Finding value in the market
25 August 2014
Advice on stock picking is, or should be, tentative. There are no absolutes, it is only possible to make comparative judgements. In finance, everything is relative to everything else -- company earnings, earnings multiples in the share price, interest rates, currencies. Each part is always moving. So no solid quantitative measures are available, it is simply a matter of making a judgement and hoping it is right.
The S&P 200 has been a good bet: it rose more than 15% in 2013. The All Ordinaries was up almost 15%. This year, though, the market has been less strong.
The international environment for equities is looking favourable. In the US, earnings per share growth has been strong. This is leading to improved sentiment world wide about stock markets. The post-GFC fear is finally beginning to wane:
Going back to the ASX, the earnings picture also looks reasonable. The AFR has a crack at trying to make sense of it:
'There are lots of moving parts for investors to keep an eye on, such as the United States Federal Reserve, interest rates and bond yields – not to mention company fundamentals.
Long-term low rates and bond yields mean that stocks perceived to be expensive aren’t necessarily that overvalued because of high yields, says Credit Suisse analyst Damien Boey. “You can look at price-earnings ratios and all those metrics, and that will give you some insight into what’s cheap or not – but, of course, earnings can change.”'
As Boey indicates, the low interest rate environment across the OECD is distorting normal valuation methods. Fund managers are split:
'Consensus is hard to come by, even at the big end of town where the serious money decisions are made. Platypus Asset Management chief investment officer Don Williams says major miners BHP Billiton and Rio Tinto are overvalued, with the price of iron ore expected to fall further over the next few years.
“We think, at best, BHP and Rio will go sideways for a number of years,” Williams says. “BHP is trying to add some value for shareholders, but just splitting the company in two doesn’t necessarily add anything, unless one of the bits gets bid for.”
But Philo Capital head of listed equities Hugh Dive reckons shareholders will be rewarded by the big miners as added capacity forces smaller players out of the market. Dive says once BHP and Rio stop adding capacity, there is room for returning cash to investors.
“Once [there are no] mega projects in the near future, their stock prices will be strongly supported for the next five years by a steady stream of dividends,” Dive says.'
Some companies seem to be on high earnings multiples, suggesting they are fairly fully valued. Resmed forward PE of 20.22 times looks high. Domino's Pizza looks high. But these stocks may increase earnings and the share price is simply factoring that in. Carsales and Seek are nominated by some brokers as possible beneficiaries of overseas expasnion.
The AFR gives this snapshot of the different sectors. Mining and airlines seem questionable:
'Mining stocks, which look cheap on a PE basis, pose significant risk to investors. Tribeca’s Fenton singles out Mineral Resources, with a forward PE of 13.36, as one in a group of mid-tier miners that look pricey.
“The further you go down into the junior iron ore stocks, the higher the cost base. They look pretty stretched,” Fenton says.
“Mineral Resources is quite a high-cost producer; its leverage to the iron ore price is quite high. Cash costs are materially higher than the bottom-quartile producers.”
Prices could be going down for Coles’s parent company Wesfarmers, and Bank of America analyst David Errington is extremely disappointed with the conglomerate’s strategy. Wesfarmers’ earnings were in line with expectations but growth is missing, he says. The company announced a $1 billion return of cash to investors, but Errington says Wesfarmers should be looking to reinvest in growth areas.
“We are least attracted to companies that sell businesses and return the capital to shareholders – due to, presumably, a lack of investment or growth opportunities,” Errington says.
“In the 2014 financial year, four Wesfarmers businesses went backwards in earnings – and in the 2015 financial year, combined with the elimination of insurance earnings, three businesses are forecast to go backwards. For a conglomerate to deliver above-market growth in earnings, to justify a premium valuation, we believe none of its businesses should post negative growth.”
Warring airlines may be great for consumers wanting to travel, but the battles have left Qantas bruised and battered, Motley’s Phillips says. “Qantas is a woeful business in a very tough category. It’s not going to make investors rich over any significant length of time.”
Some analysts predict the airline’s losses will top $1 billion this financial year, and Phillips says there are no signs the business can deliver long-term for investors.
Overcapacity is chronic in the airline industry, keeping prices low.
“Alan Joyce is doing a fantastic job running that business to keep it at a reasonable level, but he’s got to run a million miles an hour just to stay still,” Phillips says.
Philo Capital’s Dive has personal experience in the risks of investing in insurance companies. “I unfortunately was a large shareholder in IAG during 2008-2011. During those periods, people priced them as if the catastrophes were never going to end, and during the great periods they price them like [the good times] are never going to stop.”
“I’d be very concerned about buying into general insurers, like IAG and Suncorp. I think they look quite overvalued, notwithstanding a good headline number. If we have a particularly nasty catastrophe year, which could be around the corner, that could easily evaporate.”'
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