Appreciating the mighty all-weathers
One of the most persistent errors made by investors, on my observation, is a too stringent application of the 'Buy Low, Sell High' principle, usually translated as: only buy stocks that are trading on a below-average valuation and don't hold on to them once the PE ratio is much higher.
It has been one of my long-standing favourite market observations: contrary to popular share market folklore, a stock with an above average valuation does not by definition become a Sell, and neither is the opportunity gone for a great investment return over many years into the future.
Recently I was again reminded by these facts by an excellent piece of research (see further below) involving ResMed's (RMD) return over the past ten years. As most of you would be well aware, ResMed has been identified as an All-Weather Stock through my own research and the shares are firmly held by the All-Weather Model Portfolio.
This week ResMed entered the ASX50, but preceding this milestone has been a return of no less than 1262% over the past decade. Even for a long standing close observer like myself, that is quite the eye-catching number. Unfortunately, the All-Weather Portfolio is only in its seventh year running, so not all of these returns have been captured, but then again, I don't see this success story coming to an end anytime soon either.
What mostly happens when such a piece of research has been published, is that your typical value-oriented stock picker or share market analyst tries to relegate the share price achievement to the past. One of the obvious ways to do so is by pointing out that back in 2011, this stock was trading on a PE of around 25x while today the forward looking PE is around 46x. Hence, the underlying suggestion then becomes: Sell, there no longer is further opportunity for PE expansion.
While this PE-expansion assessment might be correct, it is but one factor that has contributed to the extraordinary return since 2011, and it by no means prevents this company from achieving many more rewards for loyal shareholders. I also think investors are missing the bigger picture by only comparing the PEs of today and 2011.
A more correct assessment, I believe, is by comparing ResMed's valuation in 2011 with the broader market, which back then was trading on an average PE of below 15x. In other words: ResMed shares ten years ago were valued at a substantial premium versus most other ASX-listed stocks.
When asked the same question ten years ago, today's value-oriented nay-sayers would not have recommended ResMed shares as an excellent Buy-opportunity. Because at such a market premium, the shares did not look "cheap".
Yet, over the following ten years the return from those seemingly "overpriced" shares has been nothing but phenomenal. I haven't done the numbers, but I don't think any of the "cheaply" priced alternatives back then has managed to generate anything remotely close to the reward that has befallen loyal ResMed shareholders over the period.
As a matter of fact, when I think of those stocks that have equally generated outsized returns over the period, the same basic characteristics apply as ResMed's; think CSL (CSL) and Cochlear (COH), REA Group (REA), Seek (SEK) and Carsales (CAR), but also ARB Corp (ARB), Ansell (ANN) and TechnologyOne (TNE).
In contrast, last week I was dragged into a discussion on social media about the merits, or otherwise, of the proposed merger between BHP Petroleum and Woodside Petroleum (WPL). I think Woodside desperately needs this deal. As I looked up the share price, I noticed it is at the same price level as it was back in 2004 - 17 long years ago.
Throughout most of that period, in particular post-2011, Woodside shares have mostly looked "cheap" and "great value", also offering an outsized dividend yield, but that has not generated much in terms of sustainable returns for shareholders (luckily they do pay a dividend).
Certainly, there have been rallies, and at times Woodside looked in a sweet spot, temporarily, but it'll only take a few more years for its shareholders to look back and conclude history doesn't consist of just one, but of two lost decades. So much for the "cheaper" entry!
I am certain all of us can add many more (apparently) cheaply priced examples: AMP (AMP), QBE Insurance (QBE), Humm Group (HUM), Slater & Gordon (SGH), and many, many more. Sure, at some stage they'll have a rally and outperform ResMed and the likes, but great long-term investments they have not been, and why would they be in the future?
The answer does not lay in the low or high PE ratio.
When investing in the share market, investors have roughly two main types of risk to deal with: the risk of overpaying for exposure -your typical share price risk- and the risk not all is well with the company, or that management cannot fulfill its plans and ambition and falls short of expectations; the operational risk.
The first type of risk is usually settled through generalised numbers -PE, dividend yield, relative discount/premium, etc- while the second type is much more difficult to assess and to establish, which is why most financial commentary and analysis focuses on the first part. Much easier. And it works.
If it really were the superior method to uncover opportunities and avoid value-traps, wouldn't we all have owned ResMed shares over the past decade (as well as the other All-Weathers) instead of getting caught into the next downdraught at Myer (MYR), Mesoblast (MSB) or The Reject Shop (TRS)?
I do know it's not quite that simple. Not every market participant has the same horizon or objectives, but the message remains the same: instead of ignoring the second risk and predominantly taking guidance from the first assessment, I am advocating long-term investors should practice the exact opposite: start with the second assessment and relegate the first risk to a secondary consideration, at most.
If we start with the companies -and by extension: the sector- behind the numbers and the share price, we soon discover some invaluable insights, such as:
-Some companies (and sectors) have a multi-year growth path ahead of them that is relatively predictable;
-Some companies (and sectors) can grow virtually independently from the economic cycle;
-True market leaders hold the lead in new products, innovation and developments;
-True market leaders can expand their local dominance well beyond Australia's borders;
-Sustainable success requires constant investing, both in the business as well as into new products, markets, geographies, etc
-Quality corporate culture cannot be measured, but you'll recognise it when you see it;
-Quality companies don't need to be convinced about ESG or better practices (they score highly already);
-Great management has a relatively easy job at hand when at the helm of a quality market leader in a sustainably growing industry
The most important take-away is, however, that once the market sniffs out that a company such as ResMed has all of the above characteristics, plus some, it will price its stock accordingly. So no need to wait until the PE ratio is below 15x or something similar; that simply will never ever happen, unless the company's story starts to unravel.
Judging from the latest indications, including the company's investor day last week, investors are wasting their time if their strategy is to position for the end of the ResMed growth story. If anything, most analysts returned from the investor day with the impression the company might yet again surprise on the upside next year, as major competitor Philips is struggling with a product recall.
Underlying, however, the ResMed growth story is much more powerful. It is about management correctly anticipating future trends and direction and thus investing in innovation and product expansions that not only solidify the global leadership, but also set up the company for larger market share, a closer relationship with patients and care providers, and possibly a technological moat around its leadership.
See, the odd thing that happens in our human brain is that from the moment we realise what's going on inside this high quality business, and how truly exciting the future might be, we feel excitement flowing through our veins and the urge to become part of it. If only ResMed shares were not publicly listed; we would stand hours in a queue to invest in it!
The best way to invest in a stock like ResMed is by using market volatility to your own advantage, while taking a multi-year view and realising that a "cheap" valuation is something of a short-term nature. Imagine, you'd be struggling with the same dilemma in 2011. Shall I buy around $6? Or $5.50 maybe? Maybe I get another chance below $5?
Ten years later the shares are changing hands above $40.
The focus of my own research and analysis is on the ASX and this means I am fishing in a relatively small pond. Australia doesn't have many companies of the quality and caliber of ResMed, which, strictly taken, has become more of a US enterprise with its official headquarters now in San Diego, California but still ASX-listed.
As a direct result of the limited selection in comparable All-Weathers, I tend to be quite sanguine about the valuation and entry-price to obtain exposure to such high-quality performers. One of my favourite quips is: if one pays too much for an All-Weather, one might have to wait six months or so to get in the black, but if we do the same for a low quality cyclical, we might have to wait forever and a day!
Last week, I had the pleasure of attending an online presentation by funds manager Claremont Global and while the team over there doesn't use the same vocabulary, their methodology and approach shouts "All-Weathers" from the left to the right and again from the bottom to the top, and back.
The key difference here is, Claremont has a global focus and thus the team can be more stringent and choosy when it comes to valuations and entry-points, for the simple fact there are so many more options to analyse and to consider. But, underlying, the similarities are striking; no mining, no oil&gas, no banks, no insurers, no heavily government regulated industries; and nothing that cannot be forecast with a fair degree of certainty.
Claremont only owns a maximum of 15 companies at any given time. Its preferred entry point is -20% below intrinsic valuation and the stock is usually sold above 20% over-valuation. The aim is to outperform its international benchmark by 2-4% per annum and Claremont has done exactly that by owning the likes of Nike, Microsoft, Alphabet, Aon, Lowes, Automatic Data Processing, Agilent Technologies, Diageo, Ross Stores and Sherwin-Williams.
Viewed through an Australian lens, one can see the equivalents of Bunnings (WES), DuluxGroup (alas, no longer ASX-listed), Steadfast Group (SDF), Nanosonics (NAN), and others.
In the words of portfolio manager Bob Desmond, all companies that will grow faster than the market average in the years ahead and that allow investors to sleep comfortably during a market downturn. I am less certain whether any of these companies are high on the list of managers and investors who focus solely on 'valuation' and 'cheap' PEs.
I discovered the Claremont website offers some interesting views and topics, not only explaining why certain stocks are held, but also, for example, to answer a question like: why would you sell a great business in order to buy a mediocre alternative?
Claremont Global was spun out of Evans & Partners.
The research mentioned earlier in the opening sentences of my story was by TMS Capital's Ben Clark, which, by the way, showed that ResMed's return over the decade past was eclipsed by competitor Fisher & Paykel Healthcare (FPH) having returned no less than 1754% over the period.
Ten years ago, Fisher & Paykel Healthcare shares were trading on a PE below 20x (well above market average). Today, the forward looking multiple on FNArena's consensus forecasts is 50x and 49x for FY22 and FY23 respectively.
FNArena offers truly independent & impartial share market analysis on top of proprietary tools and data for self-managing and self-researching investors. The service can be trialed at (VIEW LINK)
MORE ON Equities
5 stocks mentioned