Defensive, but expensive
Defensive and expensive
Defensives appear very expensive at present relative to the overall market (ASX200). While this appears the case when we use near term earnings expectations to derive a PE multiple as a measure of value, if we use longer term measures, such as price to book, we get a very different picture. On that basis, the outperformance of defensive versus cyclicals has mostly been removing the excessive cyclical over-valuation and we have now arrived at a situation where defensives are expensive relatively, but not generationally so. Why the difference? Well as we have been highlighting for some time the PE multiple embeds earnings expectations that in our view are still too high. Cheap stocks on a single digit multiple may actually be on 11-12x multiple once earnings expectations adjust to reality - a reality which book values being more stable tend to be more effective at capturing.
Defensives in our portfolio sit broadly in two categories:
i) utility type businesses characterised by defensive earnings but no growth. These stocks are not seeing any meaningful improvement in their operating performance and all of the relative performance has come from the market bidding up the relative multiple they are willing to pay for the same assets and earnings
ii) non-cyclical growth companies that have both high quality characteristics and multiple reinvestment opportunities for further growth – yes even in this market. These companies have been re-rated relative to the market, but in our view many of them are likely to continue growing earnings and to justify relative share price performance through time.
Given the recent performance of our defensive portfolio holdings and the dramatic underperformance of the cyclical small companies that we are underweight, we are looking to rotate away from defensives at the margin. We will be funding this from the utility type defensives and non cyclical growth companies will remain the bedrock of the Schroder Smaller Companies Fund.
What cyclical stocks to buy?
Rather than start with a list of what we are looking for, let us look at the problem the other way using a process of elimination. As the mathematician, Carl Jacobi said “invert, always invert”. Instead of looking at which cyclical stocks to buy perhaps we should remove those we want to avoid and then look at what is left. Some of the risks we think should be excluded, or at least treated with caution in this market for investors with a three to five year investment horizon (a seemingly declining portion of the investment community) would include:
Structural risks: Many cyclical industries and businesses have been under pressure for both cyclical and structural reasons. An improvement in cyclical conditions can result in short term share price gains, however for the longer term investor the structural pressure continues to undermine returns. Examples include industries such as media and discretionary retail.
Thematic risks: We have written plenty about our concerns over the risks we see in the China growth story and related commodities complex. Many of the biggest underperformers over the past year or so have been concentrated in either resource companies (both mining and energy) or those that service the resources industry. However our concern in assuming value has emerged in that under our long term commodity price assumptions, many of the mining companies fail to warrant any positive equity value. As noted previously, when the market has priced in a 15% decline in mining services earnings but a highly probable scenario is a 50% decline, value is not apparent.
Balance sheet risks: Despite the lessons we all learnt about excessive financial leverage through the GFC and the equity recapitalisation process that occurred in 2009, we are still surprised at the financial leverage many small (and large) companies continue to carry. In its simplest form, debt means as an investor you can get stopped out if you get your timing wrong. Given we do not profess to have an edge in short term timing, we prefer to invest in companies that have sufficient balance sheet capacity to protect equity if a recovery in operating conditions takes longer than many expect. The quantum of this capacity in our view should be measured in years, not quarters.
Quality risks: These are stocks that have none of the structural, thematic or balance sheet risks, but of which we are still wary – the low quality value trap. These are businesses that have no identifiable competitive advantage, and as such no way to sustain excess returns on capital in the long run.
Multiple risk stocks: A group of stocks that are the first to be filtered out of an investment decision because they carry a combination of risks, ie., low quality, excessively geared and structurally challenged. Buying a stock that gives not one but two or three ways of losing investors’ money is not the best idea to put money into.
This process of elimination reduces the opportunity set for investment within the small companies market and we continue to apply our research effort to uncover the best risk return opportunities from within this group. This is not exclusively an Australian problem. Comments from colleague Robin Parbrook, Head of Schroder Asia ex Japan equity fund management team, regarding their experience finding value in China following recent company visits, highlights a similar investment challenge. According to Robin, “Given the weakness in China shares we had hoped our visits here would throw up some interesting ideas, however in general our China visits have left us more cautious than ever and we have not added to the fund’s China related names.”
Company visits and other observations in the quarter
We spent some time in May visiting both the international operations of Australian small companies, but also other industry participants who can provide insight into what best practice looks like and to give us a better understanding of the level of competition many of these companies are facing. Without giving a full debrief of the many meetings I have summarised below some interesting observations:
– The importance of heritage and story in the creation of a luxury goods brand in Asia. We met with Mulberry and Coach who provided useful insights on the challenges Oroton will face in their Asian expansion and as importantly provided us with better questions to put to Oroton management in relation to their strategy here.
– The importance of incentives within an agency business (duh!) when trying to understand why the UK real estate classifieds market is smaller than Australia in dollars, despite having three times the population size. Answer – there the real estate agent pays for advertising out of his commission. Here the vendor pays in addition to the commission. Voila a 6x increase in per capita spending. We also gained very useful insight into how the depth product may play out for REA Group Ltd. in Australia based on the UK experience.
– Subtle cultural differences that influence entire industries. For example, casual dining in the U.S (think Applebee’s, Chipotle Mexican Grill, Olive Garden, Ruby Tuesday, TGI Friday’s Et Al) is a huge category. The Australian market is littered with failed attempts to transport the concept down here. The cultural influence is seen across countries in activities such as ten pin bowling, preference of Coke vs. Pepsi, consumption per capita differences in burgers vs. pizza and the evolution of the shale gas industry in the U.S relative to Australia, Europe and Asia to name a few we researched in our visits. Spread sheet analysis is a very useful tool, but micro factors that drive demand are critical to avoid the GIGO problem (garbage in, garbage out). Decoding the success in an industry or business requires an understanding of the history and cultural factors which contributed, as well as the most often focused upon technical and economic ones.
– The final observation from our travels is that structural change is afoot across the globe, driven by the novel conditions we face today (demographics and debt) and the condition that has existed for centuries – technological change and the capitalist pursuit of innovation for financial reward. Incumbent businesses remain blind to the magnitude of risk from disruptive innovation, and in many ways it is hard to blame them. Their very position as an incumbent and often leader within their industry has been a result of years if not decades of optimising their business through a Darwinian process to be the optimal commercial structure for the current environment. This optimisation usually runs deeply throughout the organisation, from who the directors are on the board, the background and skills of the senior management team, the assets the business has invested in, the business model employed and the capital structure of the company. This hyper specialisation tends to result in a fragility or vulnerability to any change in the environment which structural change and disruptive innovation bring.
A whole article without mentioning either Europe or Greece! Whilst these remain the macro factors that drive short term volatility in the market we thought that investors may get more informed advice on how to practically use analysis of Greek elections in their investment decisions from other sources. The reality is not a great deal has changed in addressing the structural problems in the global economy, and my guess is that when I put pen to paper next month we will still be in the same position.
More practically, we think that there remains risk to earnings in a number of stocks and sectors and with many small company balance sheets remaining stretched (and investment bankers looking for something to do) we may see an increase in the number of equity recapitalisations in the second half of the year. Given the starting point for share prices as at June 30, we view both of these events as great potential opportunities to make investments for the next three to five years.
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