offset much of the price impact but are unlikely to sustain the phenomenal earnings growth seen in recent years. We expect the earnings of the diversified majors to flatten for example, all else being equal.

Volume gains are more likely to come from the bulk commodities - iron ore where huge expansion project are in train - and coal once port upgrades allow. LNG could be another area of considerable volume growth. We see only limited potential for volume gains in base and precious metals and oil.

AD: Ian, do you think investors should be overweight resources and BHP in particular?

IH: BHP is approximately 10% of the index. It should be held, and added to on any sharp weakness which may occur if this bear market finally takes control of the commodities bull market. That will then be an opportunity as the BRIC economies story, particularly China and India, has a very long way to go. Its exposure to commodities will give it something of an inflation hedge, as was the case with such companies in the 70s and 80s.

Woodside is more interesting as the energy complex may take some downside, but it is the centre of the long-term resources story.

AD: We have seen massive write downs amongst the banks internationally and financial stocks have been hit harder than the broader market - are we out of the woods yet?

DW: Most likely the first, and worst, wave of write downs emanating from the credit crisis is over. The fear that gripped equity and debt markets over uncertainty about which institutions owned sub prime debt and might be unworthy counterparties also seems to have subsided. Credit spreads have stabilised, albeit at higher levels than before the crisis.

Now the sector faces a more traditional rise in bank provisions for bad and doubtful debts as consumer and business borrowers go into arrears or default on their loans. This would be due to economic pressures from higher energy costs, less discretionary income, higher interest rates in some countries and lower house prices in others.

Having been battered by the credit crisis, equity markets have moved straight on to pricing in the risks-to-earnings from surging oil prices. Until the implications for new loans, bad loans and the ability to raise capital and do deals are clear, prices of financial stocks will reflect the uncertainty.

AD: Is now a good time to buy banks or should we wait?

DW: Although it's difficult to pick the market bottom, the four major banks all provide good long-term value at present. Sentiment on banks has been strongly negative and share prices are down 20-25% from their November 2007 levels. Dividend yields are above 6% fully franked. Earnings estimates for FY08 and FY09 have been downgraded, but not significantly.

Some comments on the sector:

• Credit growth is slowing in response to higher interest rates and economic uncertainty - mortgages around 10%, corporate 12-15% and consumer 8-10%.
• The big 4 banks are taking market share from non-bank lenders, which have been unable to fund their growth due to the closure of securitisation markets, while the reduction in international corporate bond market activity has seen demand swing back to the traditional banking system.
• Margins have been under pressure although all banks have moved to restore margins by lifting variable rates above increases in official rates since January.
• Asset quality is generally sound despite annual credit impairment charges currently running at a record $5.0bn plus. Ratios of gross impaired loans to total gross loans are at relatively low levels, reflecting significant loan portfolio growth in recent years.
• The local banking sector is in much better shape than UK and US banks. The housing markets in those countries are in a real mess, with major falls in house prices. In the US, one in seven home loans is in arrears or default. Imagine what that would be like here - one in seven home owners you know in trouble with their home loans - and it becomes clear how much worse off our banks would be. So you can see the gulf between our housing market and those northern hemisphere markets.
• So how should you buy banks? Dollar averaging could be adopted over the next six months - 33% in each of three tranches. We currently have Buy or Accumulate recommendations on all major banking stocks.

AD: The earnings of fund managers like Perpetual, AMP and IOOF depend on fund balances and net inflows. Surely these stocks are set to underperform now markets and net inflows have fallen?

DW: The fund and wealth managers underperform the index when equity markets fall. This is because lower share prices reduce funds under management and administration, and thus investment management fees. They also diminish regulatory capital adequacy, which makes special dividends and capital returns less likely. The third effect is to discourage discretionary investment in share market-based managed funds. At the moment we're seeing the effects of this on lower net inflows. The problem for the wealth managers is net inflows can take some time to recover from a bear market. Retail investors need to see the returns in the market before they resume committing their funds, but until then the money tends to sit in cash.

The favourable long-term fundamentals supporting the industry haven't gone away however. The compulsory superannuation system still drives rising net inflows and fund balances, with the asset allocation dependent on the state of markets at the time. The ageing of the population is also positive because it increases investing activity as people save for retirement.

Most of the wealth managers we cover are undervalued, but in its current state the market doesn't care. The catalyst for the realisation of value will be a sustained rising trend in equity markets.

AD: What are the prospects for insurance stocks?

DW: The general insurers are worth a look at the moment. Although there have been false dawns before, there are suggestions the commercial insurance premium rate downturn is bottoming. If so, and if there are no more multiple major event claims like storms, then the negative earnings revision cycle for this sector could be over. QBE remains the best investment in the sector, while SUN and IAG are both undervalued, as QBE's bid for IAG showed.

AD: Rising interest rates, petrol and food prices are causing a rapid decline in retail conditions. Are there any stocks that you would invest in given this climate?

PW: The consumer is facing a fairly hostile environment at present. Higher interest rates, rising fuel prices and food inflation and near record consumer debt levels are all placing great pressure on discretionary spending. Retailers of necessities will hold up - Woolworths, Wesfarmers and Metcash - helped by food inflation. Woolworths is the top stock with 80-85% of revenue in Food & Liquor although this is reflected in the PE ratio. Wesfarmers is interesting although has a greater exposure to discretionary spending - the 6% plus fully franked yield provides an element of downside protection. Harvey Norman is being priced for recession. The share price has fallen over 50% since late November 2007 - market capitalisation from $7.7bn to $3.6bn - which seems a little harsh. It is a class retailer and good long-term value. Interesting smaller discretionary retailers include the Specialty Fashion Group, Just Group and The Reject Shop although the latter is probably not discretionary and should do well as consumers seek better value for their dollar.

AD: We have long regarded Woolworths as one of the strongest businesses in the market. What are Woolworths' competitive advantages?

PW: WOW has been the outstanding major Australian retailer over the past 10-15 years. The performance has been driven by visibility and predictability of sales and earnings growth, which provides a high level of comfort and allows for a premium multiple to be accorded to earnings growth. Compound annual EPS and DPS growth has been around 15%, driving strong total returns over the past decade. It is a growth stock with significant defensive qualities.

WOW has a strong competitive advantage with the lowest Cost-of-Doing-Business (CODB) to sales ratio of any competitor. This has been driven by the successful Project Refresh initiative which has resulted in cumulative cost savings of over $7.5bn over the past 8 years. The strategy has been to match 'Everyday Low Prices' with 'Everyday Low Costs'. Widening operating margins on increasing volumes drive cash flow. There is significant negative working capital - inventory is funded by suppliers. You and I pay in 45 seconds - suppliers get paid in 40 days. That capital is invested in expanding the business and maintaining and growing an already substantial market share and reinvesting in the powerful brand name. The IT platform across the supply chain and at point-of-sale is leading edge

Aspect Huntley