Rudi's View | Aug 16 2017
In this week's Weekly Insights:
-How To Invest In All-Weather Stocks?
-Shorter Format During Reporting Season
-Rudi On BoardRoomRadio
-2016 - L'Année Extraordinaire
-All-Weather Model Portfolio
-Rudi On TV
-Rudi On Tour
How To Invest In All-Weather Stocks?
By Rudi Filapek-Vandyck, Editor FNArena
It has taken this long, nine years since the 2008 GFC bear market, but investors nowadays are starting to address me with the moniker (or hashtag) "allweatherman".
This is excellent news given the concept of "All-Weather Performers" has been a dominant feature in two eBooklets I published in early 2013 and late 2014 respectively, as well as in the subsequent two books "Change. Investing in a Low Growth World" (2015) and "Who's Afraid of the Big Bad Bear" (2016).
All four publications are still included in paid subscriptions (6 or 12 months) to FNArena. Plus, of course, I wrote I don't know how many updates on the theme throughout the period; stories that remain available on the dedicated section of the FNArena website.
There is one constant factor that bothers many an investor, including loyal subscribers and readers here at FNArena, and that is the fact that my selection of All-Weather Performers in the Australian share market tends to trade on what seem to be elevated valuations. Hence the ever recurring question is: how does one invest in All-Weather stocks?
Below is my attempt to provide a comprehensive answer to the ever present dilemma.
First up, not a day goes by without me witnessing with a bleeding heart how talking heads on TV rattle off Price-Earnings (PE) ratios for stocks as if these numbers distinguish the good from the bad, the silly from the obvious, the "cheap" from the "expensive" stocks. This is by no means the case, certainly not in the way these numbers are being quoted by most market commentators.
When using PE ratios as a tool, it is imperative to understand that both earnings projections and the share price are fundamental to the calculation of the PE ratio, which is derived from dividing the share price by projected earnings per share next year or the year thereafter. Hence the outcome is a multiple like 14x or 32x or 8x.
Because both factors exert a dramatic influence on the calculated outcome, a falling share price in combination with lowered expectations does not automatically make a given share price "cheaper", even though the share price weakens. And vice versa for an upward moving price on the back of rising expectations.
It also means that when BHP's share price tanked to below $13 last year, the PE ratio had risen to 100x on Macquarie's forecasts, and to circa 65x on most other analysts' profit projections. Hold this thought for a moment, because this is key to what I am about to explain.
Most commentators use PE ratios in the same manner as builders use meters or grocers use kilograms. A 100 meter high building is "huge", a two meter high construction is merely "small". An object of 0.5kg is "light", but make it 25kg and it becomes "heavy". We all understand those base principles, but does this equally mean that a PE of, say, 6x automatically implies a given stock is "cheap" whereas a number of "100x" (see BHP) means we're talking extremely expensive?
Intuitively, you already know the answer. BHP shares briefly traded below $13 during the early 2016 market sell-off but they have recovered nearly 100% since. Hence the PE of 65x or 100x at that time was not indicating that BHP shares were expensive, to the contrary; BHP shares at that level were extremely cheap instead.
Confusing, isn't it?
It becomes a whole lot less so once one starts using PE ratios within their context of: what comes next? PE ratios should never be used as a static tool. They also should never be used backward looking. BHP's high PE ratio from early 2016 has since fallen to circa 15x. Guess what? The share price more than doubled, before retreating somewhat to where the shares are trading at today.
Had the share price remained at say, $15, the PE ratio would have fallen to a ridiculously low 11x. But are BHP shares at 15x cheap or expensive?
It all depends on what likely follows next.
Current market consensus has it BHP's EPS outlook is for a decline by -9.7% by June 30, 2018. This implies the real PE is not 15x but merely 17.3x. Now consider the share market's FY18 average PE is circa 15.7x. If we exclude financials and REITs that average rises to 17.5x.
It appears BHP's PE is smack bang in line with the underlying market average. Since valuation doesn't leave much room for opportunity, it is likely the outlook for the shares are now closely entangled with the direction of commodities prices and thus analysts' forecasts.
BHP will never be included in my selection of All-Weather Performers. The Big Australian is variously labeled "high quality", but the reasons behind the accolade have little to do with the company's inability to control prices for its products, and thus there often is little consistency in the company's performance.
Consider BHP's reported profits over the past three years: down -86%, then further down -36%, now this year probably up by more than five fold, but next year EPS is projected to retreat by -9.5%.
Compare this to one of the most consistent performers on the ASX, IT services provider TechnologyOne ((TNE)), whose annual gowth pace has been in double digits (10%+) every single year since 2004. Company management is yet to discover a valid reason as to why this track record will not remain unblemished in the years ahead. All analysts who cover the stock agree.
This is where things get genuinely interesting. How much does one pay for an automobile that never breaks down? For a pair of jeans that keeps its colour for ever and ever? For a piece of jewellery of the highest clarity that never loses its shine? It's difficult to exactly pin down how high/low the price for each should be, but one thing cannot be denied: one should pay more for these products than for comparables who do not last or carry serious flaws and inconsistencies.
Funny how people accept that a genuine Gucci costs more than your average blouse, or that a Mercedes Benz carries a higher price tag than your average vehicle, or that Ronaldo is one of the highest valued athletes on the planet, yet in the share market cheap trash is meant to be attractive, high quality consistency is not.
Standing in front of an audience of retail investors in Australia, I can ask every time: who owns bank shares and the whole room will show raised hands. Or BHP shares. But if I ask who owns CSL only a few hands will be raised. Yet, since December 2013 BHP shares have generated a negative return of -38% (up until June 30), ex-dividends but that's more like a bandaid for those who consider themselves long term, buy-and-hold investors.
Not that banks have genuinely performed either. National Australia Bank ((NAB)) shares are down -15% over the period, ANZ Bank ((ANZ)) shares are down -11%, Westpac ((WBC)) is down -5.7% and -finally- sector outperformer CommBank ((CBA)) achieved a grand gain of 6.5% over the 42 months until June 30th, 2017; not per annum, for the whole period.
Admittedly, these numbers improve considerably when we add in the dividends and franking that shareholders have received over the 3.5 years. But here's the rub: CSL shares, constantly deemed "too expensive", gained more than 100% over the same period, ex dividends. The aforementioned TechnologyOne shares appreciated by some 150% over the period, ex dividends and franking.
The point I am trying to make is that if shares for the likes of CSL and TechnologyOne are too expensive for investors to buy, but the others, while more attractively priced, generate a considerably lower return, then surely something is wrong with how investors make their assessment about which stocks are cheap and attractive, and which ones are expensive and unattractive?