Is a price-earnings multiple of 30 the new 20?
Just like school, the report cards have come in for another profit reporting season. All the noise, stress and conjecture during the term seemingly objectively quantified in a set of financial statements that should be relatively straightforward to digest. But no, times have changed and what is more important is the hyperbole, to the point where financial statements have become less relevant. Earnings guidance (and EBITDA at that) is critical for the throngs of cheerleaders craving a foundation to work from. Whether it is achievable or whether that number is of substance is increasingly unimportant. Cash flow – probably the best measure of quality has taken a back seat and if there is a problem with cash flow – for example there is none – just provide a myriad of normalisation adjustments in the accompanying presentation pack that befuddles that pesky analyst or investor. We suspect that in the next six to twelve months much of the euphoria from this season will subside, as management teams face the uphill battle of meeting inflated expectations of their own creation. Who needs a rod for their back? Not us but clearly some CEO’s are transfixed with short term share price performance and prefer a golden parachute exit strategy rather than rolling up their sleeves to deliver genuine shareholder wealth. We agree with Ben Graham and remain steadfast in our philosophy that the sharemarket is a voting machine in the short term but a weighing machine in the long term, and the sheer lunacy of recent times will be resolved by Darwinian forces that have prevailed since the dawn of capitalism.
Mega PE re-ratings were flavour of the month. Where a PE of 20x (i.e. 20 year payback period when buying at current share price) was seen as expensive not long ago, many market darling stocks have now re-rated to 30x and the ‘uber’ market darlings have re-rated from a very rich 30x to 40x. It appears the sharemarket is emulating the new wave think that in biological age, 40 years is the new 30. When 60 is the new 40 begins to spread through the Australian sharemarket, we will know there is a catastrophe of epic proportions brewing, if not already. Human nature (greed and envy) means constant repetition of past cycle sins, with the bursting of the dot com bubble and the GFC merely unpleasant dreams from another lifetime. Whilst biological age extension appears a structural phenomenon due to medical innovation, the expansion in sharemarket ratings is surely a cyclical phenomenon. If past investment cycles are a guide, the outworking of the current market re-rating will be irrefutably ugly. Therefore our rotation from market darlings to lower rated stocks continues, although at some point we will exhaust our ammunition as our supply of these stocks is dwindling. We are invariably early but we believe it better safe than sorry, as the margin for error in these ultra-highly priced companies is precipitously thin.
With challenging economic conditions seemingly a constant in the modern highly indebted world, earnings certainty are clearly high on the professional investor’s agenda. Well versed management teams have gleaned an opportunity to provide investors with some comfort by packing away large provisions below the line, on the view, that in future periods they can release these to provide a buffer in the event conditions continue to fall short of expectations. Many companies employing these tactics have enjoyed strong share price performances as the ‘smart money’ sees an opportunity. Clearly, in the long term “hollow logging” is an unsustainable strategy, sooner rather than later the lack of cash flow will catch-up with these companies.
Every so often, and more often than not at reporting time, we seem to get the obligatory short covering rally where hedge funds have sold a company aggressively short for legitimate fundamental reasons, with an overleveraged balance sheet and falling earnings the common denominator. This result season did not disappoint. These hedge funds must have nerves of steel as shorting stocks in a bull market seems fraught with danger given the shorter time horizons of their underlying clients, clearly one of the distinct advantages of being a long only investor is that we have the luxury of time. To combat these recalcitrant short sellers, a number of companies have resorted to ebullient outlook statements to spectacular effect in some cases. Given our penchant for avoiding over-geared and challenged business models, we saw little benefit from this dynamic in our performance for the month of August. Being the tortoise rather than the hare has its drawbacks sometimes.
The litany of private equity IPO’s listed over the last 12 months had mixed fortunes. Whilst share prices have generally traded well from listing, the actual results being delivered have failed to ignite in most instances with no one really blowing numbers out of the water and in some cases the jury remains well and truly out as to whether they achieve rather aggressive FY15 prospectus forecasts. The weight of money and the allure of a newly minted company seem to be countervailing factors. Instinct tells us that many shareholders in these companies are feeling a tad uncomfortable and are sitting around the poker table waiting to see who blinks first. Perhaps some new patsies (err players), will enter the game. The new players probably required, given the house rule, (who dreamt up this idea we will never know) that each private equity firm had to retain a cornerstone shareholding escrowed until after the first result. Increasing exposure to these IPO’s would seem a dangerous exercise, akin to swimming deeper into a lobster pot, particularly in small caps where dislocations can be sudden.
The bifurcation of the market between ultra-expensive stocks and relatively inexpensive companies continues to provide opportunities. Our performance to date has been much better than anticipated given it would appear to be a growth and momentum market, the antithesis of our value bent. It is possible some of our performance unwinds in the short term as our “biological age” argument drives a segment of the market that we are underweight to stratospheric levels as has occurred in past cycles. Our protection, although not deliberate, is the potential for M&A activity, whereby the inexpensive stocks get picked off by the expensive ones, particularly so when debt and equity is abundant and cheap, and organic growth is challenged. In recent months we have witnessed four takeovers of stocks in our portfolio, those being ROC Oil, Wotif, Oakton and Goodman Fielder.
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