Rudi’s View: Forecasts, Not Valuations

Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Jul 23 2020

Dear time-poor investor: are share markets egregiously overvalued? Is Biden as President a problem? Can Telstra create value through structural separation?

In this week's Weekly Insights:

-Forecasts, Not Valuations
-Is Biden A problem?
-Telstra, There Is Another Way
-FNArena Talks

Forecasts, Not Valuations

By Rudi Filapek-Vandyck, Editor FNArena

Once again it has become a popular opinion that share markets are pricing in too much exuberance in light of what the economic recovery story can possibly deliver.

One way to illustrate this year’s euphoria-gripped markets is by measuring the average Price-Earnings (PE) ratio and concluding this year’s swift recovery is off the charts, with PE ratios higher than at any other time in history, beating 1929, 1987, 2000 and 2007.

But is this really the most accurate measure available? Is it even appropriate to guide our views about the status and prospects for equities today?

I beg to differ.

Apples Versus Oranges

Let’s start with the most obvious observation: comparing today’s index valuation with history is not comparing apples with apples.

Indices change because their composition changes. Back in 1987, the two most important constituents of the ASX200 today -CSL ((CSL)) and CommBank ((CBA))- weren’t even listed yet.

In fact, there was no ASX200. All we can compare with is the All Ordinaries, and that index looked a lot different from its successors today.

Back in 2000 the most important index movers were two listed shares in News Corp. By late 2007, resources were trending towards peak index weight.

In 2020, the largest index constituent is CSL and it always trades at a premium versus the broader market. In-depth analysis by UBS earlier in the year established that having CSL as the top index weight in Australia adds around 100 basis points to the average PE for the ASX200.

News Corp doesn’t even feature anymore.

In the slipstream of CSL moving to top spot in Australia, we have numerous index climbers that have grown in index weight over the past one or two decades, and they all trade on much higher multiples than the stocks they replaced.

Think of Macquarie Group ((MQG)), Aristocrat Leisure ((ALL)), Fisher & Paykel Healthcare ((FPH)), REA Group ((REA)), ResMed ((RMD)), and Cochlear ((COH)) instead of Westfield, Mayne Nickless, Pacific Dunlop, Harvey Norman, and AMP.

And that’s not even mentioning the new business models that have risen to the challenge, and to investor’s attention, over the past five years or so. In 2020, all of Afterpay ((APT)), a2 Milk ((A2M)), Magellan Financial ((MFG)), and Xero ((XRO)) are on par, or even weightier, than household blue chip names such as QBE Insurance ((QBE)), Suncorp Group ((SUN)), Origin Energy ((ORG)), and Lendlease Group ((LLC)).

One does not necessarily have to agree with the valuations of these new kids on the block, but simply an acknowledgment that indices have changed significantly renders that simplistic comparison on the basis of a simple average PE calculation invalid.

PE Methodology Misunderstood

Societies are going through transformational changes; they happen fast and remain irreversible. Today’s ASX200 index is as much a reflection of this transformation taking place as it is of the extreme polarisation that is occurring as a result of these changes.

When the average share market PE is the result of combining Afterpay, trading on an unknown multiple because the company is not profitable, with Unibail-Rodamco-Westfield, Scentre Group and Janus Henderson, all trading on single digit PE multiples, surely one must question the practicality of using one all-encompassing, generic average for the market as a whole?

Even then, it seems to me many investors don’t appear to understand the essence of how Price-Earnings (PE) ratios work.

To put it simply: back in all of 1929, 1987, 2000 and 2007 share markets were priced on high PEs based on peak forecasts, which subsequently turns into a nasty problem when those forecasts fall and PEs need to reset at a more appropriate, risk-adjusted level.

In 2020, forecasts have fallen deeply since the global pandemic hit. Most economists and other forecasters, be they bullish or cautious, expect a recovery to emerge.

We can still debate the strength and exact duration, even the shape of the recovery, but not the fact that looking forward to a recovery from a trough in the economic cycle automatically translates into high PE ratios.

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