Bad Pizza: Why “Value” matters to ALL investors, not just “value investors”

Chad Slater

Ellerston Capital

It’s reporting season, and everyone is now busy, but I wanted to post a quick article on something that grabbed our attention this week when we saw the contrast of two stocks.

We’ve owned NetEase, one of China’s largest computing gaming companies (listed in the USA,) which most Australians I’d guess have never heard of, but it’s market capitalization ($50bn AUD) if it was listed here would make it Australia’s 8th largest company. Larger than Wesfarmers and not much smaller than Telstra! Another reason why Australians should cast their net wider than local shores.

But this wire isn’t about the NetEase business model; it’s about why “value” is so important, even when you are investing in growing businesses.

Below is a chart that has three lines on it: The white line is the earnings per share. It’s been a phenomenal success with earnings tripling over the last three years as Chinese (and Korean and Japanese) youth download their games onto their iPhone and Android phones and they challenge market leader Tencent.

Benjamin Graham and then Warren Buffett famously said: “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” What he meant was that markets move to price information in the medium term correctly. And if you look at the green line, it has followed the white line from bottom left to top right. The “voting machine” is the blue line – this is the P/E that investors were willing to pay over the last three years. As can be seen, it gyrates widely as they swing between bearishness and bullishness, euphorically wanting to pay 18x at some points only to worry and de-rate the stock to 12x earnings at times. But, ultimately, it weighed correctly.

So how does this relate to value Investing?

Note the range of the P/E: 12-18x. While large, it has gyrated in this range, and it’s earnings that have driven most of the returns for investors.

Now let’s look at a controversial stock in Australia: Domino’s Pizza. Another amazing success story from an earnings and shareholder perspective: earnings went from 60c to $1.65, so almost up 3x. But the big difference here was the P/E went from a low of 18x to 55x! Investors were playing “pass the parcel” of paying more and more for each dollar of earnings. 

So management will be sitting there wondering what they have done when all they have done is deliver strong earnings growth.

But the key takeaway I’d want readers to acknowledge is that always be aware of just how much the P/E is re-rating with the growth when they own shares in a stock. By using even loose value metrics (most value investors would consider 18x far too expensive), and combining that with growing earnings in good businesses, investors should be able to avoid some of the more nasty outcomes like Dominos over the last six months.

We had a small short position on the stock ahead of the result and closed it out when the stock had fallen 9% yesterday. The worrying thing for investors is that while the P/E has normalised a lot, it still hasn’t reached the low end of its own trading range and more importantly earnings have been downgraded for the first time in over three years. Tread carefully would be my advice.

Chad Slater is joint Chief Investment Officer of the Morphic Global Opportunities Fund for high net worth, retail and institutional investors. For more information, please visit our website

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1 stock mentioned

Chad Slater
Co Head Global Equities (ex-Asia)
Ellerston Capital

Chad co-founded Morphic Asset Management in 2012. As a stock picker Chad is also a generalist but has strong regional knowledge of Europe and the Americas. He has also been awarded the CFA Charter.

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