From time to time, here on The Value Perspective, we are asked whether we are perhaps being remiss in ignoring the recommendations investment analysts make about particular sectors or stocks. Such a question, however, mischaracterises the esteem in which we hold these fellow investment professionals.
While we admit our opinion of analysts may on occasion verge on the jaundiced, we would never deny they can boast a great deal of specialist industry knowledge. What we aim to do is build on that knowledge by imposing a valuation framework that, all too often, analysts have neglected to factor into their work because they have been too focused on the nitty-gritty of the various businesses.
A good example of this, as it were, failure to see the wood for the trees – or ‘inside view’ as we defined it in Pep talk – came in a piece of research we read recently on Hong Kong’s banking sector. As it enthused about the significant market shares and competitive positions enjoyed by a small number of businesses, it became clear the author knew a great deal about deposit mixes, funding costs and so on.
At the end of this hugely detailed note came – almost as if it were an afterthought – a section on valuation. This included an economic formula, from which emerged a sort of rule of thumb that implies a bank that is earning a 20% return on its equity should trade on at a market capitalisation 2x its book value, a bank earning 30% should trade on 3x, and so on.
It is important to add that, by using a current 20% return to justify a 2x book value multiple, the analyst is implying that this attractive return will continue in perpetuity. Now, while that may be possible in theory, it is flawed in practice because, over the longer term, rational economics tends to win out. In other words, if your potential competitors see your business earning such attractive real returns, then that will encourage them to enter your market – which will eventually lead to the sector’s returns reverting to the mean.
We don’t want to single-out a particular analyst, as this type of thinking is common in the market. The charts below show a real example of this using the characteristics of Hang Seng Bank, dating back to 1997. When returns on equity were over 30%, the bank traded on 4x price-to-book; when returns on equity were in the 20s the bank traded around 2x. Effectively, whether the returns on equity were very high or just high, the market priced-in that the situation would go on forever.
Although book value per share has steadily grown at Hang Seng, the price of the shares (in orange) has swung around wildly, as analysts and investors have mistaken various transient environments for permanent conditions.
This is where we aim to add value at The Value Perspective; we are not experts in each sector but we know how to spot when the market is pricing conditions as permanent but history tells you that they will be transient.
Source: Bloomberg Finance L.P May 2014
Top chart – Green line represents return on equity
Middle chart – White line represents price to book ratio
Bottom chart – Orange line represents share price and white line represents book value per share
The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.