Quality Is Not In A Bubble

Rudi Filapek-Vandyck

What if I told you you have the chance to buy into an investment that generates on average a return of circa 25% per annum, significantly above the market in Australia, while also high returning during periods of share market turmoil; say high single digit when European banks and Greece are in trouble (2011-mid-2012) and mid-teen percentage return between May 2015 and March 2016 when very little seemed to work in equity markets worldwide?

Even back in 2008-2009, when the world came to a dangerous stand still and equities lost half, or more, of their value, there was no loss for shareholders.

You'd probably smile and say "Thank You, I'll take it. What's the catch?"

That is, if you believe me. (Trust me, you can).

Now what if I offered you an alternative, say, an investment that, at best, tracks the index in Australia and that sinks like a stone, along with the broader market, every time uncertainty and turmoil hits? Average return over the past four-five years: not much, mostly paid out in dividends, which compensates for the slight erosion in capital. Would you be equally enthusiastic?

Now you say: No, why would I? (Am I stupid, or what?)

But you see, here is where things get interesting. Because, in real life, you are most likely to choose option number two.

Because option number one is CSL ((CSL)), trading at a significant premium towards most other ASX-listed shares, and most professional investors, commentators and other kinds of share market experts won't stop warning we should all be careful about buying stocks that trade at a premium. We might lose a lot of money.

These warnings are nothing new since CSL's premium has been around for more than two decades, but as everyone can see on a simple price chart going back far, far into the past, these constant warnings are in sharp contrast to what actually transpires in real life, and that is that CSL's share price very rarely pulls back significantly, and every time it does it recovers and then moves onwards to a new high.

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The error most people make is to put all stocks in one basket and then try to distinguish on price. A low Price-Earnings (PE) multiple is "good", because you'd want to purchase at a low price. A high PE multiple thus is "bad" because the asset in case has now become "expensive".

This approach is in contrast to standard practice in just about every other sector that exists in the modern day economy. Does a Lamborghini cost the same as a Skoda? Is a Gucci dress more expensive than clothes bought at Target? Why do Ronaldo and Messi cost so much more than Tim Cahill? You can have a cheap holiday in Bali but you cannot replicate that on Capri.

The reason why stocks like CSL trade on a premium is because, simply put, they are of a higher quality. And the difference in quality shows up through much greater, sustainable rewards for shareholders in the long run.

This, by the way, has always been the case. But amid the hectic news reporting on day to day events and the smorgasbord of conflicting predictions for financial markets, this is not something that easily attracts a lot of attention (if any). However, as far as the past five years are concerned, the outperformance of "quality" over every other segment in the local share market has been brutal, as once again proven by recent data analysis from stockbroker Morgans.

What Morgans' analysis shows is that consistent high growth achievers have outperformed the ASX200 by 13% per annum since April 2013. All the while, investors rummaging around in "cheap" looking stocks are likely licking their wounds today, while those in the middle where growth is not more than average, with stocks trading on average PE multiples, those stocks have generated rather mediocre investment returns, as did the index.

Wait a minute, I hear you thinking, there have been plenty of examples of High PE stocks that have come crashing back to earth, try Domino's Pizza ((DMP)), for example, and Blackmores ((BKL)). True, but the same can be said about stocks trading on much lower multiples. Shareholders in AMP ((AMP)) just lost one quarter in only a few weeks time. Telstra ((TLS)) shares have more than halved since February 2015. Not to mention what happened to the stoic and faithful in IPH ltd ((IPH)), iSentia ((ISD)), Retail Food Group ((RFG)), Myer ((MYR)), or Village Roadshow ((VRL)), to name but a handful out of an excruciatingly long list.

The conclusion here is not that High PE stocks represent higher risk (which is incorrect - see Morgans' research), rather it is that not every High PE stock is equal. Just like some stocks that fall in price can prove an unexpected bargain, while others are a value trap and nothing less.

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So how does one distinguish a High Quality stock that deserves to trade at a premium from others that won't be able to sustain it?

Years of research into this matter have taught me that non-cyclicality plays a major role. A true Aristocrat, or Champion Stock, or All-Weather Performer, whatever name we choose for these companies of exceptional qualities, operates above the vagaries of the typical economic cycle. They are the best in their field, which often acts as a moat around their operations and market share. They also have great management running the company with the added notion it is much easier to successfully run a great business than it is a not so great one.

In the words of Warren Buffett: It is smart to invest in a good company, one that, say, your idiot nephew could run. Because if you have a really good business, it doesn't make a difference.

Great businesses run by quality management display consistency, as well as dependability. You won't see CSL issuing a statement that next year's profits might be -30% below previous guidance. They might have debt on the balance sheet, but never in excessive quantities. You want to see consistency and dependability in action? Open a spreadsheet with CSL's annual sales, profits, margins and dividends over the past two decades.

One key characteristic that is often overlooked is these businesses continue to invest for the future. It is no coincidence CSL is one of the most generous spenders on R&D in the Australian share market. Investments effectively keep the business weather-proof through new product development, new markets, improved practices, higher efficiency, new applications, share buybacks, and the occasional acquisition.

Irrespective, after nearly three decades of strong growth, CSL might find the going a tad tougher if only because it has grown so much in size. In fact, this is one reason as to why some critics are warning there is a Bubble in Quality, with a strong suggestion share prices for companies including CSL are about to repeat the boom-bust experience of Bitcoin and other virtual coins.

Their argument is based upon two observations: firstly, the premium that quality growth stocks are trading at versus the rest of the market has never been this large, plus premium valuations today are also well above long term averages for the individual companies involved. Secondly; growth in many cases, including for CSL, has slowed down a notch which sits at odds with an even higher valuation premium.

What is missing in these Bubble Must Burst predictions is these premium valuations are not simply a multiple of next year's profit per share; there is an unquantifiable part that relates to the consistency in delivery and to the high degree of trust investors can place onto management's guidance, targets, and execution.

Equally important, while absolute growth might be slower today, on a sustainable basis, it is not that difficult to make the argument that on a relative comparison, companies like CSL today actually stand out even more from the pack because an increasing number of lesser quality peers finds consistent growth even harder to achieve than, say, five years ago.

Such is the contemporary environment for many an Australian company in which regulatory scrutiny, tight household budgets, rising bond yields, higher energy prices, a peak in the housing cycle, digital disruption and slowing economic momentum outside the USA are creating more headwinds and operational challenges than otherwise might have been the case.

Investors need not look any further than the latest company reports with all major banks bar Westpac ((WBC)) underwhelming on already reduced expectations (all consensus price targets have fallen post financial results releases), and with share prices facing selling pressure post trading updates and financial results releases from Orica ((ORI)), Incitec Pivot ((IPL)), Nufarm ((NUF)), Eclipx ((ECX)), iSelect ((ISU)), Greencross ((GXL)), Australian Pharmaceutical Industries ((API)), Perpetual ((PPT)), Fleetwood ((FWD)), Village Roadshow ((VRL)), Catapult Group ((CAT)), Gateway Lifestyle ((GTY)), and others.

Management at JB Hi-Fi ((JBH)) recently tried to bury their profit warning for the running year inside a presentation to institutional investors (for which it was suitably embarrassed by the stock exchange). Similar to trying to get away with bad news via releasing it after the market's close on a Friday, this too is something you won't see happening from a true quality company. The same goes for accounting shenanigans (no room for "aggressive accounting").

Incidentally, the one result that proved truly awe-inspiring so far this month came from Macquarie Group ((MQG)) which, you probably guessed it, is also a member of the High Quality few enjoying a premium valuation.

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There is one danger though, and that is that true Champions like CSL and Macquarie stand out too much for too long, which in share market terms means too many participants jump on board while the times are good and momentum is positive. Few ever doubt the quality and merits of an investment when the price is trending upwards.

During a presentation to investors two years ago, I was asked how long before stocks like CSL might fall out of favour? My answer was this is not a matter of time, but of circumstances. Everything needs context. It seems like a distant memory today, but CSL's share price did not perform between 2009 and mid-2012. Apart from some minor company specific issues, and the headwind from a rampant Aussie dollar, those were the years investors focused on the global recovery post the Grand Recession of 2008-2009. Having plenty of choice among beaten down share prices, and with profits surging after heavy falls, there was no need to value consistency, reliability, quality, sustainability or even growth in itself.

Who needs quality when one can make 40% return from beaten down cyclicals?

Another time of heavy investor selling happened in the second half of 2016. Financial markets started pricing out emergency low bond yields, and every fund manager in the country sat overweight defensive growth and Champion stocks. The portfolio switching proved violent and swift, with every stock on a High PE sold down in exchange for "value" among banks and resources stocks.

It didn't last long.

Champion stocks have rallied to new highs and their relative premium versus low growth strugglers (let's call them for what they are) is again near an all-time high. At least, that was the case after the February reporting season during which many a High PE, High Growth company delivered more evidence of why their stock deserved to trade at a significant market premium.

Next came general market weakness during which those stocks on premium valuations displayed better resilience. Oops. That meant the relative premium was now even larger!

The correction since is taking place through relatively stronger performances from energy stocks, miners and various other laggards since the beginning of April. Tellingly, there has been no en masse abandoning of Premium High Quality Growth Stocks, despite higher bond yields in the US and "experts" warning about The Next Bubble.

It is possible this relative underperformance versus cheaper "value" has further to run, as I suspect funds managers have again found themselves with too high levels of cash and not enough risk to warrant a sell-off in markets. I very much doubt, however, we are going to see a repeat of late 2016 anytime soon.

Beyond the short term, I remain of the view High Quality, High Growth will continue to deliver, and continue to perform. Because such is the general corporate and economic context.

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Rudi Filapek-Vandyck

FNArena is a supplier of financial, business and economic news, analysis and data services.

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dani ecuyer

Excellent piece !!

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AndrewR

Thanks Rudi. Great summary and very wise analysis. Value traps are so easy to fall into. You make me feel guilty I dont subscribe!

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Dave McKagan

So what price would be too high to pay for CSL right now? It may be worth a high price but nothing is worth "any price".

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