Rudi’s View: Balancing Between Opportunity & Risks

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 | Jun 30 2022

In this week's Weekly Insights:

-Balancing Between Opportunity & Risks
-Conviction Calls
-FNArena Talks

By Rudi Filapek-Vandyck, Editor FNArena

Balancing Between Opportunity & Risks

If there is one strong universal agreement among investors of all kinds and colours it is that bear markets present opportunity for those who can look beyond short term volatility.

The flipside to this narrative is that when investors buy in too early, they can still suffer heavy capital losses and might then have to be patient for much longer to see their bravery rewarded, assuming they pick a company that will survive the economic downturn and the share price doesn't get obliterated in the meantime.

Probably the most famous anecdote regarding the latter concerns Isaac Newton who, despite his revered intelligence, lost a financial fortune during what is today known as the South Sea Bubble of 1720(*).

But investors don't have to go back that far into history to establish that time does not heal all wounds suffered on the share market. Plenty of sorry tales stem from the Nasdaq meltdown in March 2000. Today many might have forgotten but the second tranche in the privatisation of Telstra ((TLS)) back in 1999 was sold for $7.40 a share to retail shareholders.

More than two decades later and the Telstra share price needs to double to get back to that level, and that's conveniently omitting the fact the shares surged a lot higher at that time. Luckily, the company does pay a hefty dividend, and it has done exactly that over the period since, but a pretty picture or a Grand Return it offers not.

What about the fact that three of the major banks in Australia never managed to return to share price levels achieved pre-2008? Shares in National Australia Bank ((NAB)) traded well above $40 back in 2007. They would have looked an ab-so-lute bargain at $30, but two decades later and $30 is double digits above where the shares are trading.

The message for investors could not be any clearer: don't assume a lower share price by definition means better value, a bargain, or excellent long term returns. This warning in particular applies during a time of major asset valuations resetting on the back of higher inflation, higher bond yields and central bankers winding down extreme policy support.

Some of this month's broker updates are indicating that with changing times comes a much lower valuation for companies that find themselves on the wrong side of the economic cycle.

Last week, UBS prepared for a much tougher outlook for consumer discretionary spending, not just in Australia, but worldwide. UBS's modeling now has a valuation/price target for shares in women's plus size fashion retailer City Chic Collective ((CCX)) of $2 - not that far above the $1.91 the shares are trading at on Monday.

Nine months ago City Chic shares nearly touched $7.

Admittedly, one single broker valuation or assessment is not necessarily the most accurate guide. Consider, for example, Ord Minnett has a valuation of $2.35 for Metcash ((MTS)) whose FY22 financials proved much better-than-expected on Monday. With other brokers carrying valuations between $4.20 and $5 it seems Ord Minnett is simply the odd one out, even more so now that Metcash has outperformed forecasts, fueling expectations its operations are solidly defensive and might continue growing.

Metcash is not the only ASX-listed company that has defied accumulating headwinds and investors' more sombre outlook with the likes of Growthpoint Properties Australia ((GOZ)) and Vicinity Centres ((VCX)) equally beating market scepsis with their trading updates, suggesting maybe, just maybe, investors have been wrong when fearing the depth of the economic downturn that is by now on everbody's mind?

I am afraid such assessment stands in frontal contrast with the trend in economic forecasts which increasingly sees a skew emerging towards much slower growth and possibly economic recessions (negative growth) for all of Europe, the UK and even the USA. Most companies cannot grow at a faster pace than the economy, and even those that can might not prove 100% immune.

True, not all forecasts will prove accurate, and certainly not everyone is on board with the new trend, but these economic shifts are slowly moving events. An operational update today might not necessarily be representative for what happens in six months' time. Meanwhile, the weakest dominoes have started to reveal their vulnerabilities.

Small cap Pro-Pac Packaging ((PPG)) just issued its second profit warning in six weeks. The CFO left seven weeks ago. Always hopeful skin care retailer BWX ((BWX)) announced a sudden capital raising at a heavily dilutive price of 60c (last share price $1.17).

Link Administration ((LNK)) suitor Dye & Durham now wants to pay $4.30 per share instead of the previously indicated $5.50 (last share price $3.85).

It's not like mining companies have been all about good news either. Shares in WA gold producer Dacian Gold ((DCN)) are today lingering around 8c, down from 32c in April (52c in early 2021) as the company's previous guidance for FY22 was shot to pieces because of staffing problems and sharply rising costs. Gold producers are subjected to prices for diesel and gas like so many others.

Shares in St Barbara ((SBM)) equally experienced another dive lower following yet another disappointing market update, as proved the case for Ramelius Resources ((RMS)). Even industry heavy-weight Glencore disappointed with management citing higher input costs from diesel, explosives, logistics and electricity.

One of the big debates that is colouring and dividing the outlook for economies and corporate sectors this year is how much of an impact does the accelerating tightening by central banks have on housing markets, and how much will impact on consumer spending?

Is it too obvious to state that history may not be the most accurate guide this time around?

Maths & Multiples

Stepping aside from the macro-economic enigma, for now, there is one reason why most investors tend to under-appreciate just how damaging this year's re-adjustment process can still turn out to be for risk assets such as listed equities. In simple terms: it's the power of mathematics.

A company generating $11 in earnings per share trading on a multiple of 21x would have been valued at $231 and possibly trading at a premium pre-November.

What happens this year if EPS drops to $10 and the multiple contracts to 15x? All of a sudden that valuation shrinks to $150 - a loss of -35%.

This still assumes the market remains comfortable with the outlook for next year and the year thereafter, as well as with inflation returning inside the targeted 2-3% range.

If the latter proves not to be the case, as is the forecast of a number of renowned economists (Blanchard, Ferguson), then the market's multiple will shrink further, as has always happened during periods of higher inflation. During the 1970s, as some market observers keep pointing out, the average Price Earnings (PE) multiple for share markets in developed economies shrank to single digits.

Former Merrill Lynch alumni David Rosenberg (Rosenberg Research) keeps telling his clientele: for your own sanity, you don't want to put such a low multiple on this year's profits, even without taking into account those profits most likely will be lower next year.

The full story is for FNArena subscribers only. To read the full story plus enjoy a free two-week trial to our service SIGN UP HERE

If you already had your free trial, why not join as a paying subscriber? CLICK HERE