It is a popular sport around the traps of the Australian share market to tear down popular growth stocks trading on high Price Earnings (PE) multiples. But as I like to repeat, time and time again, Price-Earnings multiples are misunderstood by most investors and equally so by most analysts and market observers.
Any PE without additional data and insights about share prices and earnings growth past, present and future is misleading under the best of circumstances, and simply useless in all other scenarios. A low PE does not automatically imply a given stock is low risk or great value, just like a high PE does not equal a given stock is "expensive", or high risk, or suitable for short term momentum trading only.
It remains true that investors can fall in love too deeply with a stand-out performer, and as a result the share price can rise for way too long, and way too high, until that moment of reckoning arrives.
But it is also my observation such "Icarus" stories attract far too much attention. Think Domino's Pizza between late August last year and early September. Excessive coverage of "fallen angels" deter investors, professional fund managers included, from owning solidly performing, high quality growth stocks such as Cochlear (COH), ResMed (RMD), Treasury Wines (TWE), Altium (ALU) and WiseTech Global (WTC).
The fact that many of the stocks I have identified as "All-Weather Performers" trade on above market PE multiples, yet the fact they outperform the broader market in most years, including the lower PE stocks over mid to longer term horizons, is a regularly occurring observation that cannot be reconciled with how most experts talk about investing in the share market.
And so it is that I often marvel at the sheer simplicity, and the blatant absence of much intelligence, when journalists, commentators and analysts alike are launching yet another attack to tear down high PE stocks, as if High PE is one universal label that fits all stocks that are trading on, at face value, elevated multiples.
This time last year the ruling mantra in the share market was "sell High PE stocks", and thus NextDC (NXT) shares were abandoned alongside Aristocrat Leisure (ALL), Domino's Pizza, Cochlear, CSL (CSL), Corporate Travel (CTD), Transurban (TCL), Goodman Group (GMG), REA Group (REA), and many others.
Yet, today, with the notable exception of Domino's Pizza, most of these stocks are trading at much higher levels (most have paid at least two dividends in the meantime too). Transurban is not, but despite the natural headwinds of rising bond yields, it is not that far off from last year's share price.
I am willing to bet more losses are being generated each year by investors trying to scoop up cheap looking stocks like Telstra (TLS), Vocus (VOC), TPG Telecom (TPM), iSentia (ISD), Mayne Pharma (MYX), Brambles (BXB) and the likes, rather than through adding High PE champions to their portfolio that would have brought along significant outperformance, not just over the past year, even including Domino's Pizza and Ramsay Health Care (RHC); both had one bad year among many more fortuitous ones.
I have yet to see the first research report that genuinely sings the praises of the High PE stocks mentioned above, which is not a small feat considering I have been reading analyst research in Australia for more than seventeen years now. Also consider that many of those stocks are among the top performers in the local share market post 2010.
The investment strategy team at Credit Suisse is the latest to issue research not in favour of owning High PE stocks, in this report named as "market darlings". When to dance with a darling? asks the report. The answer is pretty straightforward: you own a market darling before the stock becomes a darling.
Easier said than done, of course. We'd all like to go back in time and, with the knowledge we have today, buy as many shares in Aristocrat Leisure, CSL, Cochlear, et cetera as we can lay our hands on. It goes without saying investment returns are greatest during the process of expanding PE multiples.
But from here onwards, the Credit Suisse strategists reveal their inherent bias. Once a stock becomes a market darling, relative outperformance against the broader market becomes a lot smaller. According to the research conducted, we're now talking about a mere 1% per annum above the market's return.
Hence their conclusion is: there is no need anymore to own market darlings once they officially are a darling.
I disagree. And I have some clout in this discussion since the portfolio I run owns shares in CSL, REA Group, Aristocrat Leisure, and the likes. Nobody would deny any of these names the status of "market darling", and neither would they have twelve months ago, or the year before, or the year before that year.
Yet, as anyone can see once they start lining up the hard data/evidence, in most years these stocks beat total market return, and often by quite a margin too. And that's not even taking into account that research done, as in the case of Credit Suisse's, uses passive data (like all calculations rum from January 1st till December 31st) while investors can adapt to a more flexible approach, like selling shares when PEs run out of oxygen and buy a lot more when share prices fall and bottom out.
REA Group shares are an ideal example. After last year's FY16 result, the shares fell from circa $62 to $50, yet this week they are trading above $73. Forget about the dividends for now, shareholders who held on at last year's peak, are today enjoying a gain of more than 17.5% (what do you mean a slight beat of the broader market only?). That instantaneously improves significantly when new shares were added near the $50 level, nearly -40% below today's share price.
It's not a one-off either. In 2015 the shares fell from $49 to below $39. In 2014 they fell from above $49 to $43.
Admittedly, the gains are a lot higher when darlings are in the process of becoming a darling and PE multiples are steadily increasing. On Credit Suisse's numbers, the average outperformance achieved is some 23% above the market's return. The problem is, of course, that in most cases it's a lot easier to identify market darlings in hindsight than it is before or during the process.
The strategists have nevertheless compiled a list of stocks they believe could become tomorrow's darlings. Tomorrow's potential glamour stocks all have large profit margins, little, if any, debt on the balance sheet, while enjoying solid sales and earnings growth momentum.
Candidates put forward are Computershare (CPU), EclipX (ECX), Macquarie Group (MQG), Qantas (QAN) and Webjet (WEB).
Credit Suisse has made the effort to identify today's market darlings, with the underlying suggestion that these stocks should from now onwards be best avoided. These are:
-a2 Milk (A2M) -Cochlear (COH) -ASX (ASX) -Corporate Travel (CTD) -InvoCare (IVC) -REA Group (REA) -Steadfast (SDF) -Costa Group (CGC) -Altium (ALU) -Aristocrat Leisure (ALL)
The analysts are supported in their belief by the observation that a similar list of market darlings from two years ago, has seen the majority perform disappointingly since. Market darlings in October 2015, since dominated by fallen angels, were:
-Transurban (TCL) -Sydney Airport (SYD) -Blackmores (BKL) -DUET (DUE) -TechnologyOne (TNE) -Domino's Pizza (DMP) -Aristocrat Leisure -APA Group (APA) -Westfield Corp (WFD) -Cochlear
The obvious observation here is that most of the nominees two years ago were beneficiaries from monetary stimulus and falling bond yields, a theme that has since reversed, at least in underlying trend terms. Take out those examples, and all of TechnologyOne, Aristocrat Leisure and Cochlear still managed to significantly outperform the broader market.
Thus while Credit Suisse's observation stands tall, in that returns are much higher during the process of becoming a market darling, my own experience and the three examples from the October 2015 selection equally prove one should not categorically avoid high PE market darlings simply because the better returns belong to the past.
Time to zoom in on the characteristics required to become a future glamour stock. According to Credit Suisse, the following three items are stand-out requirements:
1. Future market darlings enjoy large profit margins. Two-thirds have EBITDA margins of more than 20%. A third has margins of more than 40%;
2. Future market darlings have strong balance sheets. More than a fifth are in a net-cash position. While almost half have net-debt to EBITDA of less than 1x;
3. Future market darlings already enjoy solid profits momentum. They are often stocks past their infancy stage and enjoying the steep part of their development curve.
In summary: future market darlings are stocks that are listed on the equity market, but do not need the equity market. They already generate plenty of cash via their large profit margins and can tap creditors if need to.
In addition to the five names mentioned earlier, and clearly Credit Suisse has shown its preference by putting those forward in a small selection, the following candidates have been put forward for potential future market darling inclusion:
-Tassal (TGR) -oOh!media (OML) -Iluka Resources (ILU) -Adelaide Brighton (ABC) -James Hardie (JHX) -Carsales (CAR) -ALS ltd (ALQ) -ARB Corp (ARB) -ResMed
-Janus Henderson (JHG) -Mirvac Group (MGR) -Perpetual (PPT) -GPT Group (GPT) -BT Investment Management (BTT) -Goodman Group (GMG)
All this just goes to show how important are one's interpretation and definition of a widely used concept like "market darlings". Personally, I'd consider stocks like Carsales, ARB and ResMed already as part of the glamour stock community in Australia. These stocks already trade on above market PEs, and they have been for an extended period of time.
One clear deterrent for stocks to become a high PE market darling, in my view, is there cannot be any lingering questions about the outlook for the stock or the sector in which it operates. Given this I am surprised to see inclusions like Mirvac, Iluka and GPT. But we all have to be open minded about these things, so I'll happily review all of this in one or two year's time, and see where we're at then.
By Rudi Filapek-Vandyck, Editor FNArena. Try our service with a 14 days no costs, no obligation trial at (VIEW LINK)
FNArena is a supplier of financial, business and economic news, analysis and data services.
Actually there is a ton of research on the performance of high PE stocks versus low PE stocks... its all there just look. Additionally as a provider of stock analysis it would be very easy to do some objective PE performance comparisons rather than provide defensive retort to a competitor.
Brilliant article Rudi. I agree that PE is completely misunderstood in terms of risk profile and too often viewed without context. Long term quant studies do show outperformance of low PE stocks, but this also shows Value (or Low PE) to be a high risk cyclical characteristic. Stocks that are cheap tend to be that way because earnings are unreliable or high risk. Low PE tends to outperform in a high growth, high inflation environment and underperform during periods of market weakness or low growth, low inflationary environments. Coincidentally, the studies showing outperformance of Value tend to focus on data since about the 1930s - a period of predominantly high growth high inflation. We see that Value as a factor has underperformed over more than a decade. Quality (which will be correlated with high PE, but will actually be more based on high profitability etc) has shown to be a more resilient performance factor. So any analysis of PE needs significant consideration of the context of the numbers. Any isolated example of a market darling subsequently collapsing is far from evidence to avoid market darlings.
Imagine 2 stocks one on a PE of 30 growing at 15% per year and the other on a PE of 15 growing at 5% a year. Then 3 years go by and then remain on the same profit growth and the same PE. One went up 45% and one went up 15%. Which was which and that's an argument for high PE stocks. ie If they can hold their PE they will outperform.