High PE stocks – should we avoid them?

James Gerrish

We talked about high PE stocks this morning with the view to being very cautious around that part of the market. That said, there were still a number of them that are on our radar and indeed a few that we currently own. There’s no sugar coating it, this part of the market has been smacked in the last 6 months with the return of the companies listed below being -38% during that period. The average PE for these stocks is 43x forward which compares to the ASX 200 in aggregate which sits on around 15.5x forward.

Not all high PE stocks are the same, though, and the basis for the high PE should be understood. For instance, Ramsay Healthcare (RHC) is a high PE stock, but they’ve got a long history of not only growth but predictability/certainty of earnings. Aconex (ACX) on the other hand, has a great product which they are monetising, and there is little doubt that they will do well over time, however as with any newer company that is priced for unabated strong growth, hiccups can happen, and there is very little certainty in their earnings. Altium (ALU) is a similar sort of story. QBE is a different beast, but still on a high PE. They have many external factors impacting their earnings, and the market is now seeing those factors turn in QBE’s favour. Hence, the share price gets bid up well ahead of an actual change in earnings – if the external conditions change or earnings fail to materialise, then the stock gets re-rated back down.

Resource companies are a similar story, the time to buy them is when they are on very high PE’s and the time to sell them is when they are on very low PEs. That might sound strange but the external environment that drives future earnings will turn a lot quicker than the actual earnings themselves – and share prices are all about the future. Once the economics become obvious in earnings/dividends etc. then new production has probably started, and commodity prices are likely nearing a peak. So, looking at PE’s and using them as a guide is one thing, but having an understanding of underlying earnings that supports (or doesn’t) the ‘E’ of the equation is very important. We’re not against buying high PE stocks; it just means if they falter, then drops are very BIG as we’ve been witnessing lately.

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Prices as at 31/1/2017 – Source Reuters

Fortescue Metals (FMG) approached $7 today but pulled back in the afternoon following very strong production numbers yesterday. No doubt this has been a corker running up from sub $1.50 - and we owned it for a period from those levels, but even when you listen to Nev Power, FMG’s exceptionally good/impressive CEO, he thinks Iron Ore should be between US$40-60 /tonne – not above ~US$80 as it is now. The earnings momentum in this business now is very strong, and because of that it’s hard to stand in front of it, however, keep FMG in mind when considering our discussion about high PE stocks, and our reference to resources. A double top is bearish. We simply can’t be involved at these prices

Fortescue Metals (FMG) Daily Chart

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Elsewhere, Oz Forex (OFX) copped a battering today dropping ~24% on another downgrade, and they also appointed a new CEO. Clearly, this business has many headwinds, and it will take a long time for it to get back on it’s feet. Importantly, though, the business model is not broken, and there will be a level that OFX represents value. One to keep on the radar after a very tough few years.

OFX Group (OFX) Daily Chart

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James Gerrish

James is a Portfolio Manager within Shaw and Partners heading up a team that manages direct equity and option portfolios. He is also the Primary Contributor to Market Matters, a daily investment report that offers real market insight.

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