REPEAT Rudi’s View: Lack Of Value Hurts

This story features JB HI-FI LIMITED, and other companies. For more info SHARE ANALYSIS: JBH

(This story was originally published on Wednesday, 27th October, 2010. It has now been republished to make it available to non-paying members and readers elsewhere).

By Rudi Filapek-Vandyck, Editor FNArena

High growth stocks. It has been my long standing view that many commentators and investors in Australia still need to get their heads around the true meaning of a high growth stock. Recent commentary leading up to the price setting and allocation for shares in QR National have only further strengthened my view.

What is a high growth stock? It is a company that achieves 20%-plus growth in earnings per share, year-in, year-out. One such prime example would be JB Hi-Fi ((JBH)), another is Cochlear ((COH)).

Both stocks have done well over the years past and that's why their Price-Earnings multiples -otherwise known as Price-Earnings Ratio- have tended to be around or even above 20. The share market works according to very simple and straightforward principles: if one performs well, one gets rewarded. If one performs consistently well, one is consistently being rewarded.

In practice this means that if a certain company manages to set a track-record of high growth, its acceptance as a growth stock will grow and so too will its PE ratio, and thus its share price. Alas, all growth stocks have something in common: there comes a time when the road ahead turns into a bump, and that's when those high multiples become a double-edged sword.

This is when investors should pay extra-attention: lower earnings growth in combination with contracting PE ratios can be quite devastating for share prices in the short run. This is something both JB Hi-Fi and Cochlear have in common.

Even though consensus forecasts are for JB Hi-Fi to still grow EPS by 20% this year, the market is not taking it for granted and the PE ratio has now fallen to 15. In the case of Cochlear, market consensus has come down pretty hard this year and the growth forecast right now is for 13.4% EPS growth only for the current year. Next year's forecast sits at 9% and, if correct, that will be a problem.

Cochlear's PE ratio was above 25 earlier this year. It has now fallen to 22.7. I predict it will go much lower still as the market becomes aware of the rather subdued expectations for the years ahead, unless proven otherwise.

Cochlear's share price has already come down from $78 to $70 in only a few months . JB Hi-Fi was trading at $22.50 earlier this year. The share price is now below $20.

The key characteristic for high growth stocks is that in good times the high multiple in combination with high growth in effect pushes an accelerator on the share price. But in not so good times, the opposite is true. This is when relatively small bumps can make a BIG difference for share prices.

Here's a simple mathematical example to illustrate what I am talking about:

EPS grows from $1 to $2 – market says “yes, we like it” and puts a PE ratio of 30 on the stock – share price rises to $60

Alas, disappointment kicks in and EPS remains at $2 – PE ratio falls to 14 – share price more than halves from $60 to $28

This is why CSL ((CSL)) shares have failed to perform over the past 18 months. Two other examples that have caught my attention this year are WorleyParsons ((WOR)) and Wotif.com ((WTF)). Both Ws are trading well below share price levels seen earlier this year and gradually revised consensus price targets suggest neither of the two is currently offering compelling value, despite the steep falls in price.

Another key characteristic is that growth stocks yield below average when it comes to dividends. Always. This is not because growth companies don't pay dividends, as one might be inclined to assume, it is because of the high multiple (PE ratio).

Take Cochlear and JB Hi-Fi, for example. Both companies distribute sizeable amounts from their annual profits to shareholders. This is probably best illustrated by the fact that if they were to trade on similar PE ratios as the banks and the big diversified resources companies (between 10-12.5x) dividend yields would in both cases rise above 6%.

This also shows that investors cannot have it both ways: either you own a growth stock, and thus by definition your shares do not yield a high dividend return, or you do not own a growth stock. In the latter case, a high distribution should translate into an above average yield.

Many ex-growth stocks end up at the top of stockbrokers' (and newspapers) dividend rankings. Think Telstra ((TLS)), for example, or Tabcorp ((TAH)). As recent years have once again highlighted, companies that cannot grow are not a great investment, even if they promise an above average dividend return.

All of the above instantly answers a few key questions regarding the upcoming IPO of QR National:

– Don't whinge about the relatively low dividend yield; it's a growth stock

– There are always risks when it comes to predicting the future, but if management gets it right and consistently delivers on the high promises, QR National will attract a following of happy, loyal shareholders (high multiples + high growth = high share price = high returns for loyal shareholders)

– However, the room for error is pretty small for a company that in essence has no track record whatsoever (even franking credits are absent). If QR National wants to be a growth stock then it better deliver, without any excuses or delays

– Price is an issue. Retailer Myer ((MYR)) was arguably too pricey when it returned to the stock market last year. Myer shares were sold to investors at a multiple in the high teens. Since then, the multiple has contracted to 12 and what is the result? Investors who bought in at the IPO level are today still in the red

– As an aside; at present Myer shares do offer an implied dividend return of no less than 6.3% this year and 7.2% next (lower multiple means higher dividend return, but only if you buy after the multiple contraction takes place)

– At the indicative price range for QR National, the shares are offered at a PE ratio between 21.1 and 25.3 (FY11) – this is by anyone's account pricey

– The closest reference we have in Australia, is Asciano ((AIO)) and those shares are trading on around 18x FY11 forecast EPS (consensus)

– True to being a growth stock, those multiples for QR National are predicted to come down rapidly, to 16.5-19.8 for FY12 – however, this is still on the high side

– Extra bonus shares and an 10c discount for Queenslanders offer a bit of relief, but not much – if QR National's multiples start to contract, for whatever reason, these extra's won't offer much of a buffer. On the lead manager's own assessment, extra benefits for Queenslanders will only lower the PE ratio by around 10%, which means the shares will still trade on a FY12 multiple of nearly 15

– Adding it all up, it would seem that an investment in QR National at IPO level carries more downside risks than upside potential on a two-year horizon. This has nothing to do with management's capabilities, or with a unionised labour force, or with the need for some beefy capex investments, but this is predominantly related to the bloated Price-Earnings ratio the shares will carry from the start

– One sentence I have come to use a lot over the years past, and every year I come to appreciate its meaning more and more, is that “value does count” – in the case of QR National it would appear there's not enough value on the table to compensate for the risks and the uncertainties that inevitably lay ahead

– None of the above guarantees that QR National will fail as an investment, it's just that the risk-reward balance doesn't seem appealing

And for those who liked my Weekly Insights story this week (“Welcome To Bubblin”), below is the cover page of a fierce attack on the Federal Reserve's policies, dressed up as a research report, by GMO Chairman and investment legend Jeremy Grantham.

Needless to say, Grantham doesn't think Bernanke and Co are providing long term solutions. To the contrary, Grantham predicts the US and the world will pay for present policies in the longer run.

(To be continued…)

P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website.

P.S.II – If you cannot see the illustration in this story, and you are reading this via a third party source, I apologise. Technical limitations are to blame.

P.S. III – I couldn't help but noticing market strategists at RBS elevated OM Holdings ((OMH)) to a Conviction Sell today. Yet another example that what has become cheap is not by definition also a bargain?

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