Price vs value: a dangerous game
Andrew Fleming, explains how low interest rates have seen the multiples paid for equity move higher and that buying equity at very high multiples can a dangerous game for investors to play, even for companies that grow earnings.
Bubbles, by definition, exaggerate the span of multiples paid for cashflow streams in equity markets, as in squeezing up the favoured they tend to emaciate the orphans. In early to mid-2000, Computershare was the most favoured poster child for technology stocks listed in Australia. In current terms, its share price had climbed from 30 cents to $9.00 per share over the prior three years, when the last full year reported earnings before interest and tax (“EBIT”) figure was $32m. Fifteen years later, its share price is barely 10% above where it got to in early 2000, whilst its EBIT has grown more than 15 fold to well above $500m. A shareholder purchasing a share in Computershare in early to mid-2000 has seen capital appreciation for the investment of less than 1% per annum whilst EBIT has grown at more than 20% per annum. The derating of the cashflow stream has negated almost all of the cashflow growth enjoyed by an equity owner through that time. Price is what you pay, value is what you get; especially when multiples are elevated.
This is now a real issue for equity owners, as two exaggerated forces for multiples in the equity market are now at levels rarely seen. The first force is interest rates, through bond yields, which at 2.2% in Australia are at record lows, following the global pattern of recent years. This in turn has seen the multiples paid for equity move higher, which is fine except that as bond yields fall, and equity multiples hence expand, the revenue and cashflow forecasts which are being discounted may fall commensurately (to reflect the weaker economic environment). This has ultimately transpired this year; the market now hosts no forecast earnings growth for industrial stocks for F16 but is forecasting 10%+ growth for next year (and the same thereafter); it is clear that these forecasts are too aggressive. In turn, this has presaged the second bubble; the price paid for earnings growth is in rare territory, at levels seen on only a few occasions through the past twenty years. As in the Computershare example recounted at the beginning of this commentary, buying equity at very high multiples is a dangerous game for investors to play, even for good companies that grow earnings. The beneficiaries of rerating have been the stellar performers of the past year; the Computershare example shows they may not be for the next decade.
Price to book multiples, which better dimension the impact of changes in bond yields upon multiples than earnings related multiples, shows defensive industrial stocks at more than 3 times book, a level not hitherto seen. Cyclical industrials have performed well through the past year and are now at more than 2 times book, a level last seen in 2007, whilst Banks at 1.6 times book are at reasonably low levels relative to history – and hence are fundamentally starting to look attractive. While Resource stocks continue to trade near book value, at record lows and about 80% below the levels seen when “Stronger for Longer” was in full cry. It is clear that two extremes – defensive industrials and resources – remain, and that the magnitude for each is extreme. To talk about “the market” being cheap or expensive is a meaningless exercise; that aggregate number merges several extremes.
The travails of listed nursing home operators – Estia, Japara and Regis - highlight the danger in assuming that the Government will happily fund excess returns for shareholders into perpetuity. Whilst demographics means that volume growth in Healthcare should remain robust, the fact that Governments fund much of the revenue for many of the companies in this sector, should give investors pause for thought. Government regulation, across sectors through time, can (and should) change – ask any shareholder in Telstra when the NBN was announced, Star Entertainment when a further casino licence in NSW was awarded, or Banks as capital rules change requiring fresh capital to be injected into them. Healthcare also has a long history of regulatory suppression of returns in some areas – payments to GP’s relative to GDP has been flat for 20 years, despite volume far outpacing GDP. That this focus extends to nursing home operators should not surprise, and it may yet extend much further in the Healthcare sector in coming years, muting some of the apparent shareholder benefit from increasing volumes, even when they have been evident in most recent years (as indeed, was the case with nursing home operators).
So, whilst where we see value within the market remains clear, the sentiment of the market still does not reflect this positioning, despite some changes in recent months. For several years now, price momentum has been recurrent, with the best and worst performing sectors over a trailing quarter and year being the same. In the past quarter, this has changed, with Energy and Metals stocks outperforming through the quarter, whilst still being the stand out laggards over the past year. Sentiment and price momentum are, unfortunately, circular; the same management team and Boards, doing the same things, that are lauded for increasing or accepting increased prices on the way up, and hence increasing dividends and shareholder returns at the same time, are pilloried when prices revert (Woolworths) or are reverted around them (Energy and Metals stocks). For context, though, we still see material value using long run metal price assumptions for low cost, long life miners such as BHP, RIO, Alumina and Iluka, and material downside to our valuation for many industrial defensive names.
Finally, macro events continue to play havoc with how fundamentals and sentiment interact in terms of equity market returns. The major driver for the bubble in the multiple paid for defensive industrial price to book multiples - and the consequent collapse in that multiple for Metals stocks – has been monetary policy. Policy movement this year has differed, for the first time since the GFC. Policy intending to suppress bond yield’s has been in place since 2008, when the US initiated a quantitative easing program, and augmented since as the EC and Japan has followed the QE path. Senior US economic policy commentators have this year, however, been advocating a different approach. For example, Ben Bernanke, the recently retired Chair of the Federal Reserve, has written three times in the past three months on a similar theme, summarized with this quote:
“… there are signs that monetary policy in the United States and other industrial countries is reaching its limits, which makes it even more important that the collective response to a slowdown involve other policies—particularly fiscal policy. A balanced monetary-fiscal response would both be more effective and also reduce the need to use unconventional monetary tools…” (http://www.brookings.edu/blogs/ben-bernanke/posts/2016/03/18-negative-interest-rates).
Larry Summers, US Secretary of the Treasury for a decade until 2001, has written along similar lines:
“… The core problem of secular stagnation, the neutral real interest rate is too low. This rate, however, cannot be increased through monetary policy. Indeed, to the extent that easy money works by accelerating investments and pulling forward demand, it will actually reduce neutral real rates later on. That is why primary responsibility for addressing secular stagnation should rest with fiscal policy. An expansionary fiscal policy can reduce national savings, raise neutral real interest rates, and stimulate growth…” (http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/).
Of course, the global economy is struggling with lower than anticipated levels of activity as demographics and debt take their toll. These are omnipresent forces that will not revert. Nonetheless, it is facile to suggest that bond yields, and hence the multiple attaching to defensive industrial stocks, have not been influenced by the domination of QE as a policy setting to combat low growth rates. With multiples at all-time highs, any potential change in the policy that has presaged these levels is folly to ignore.
The interaction between valuation, sentiment as calibrated through price momentum, and policy is key to our portfolio positioning. Differences in the valuation of cyclical stocks relative to defensive industrial stocks has only through the past quarter moved slightly away from hitherto unseen extreme levels. Sentiment, as ever, has followed this move, as measured through price momentum, with “valuations” of cyclical stocks in some cases seemingly moving faster than the 50% moves in share prices, down and then up, seen through the past year. Macro policy continues to be a major factor behind why such extremes in multiples of defensive industrials and cyclical stocks exists. Consensus is that macro policies seen through recent years continue unabated, and equity prices aggressively reflect this consensus. Any move away from this policy position, however, will have outsized consequences for equity multiples, which, is why rhetoric suggesting a broadening of policy away from the narrow QE focus of recent years is important for relative returns between these sectoral extremes.
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