Valuations And Expectations

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By Rudi Filapek-Vandyck, Editor FNArena

Price Earnings ratios, or PEs, have increasingly found their way into mainstream financial commentary over the past decade, but there are a few obvious traps and misconceptions about PEs that can easily wrong-foot investors looking to (re-) enter the Australian share market. Here's an attempt to address these traps and misconceptions.

Firstly, market strategists and so-called Top Down analysts like to use generalised market PEs to gauge whether the share market as a whole is cheap or expensive. This is usually done by comparing the present forward-looking PE with an historical average.

In the post-2007 era this practice has invariably led to conclusions that equities are either cheap or very cheap since average market PEs post-2007 have consistently been lower than in the preceding three decades.

However, I believe such an approach is far too simplistic since it omits the fact that the period 1981-2007 contains the largest bull market for equities in modern history (1981-2000) plus a temporary bubble in resources stocks (2004-2008) and the general context for economies and risk assets has dramatically changed since late 2007.

Even if you disagree with my view, history shows PEs have been much lower than what they were in the run up to 2007 and for prolonged periods of ten years and longer, not just for a year or two-three. Were we to calculate the average market PE over many more decades we would end up with a long term average around 12.5x, pretty much where we are today, believe it or not.

Equally important is that PEs in the sixties and the seventies, which is my favourite period to compare the present market situation with, were much lower. Back then, single digit PEs were no exception when market angst would dominate. So far we have only experienced single digit PEs in early 2009. History never repeats itself, but it certainly rhymes. Critics of central bankers' quantitative easing support efforts should consider the difference between equities on single digit PEs and today's no longer exuberant, but still double digit market PEs.

In Australia, the difference between an average PE of 9 and where we are today consists of an estimated 1100 points to the downside for the ASX200, without taking into account any impact on earnings or earnings forecasts. This would take the index back to near its March 2009 low of 3145, signalling the lack of real sustainable earnings growth that has dogged the Australian share market since that time.

But working with such a generalised PE value doesn't tell us much about what really is going on inside the share market: about the internal dynamic between leaders and laggards and between the various sectors that make up the Australian share market. Last month, for example, I calculated that without miners and energy companies, the Australian share market had actually managed to keep pace with Wall Street this year. Thus the underperformance at face value is directly related to the international de-rating of the China-Super Cycle theme, not to any of the explanations that are touted here and there such as "lack of trust in the Gillard government", "the absence of foreign institutions" or "a perceived higher sovereign risk".

I know, my analysis cannot be genuinely popular in a country that loves its international image of a resources power house, and it generally isn't (judging by emails and other responses I tend to receive after my publications). I note, however, recent analysis by analysts at Goldman Sachs in Australia has led to that same conclusion of an international de-rating for resources. Also, have a look at the following conclusions drawn by Tim Rocks, Investment Strategist at BA-Merrill Lynch in Australia:

"The overall Australian market appears inexpensive on PEs… This apparently cheap valuation is heavily influenced by the two large sectors (financials and materials) where in our view lower valuations are justified by the likelihood of weaker earnings growth in the medium term. If these sectors are excluded, the forward PE for the core market (ex materials and financials) is 14.8 times. This is lower than historical averages, but not significantly so, and is not an outright low number… This higher valuation for the core market suggests why investors are struggling to find stocks to buy even though the market is apparently so cheap."

Finally, and this is especially the case in Australia where the major index only consists of 200 stocks of which many are small caps and/or resources stocks, I tend to go through the 200 consensus forecasts that make up the combined average market PE with a fine tooth comb, excluding the outliers that are expected to grow their earnings by more than 100% one year and then dive deep into the red the following year. I would hope that everyone agrees these outliers only mask the true picture that lies underneath. (At various times my "adjusted" market PE will reveal a less rosy picture than suggested by the non-adjusted PEs I see quoted in media and research reports).

As such I can only concur with experts at BA-ML, Credit Suisse, JP Morgan and (some) others: the Australian share market is not particularly cheap. This view is further supported by the observation that major bank shares are trading at or above consensus price targets while resources have lost a lot of share price value over the past year or so but for two very good reasons: big question marks about the longer term sustainability of elevated commodity prices and persistent downgrades in earnings forecasts.

Before we zoom in on that key ingredient of PEs -earnings forecasts- let's first address one other perpetually returning big misunderstanding about PEs for individual stocks. The standard explanation for what is a PE ratio is that it signals how many times investors are paying for next year's profits in today's share price. Technically speaking, this is correct. That is how PEs are being calculated. But what does it mean?

Most commentators infer that a stock trading on a high PE is "expensive" and thus should be avoided while a stock on a low PE represents good value ("cheap") and should thus have an investor's preference instead. One simple comparison between Invocare ((IVC)), a company whose shares are constantly trading on a high PE, and a retailer like JB Hi-Fi ((JBH)), trading on a low PE, instantly reveals the flaw in this PE comparison methodology. Since bottoming near $4.50, Invocare shares have gradually risen to above $8 today, which makes the stock a proud member of that exclusive selection of stocks in the share market that is nowadays trading well above peak prices of November 2007. If ever there was an excellent example of what I have labeled an "all-weather performer" (see also bottom of this story) in the Australian share market, it has to be funeral services provider Invocare.

Discount electronics retailer JB Hi-Fi, on the other hand, managed to rally above $22 in 2009 but the shares have, post yet another profit warning, fallen below $10 this week. Invocare shares are trading on 20x times this year's estimated earnings, they have been trading at such lofty levels for years, while JB Hi-Fi post yet another cut in market expectations is trading on 8-9x times prospective earnings.  JB Hi-Fi shares have consistently de-rated after peaking at similar PE levels as Invocare's in 2009. So, after an appreciation of close to 100% for Invocare shares and a savage depreciation of more than 50% for JB Hi-Fi, is the latter today a better buy than the former?

Only if the tide turns for one of them in terms of sustainable earnings growth. In which case Invocare shares might prove too expensive and JB Hi-Fi shares too cheap. Thus far, however, this has not proved to be the case and this is exactly what is being reflected in today's PE ratios for both.

A better way of viewing PE ratios for individual stocks, I believe, is through the lens of investor confidence. Invocare has revealed itself as a highly reliable, consistent performer and this has led to the market putting a lot of confidence in management and in the company's strong market position, hence the reward of a high PE. In simple terms this becomes High Confidence = High PE. JB Hi-Fi has done the exact opposite since 2009 (not necessarily all of its own making) and thus market confidence is low, which thus leads to a low PE. Note that if it wasn't for the dividend support (currently estimated above 7%) today's PE would be much lower.

PEs can be a useful tool in determining where the market's confidence/pricing is off the mark.

Which brings us to the most valuable ingredient to check PEs in the share market: earnings forecasts. As I have pointed out in earlier writings, current consensus expectations for the 200 members of the ASX200 are for very low growth in the year to June 2012 and with more downgrades to follow in the weeks ahead, the end result for FY12 might well end up in the negative. Note both BHP Billiton ((BHP)) as Rio Tinto ((RIO)) later on will -as things stand right now- both report negative earnings growth for the present fiscal year.

Because we are near the end of fiscal 2012 (only two months left), investors should now focus on what is likely in store for FY13 and beyond. Here the news can potentially turn out much more promising with RBA rate cuts, a less expensive Australian dollar and historically low margins in many sectors setting the Australian share market up for better opportunities going forward. For example, current consensus forecasts for Invocare suggest that after a stellar year in which earnings per share are expected to grow by no less than 60%, next year growth should fall back to 8.5% only. This may lead to the shares losing some of their premium in the year ahead.

As for JB Hi-Fi, analysts are not enthusiastic about the near term outlook with this year's 12.5% fall in earnings per share expected to be followed up with a 2% rebound only in FY13. This reinforces the idea that a low PE does not automatically mean "attractive". Note that for both BHP and RIO expectations are that profits will bounce in the following fiscal year, but more than one analyst has again penciled in negative growth thereafter. This is the longer term Big Question Mark I have been mentioning for a while when writing about both companies in terms of longer term earnings outlook.

One of the obvious tools to look for mispriced equity valuations is FNArena's R-Factor, available for all paid subscribers on the website. As of today, the Top Five consists of Iluka ((ILU)), Kingsgate Consolidated ((KCN)), Mount Gibson ((MGX)), MacMahon Holdings ((MAH)) and Southern Cross Media ((SXL)). It can hardly be a surprise that three out of the five are resources stocks and two of those (Iluka and Mt Gibson) promise a very high dividend for FY13. However, investors willing to take a punt purely on cheap PEs in the face of high growth expectations should never dismiss what cannot be measured in advance: risk. This in particular applies to Southern Cross Media, in my view.

Analysts at some of the major stockbrokerages in the domestic market have equally done some research into earnings expectations recently. Below are some of the key takeaways:

According to BA-ML:

– a market PE of around 12 is probably appropriate for the years ahead (echoing similar conclusions drawn by Macquarie and myself earlier)
– overall, earnings growth expectations are still too high and reductions of up to 20% remain possible (for FY12 and FY13 combined)
– more value to be found among smaller caps, less so among large caps
– combination of further earnings risk plus increased macro instability may well push ASX200 back to 4000 by year end

According to UBS:

– overall risks to earnings forecasts remain, but the worst now seems behind us
– expects moderate cuts to consensus forecasts only for both FY12 and FY13
– still doesn't like domestic oriented sectors such as retailers and media, instead favours housing sector exposure
– likes insurance as the particular cycle for that sector has turned for the better
– remains attracted to companies that leverage off the investments and volumes generated by miners and energy producers
– looks for improving fundamentals for companies directly exposed to USD and/or US economy

According to Macquarie:

– risks remain uncomfortably high for expectations regarding companies with a domestic focus in Australia
– singles out discretionary and materials stocks (resources) as at risk because of too high margin assumptions
– notes the current five year long period of extremely weak profit growth in Australia has been exceptional
– remains of the view that weak domestic sectors continue carrying the highest risks to forecasts
– risks appear less for forecasts/margins for companies with international focus

According to Deutsche Bank:

– there is potential for margin surprises from the banks in the second half of calendar 2012

Investors should note the present corporate profit season in the US has surprised to the upside and earnings expectations in the US are rising as a result. Nevertheless, there seems almost universal agreement among analysts that headwinds are building for US corporate earnings for the quarters ahead ("unrealistic expectations"). Internationally, the pace of downgrades to earnings forecasts is slowing down, which supports share prices. Australia, however, remains among the underperformers in terms of earnings forecasts.

(This story was originally written on Monday, 30th April 2012. It was published in the form of an email to paying subscribers on that day.)

Subscribers/readers should note that I remain convinced the overall investment climate has irrevocably changed post-2007. My three key points of attention post-2007 thus remain: 1) solid, sustainable dividend yields; 2) All-Weather Performers; 3) Companies leveraged to the boom in industrial commodities via equipment and services

Note that all paying subscribers receive two e-booklets written by myself. The second one explains in detail the how and why behind these three investment strategies, as well as the concept behind the "All-Weather Performers". If you are a paying subscriber and you haven't received your copies, send an email to info@fnarena.com

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