The rhythm of life is no different to the rhythm of economic and corporate cycles. The optimism of birth, the excitement of growing up, the cynicism arising from the compromises that come with maturity, the tumult of unfair turns and the joys of victory, all in turn impacting upon performance. In a company life cycle sense, determining where a company sits in its life cycle, and how that impacts upon both corporate strategy and valuation, are critical judgements made in valuation.
The economic cycle has played a role in how equity markets have behaved through the past year in an obvious way. After the better part of a decade of central bank intervention, the US has led the way in withdrawing stimulus and raising cash rates. For investors, the past decade has perversely seen bonds present capital gain and equities provide income. Equities with income characteristics have been bid to hitherto unseen price to book multiples, far exceeding the prior highs seen until 2008 (and then crushed as credit was rationed through the GFC). The reversal of the direction of bond yields through the past 12 months has seen a change in this dynamic, with a cessation of the outperformance of many bond proxies (especially infrastructure names) and relative underperformance from many yield proxies with earnings risk (especially Telstra and the Banks).
We continue to be underweight bond proxies, seeing many infrastructure and property names as expensive and where value is emerging, such as with Telstra and the Banks, earnings risk is a clear and present danger. Earnings risk in itself won’t deter us from investing where a value case can be made, but we do need to be clear about the magnitude of erosion to existing earnings that we expect in deriving these valuations; for example, we capitalise an ebit for Telstra which is 40% below current levels, and for the major Banks we capitalise earnings approximately 25% below current levels. The economic cycle is clearly entering a new stage of life, and with it the winners and losers of the past decade are starting to unwind.
As bond commissars no longer provided a growth platform for investors, new heroes were needed. Enter the aggressive rerating of the FANG stocks globally, and a bunch of derivatives locally.
The sectoral winner in the ASX through the past year from the search for growth is the Healthcare sector, which is the only sector on the ASX to have materially increased in value through the first quarter.
This is mostly in the form of rerating through multiple expansion, as indeed was the case through most of the past several years. For most of the decade to 2010, Australian and US healthcare stocks traded at similar multiples, but since then the aggressive rerating of the ASX listed healthcare stocks sees them trade at a 60% premium to their US peers. This allure of growth has also seen multiple expansion across the mid to small cap industrial stock spectrum through the past year, with stocks such as HUB24, Afterpay, Altium, A2Milk and Bellamy’s all at least doubling and in some cases increasing in value up to 400%, and in every case being valued between ten and fifty times current revenue.
Unfortunately, with these hits comes some misses as a genre, with stocks like Blackmores, Vocus and Wisetech Global all having a poor quarter after being bid up to high multiples in prior periods. At 17 times earnings, the multiple for industrial stocks on the ASX was higher than it has been at any point since 1990 in the first quarter of 2018, and even with the recent market sell off it is still at levels only seen in a few months through the past thirty years. In contrast, at 11 times earnings Banks are in line with long run multiples, and at 13 times earnings Resources are similarly priced in line with long run average levels.
Different sectors, different rhythms; industrials are the hero the ASX market wants currently.
The truth is that the growth prospects in the Australian market are neither higher nor more dispersed than in the past, suggesting that current levels of multiple dispersion are unwarranted on current operating trends. For context, since 2012 Banks haven’t grown more than 2% in any year, and Industrials haven’t grown by more than 4%. Total market earnings growth hasn’t been above 5% in any of these years, until last year when increases in commodity prices saw Resources drive it much higher.
Consensus is for Industrial stocks to produce close to 8% growth in F19, but we think Dave Warner is more likely to be captain of Australia that year than this number is to be realised. With those downgrades to expectations, from a record high starting point for multiples, will come material deratings, especially among those stocks that have been bid up the most through the past two years as the aggressive rerating of Industrials took most hold.
In the past year, sources of return have been more varied by stock and sector than has been the case for many years. In points contribution to a relatively flat ASX index return, for example, BHP and RIO have been among the best contributors and Fortescue the worst. There are only three thematic drivers we can point to that are material and prone to reversion; Healthcare and mid to small cap industrials with the perception of growth have been bid up to record and we now believe unsustainable multiples, whilst major Banks have been among the worst performers and now represent relatively good value, even in the face of falling earnings.
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Andrew - i might misunderstand, but you have one comment saying you capitalise earnings on banks at 25% below current share prices, yet suggest banks 'now represent relatively good value, even in the face of falling earnings''
Thanks Michael. For every company we value, we determine "sustainable earnings", which is an average level of profit we expect a company to make in the future; this may often be a long way from current earnings. We feel that the Australian banks will earn (approximately 25%) less in the future than they do currently, especially as credit growth slows and credit costs and other regulatory penalties rise. Having said that, the current earnings multiple attaching to the Banks is relatively low, whereas for many ASX companies, and especially growth oriented industrials, multiples are very high. Hence, even as profits fall, it need not be that the Banks are ultimately poor investments, especially from this point relative to other companies listed on the ASX. Put another way; in recent years, multiples have tended to be pro cyclical, that is, as earnings have risen, so have multiples, and vice versa. In the past year; that has started to reverse so that as an investor you may invest in a company which has earnings growing/being upgraded but still underperforms (as Wisetech Global, say, has in the past year) or alternatively a company where earnings are falling/being downgraded but where the share price has outperformed (as Chorus, say, has in the past year). Of course, for most companies, multiples tend to still follow earnings, but there are now exceptions to the rule starting to emerge when multiples get to extremes, and we would expect this to continue apace. Hope this helps. Regards Schroders Australia