REPEAT Rudi’s View: Value Does Trump Everything Else

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

(This story was originally published on Wednesday, 23rd March 2011. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere).

– Does David Jones always beat Rio Tinto?
– There are plenty of David Joneses around, here's another one
– Melbourne investor meetings a success, whereto now?
(The latter question is as to where you can play a leading role)

 

By Rudi Filapek-Vandyck, Editor FNArena
 

"Value trumps everything else"
 

Last week I participated in two highly successful investor meetings in Melbourne, upon which I will elaborate further down. One of the subjects discussed during these meetings was a story I wrote a few weeks ago, wherein I offered investors the opportunity to go back in time and start all over again in late 2003 with one million dollars in the pocket and two choices: David Jones ((DJS)) or Rio Tinto ((RIO))?

Nobody picks David Jones, yet the upmarket retailer with no direct leverage to China, emerging markets or excess Fed liquidity, beats Rio Tinto by an incredibly wide margin, delivering more than double the investment returns for one of the champions in the resources space.

If I combine the responses received during the Melbourne meetings with the ones via email since publication of that particular story, I am able to distinguish two main questions among investors willing to take on board my message:

1. Does David Jones always beat Rio Tinto, no matter what?

2. How do we find the next David Jones, since the original one no longer seems to apply?

Let's start with question number one as that is the easy one. The answer is no. Buy Rio Tinto after it has been sold down following suitor BHP Billiton ((BHP)) abandoning its offer -preferably as close to $30 per share as possible- and you will see better returns from your shareholding than owning shares in David Jones. Similarly, when the investment community awoke to the emergence of China, and the change in dynamics for natural resources, back in 2004 the immediate impact on Rio Tinto's share price was enormous.

What a lot of investors forget, however, is that in both situations "valuation" plays a key role. Most investors solely focus on "growth" and while doing so, they casually forget about "valuation". On both occasions I mentioned in the previous paragraph, Rio Tinto shares had become inexpensive -"cheap"- and when one subsequently adds "growth" this cocktail leads to an explosive combination – one that can bring above average investment returns.

The same applies to David Jones in 2003. The stock had lingered around $1 for three years. The shares were intrinsically cheap because the share market always prices in the present situation into eternity. Remember that one, as it also applies to those companies which enjoy favourable market dynamics. This is why share prices run too high, too far and why others are being priced at bargain base metrics.

However, at more normalised valuation metrics, the answer becomes yes: David Jones will beat Rio Tinto, time and time again.

Remember this one too, as this is the one that will prove key in your long-term investment strategies.

The "secret" so to speak, involves the accumulation of growing dividends. It is my observation, and experience, most financial experts and investors consistently underestimate the wealth-impact from compounding dividends. As it turned out in the end, total dividend returns from David Jones nearly matched the total investment return (share price appreciation + dividends) from Rio Tinto shares between 2003 and now; and that's why David Jones back in 2003 will ALWAYS win from Rio Tinto. The one exception is when we manage to buy Rio Tinto shares ultra-cheap (as we've witnessed, those opportunities do come along).

Note that I am judging both stocks on the metrics of a longer-term investment portfolio. Shorter term, traders who manage to buy low and sell high successfully can significantly improve their returns and Rio Tinto, more than David Jones, offers such possibilities in spades.

For those readers who want to read the original story: "A Tale To Remember", Rudi's Views, February 28, 2011.

***

Over to question number two. My personal advice to all attendees in Melbourne was that anyone who wants to be a serious investor in the share market needs to understand "valuation" and thus methods and techniques to determine what is "valuation". Most investors don't really know how to use Price-Earnings ratios (PEs), which is one of the consensus data we offer on the FNArena website. My advice (with a bullet) is: get acquainted. Learn. Get it under your belt. But also: allow yourself some time to really learn how to work with PEs.

Price-Earnings ratios are not the end and be all, far from it, but they can help answering a lot of questions. The comparison I usually make is with learning French. Often in French there is a rule, followed by lots and lots of exceptions. Working with PEs is pretty similar. There's no robotic universal rule that fits all equities and circumstances.

The FNArena website offers a second tool in the form of consensus price targets, but while price targets can be an excellent tool on the upside, they can be very treacherous when shares trade well below them.

Cutting a long story short: while many readers understand the concept of buying cheap is better in the longer run, they have difficulties fully grasping the concept when having to choose between "value" and "growth". This, by the way, is understandable. Nobody does the analyses I do and if I hadn't done them myself, I would have similar difficulties.

So to once again illustrate the point that "value trumps everything else, including growth", I went out to find a next David Jones…

***

What is the most boring stock in the Australian share market? I think APN News & Media ((APN)) is a genuine contender for that title. I cannot remember having read any stories on the company for a long time and I am pretty certain this is the case for most readers too. The company provided a trading update to the market last week, which proves my point.

"Boring" APN has had a perfect storm hitting its operations recently. A quake in New Zealand. Floods in Queensland. With the company's regional newspapers concentrated in northern NSW, Queensland and New Zealand it is not difficult to figure out why I use the term "perfect storm". Add the fact that traditional media companies have been de-rated over the past 18 months and you probably don't need me to point out that nobody in the share market is interested in buying APN shares. Which is ideal for people who are looking for strong performance over, let's say, a three year horizon.

"Boring" APN has two key characteristics every long term investor should like:

– The shares are cheap, trading on forward looking consensus PE ratio of 8.6 (this is the result when nobody is interested)
– The shares pay an above average dividend yield (current consensus forecast is for 8.6% for the year to December 2011)

As I explained during the Melbourne sessions, dividends make it attractive to sit on undervalued stocks, and wait. They "reward" you in the meantime. Also, and as shown in the example of David Jones, if we could add "growth" and allow time to accumulate this combination can be no less than lethal for the competition (as in: other stocks that might have been picked otherwise).

What has happened, in layman's terms, is that APN shares have been priced without any prospects of any growth occurring anytime. Of course, this is nonsense. APN is not going to shock the world and double its profits at some stage, like BHP Billiton and Rio Tinto did last financial year, but -and this is the crucial element in this story- this is not required to still provide investors with a good return in the years ahead.

Because the shares are so cheap.

Logically, at some point things in Queensland and in New Zealand will normalise, they might even accelerate during the rebuilding phase and some of this should also rub off on APN's operations. But let's not bank on any blue sky at this point in time. We know the shares are cheap and there's a dividend yield of 8.6% waiting for us while we await a return to a more normalised valuation. Note: we're not banking on any fireworks, simply a normalisation in valuation.

Taking a conservative approach, I have taken this year's consensus forecasts (downgraded across the board in February and last week) and have assumed 4% growth in 2012 and in 2013. 4% is not a lot, I think you will all agree on this. In addition, I have assumed the dividend pay-out will fall, leaving the dividend unchanged for all three years. Both these assumptions look very conservative to me. This has generated the following projected return:

In dividends: 8.6% + 8.6% + 8.6% = 25.8%

In share price appreciation:

EPS of 17.4c (consensus forecast for 2011) grows at 4% per annum to 18.81c in 2013. I anticipate that over that period the PE ratio improves/normalises from 8.6 to a little under 11. If this occurs the share price will be above $2 in 2013. Today, APN shares closed at $1.50. The difference is 33%.

If the above scenario unfolds, "boring" APN should generate close to 60% in return over the next three years, or 20% per annum.

Mind you: there's absolutely no guarantee in these numbers. But then again, I have build in virtually no hope for positive surprises. In fact, I'd be confident the company will do better over the next three years. And thus so should be the performance of its share price. And in case I got it totally and utterly wrong, I will be receiving 8.6% in dividends, each year, which is only marginally below the long term average return for Australian shares.

Of course, and I agree, there's no such thing as a 100% watertight investment opportunity. We're talking share market. There are risks everywhere and it may well be that management at APN has yet to announce the big disappointment nobody is yet aware of. But isn't this always the case?

All in all, I would say APN shares at current valuation levels seem to offer minimal downside, but a lot of upside potential. In fact, unless you are really an Uber-Bull on the Resources Super Cycle and on Rio Tinto's return potential in the years ahead, I think investors will find that boring and no-good APN shares will beat the sexy and exciting Rio Tinto. It would not surprise me if dividend yield for APN in 2013 will be closer to 10% than my conservative 8.6% and I suspect that my total return of 60% might prove conservative too.

I'd be willing to bet that, in three years from now, APN will have outperformed Rio Tinto, just like David Jones did between late 2003- early 2011. My underlying message is: David Jones was not an aberration; not an exception; not some alien event I managed to localise in the Australian share market. Today, there are lots of David Jones's in the Australian share market -just like APN- and the quicker investors learn how to spot these opportunities and to utilise them to their own benefit, the better their investment returns in the years ahead will be.

For those who are concerned about capital protection, I'd argue opportunities such as APN should still tick all the required boxes, because you buy cheap (the best protection against further downside) and you are enjoying very high dividends, which is strong protection too. But yes, there are no guarantees involved. Always good to keep that one in mind.

Now you all know why market strategists at leading stockbrokerages say the best opportunities in the share market are amongst industrial stocks. I fully agree. Over to you.

(Do note that, in line with all my analyses, appearances and presentations, all the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)

****

The Melbourne Sessions
 

Last week's meetings with investors in Melbourne have exceeded many expectations, including mine. All emails I received from attendees since have one element in common: they all ask when I plan to do it again. I cannot think of a better indication that last week's experiment has gone well.

Where the Melbourne sessions differed from all previous meetings is that we kept the audience limited to 10-11 people at a time. There was no projector, no stage, no microphone, no white board. Just me on a chair, accompanied by a laptop which we hardly used. We talked. About FNArena, my views on the world, the financial markets and investment strategies. How to use tools and applications on the FNArena website. How to wear two hats when participating in the markets; one for short term opportunities, one as a longer term investor. Questions were raised. Answers followed.

One of my key themes was the same as in the story above: for longer term portfolios, today's opportunities are not amongst the popular stocks in the share market.

What I learned from last week's sessions is that it is probably best to have two halves of one hour each: one part focused on the markets and investment strategies, and a second part focused on FNArena and the many tools and data available.

I think the Melbourne enthusiasm should be extended to other places, which takes us to the obvious question: whereto next?

This is where you can play a decisive role. Are you part of an investor community and would like to invite me over? Are you an investment advisor with clients who would be interested? Or a financial service provider whose staff is interested to be challenged and surprised?

Send your ideas and suggestions to info@fnarena.com and we will assess and get back to you.

Here are a few snippets from the feedback I received post the two sessions (Fri-Sat) in Melbourne:

"Rudi, I really enjoyed the session on Saturday.

"The small group format makes the session more beneficial as everyone has more than one or two opportunities to ask questions.

"I certainly got a lot out of it. New thoughts but also reinforcing and reminding me of investment rules and themes that I already had considered."

***

"Enjoyed the Melb. Session very much. Intimate but intelligent audience asking sensible questions. Like the informal ambience and appreciate very much your Editor’s observation of how the share market operates. I concur with Rudi that individuals should invest differently from the Funds.

"I like the honest & unbiased opinion expressed by your Editor. What he writes makes a lot of common sense which the herd lacks. If opportunity comes, would attend again."

***

"Hi Rudi,

"I greatly enjoyed your informal style of investment briefing, and found it very informative. I attended your session with an open mind and was pleasantly surprised at the quantity and quality of your delivered content. May I suggest that having a small size audience gives a lot more personal touch."

***

"Dear Rudi,

Thank you for the opportunity to hear you speak in Melbourne. The small audience and topics covered were excellent and the experience more than met my expectations."

***

For all your ideas and suggestions: info@fnarena.com
 

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 – All paying subscribers have access to an e-book I wrote last year, "Five Observations (That Matter)". If you are a paying subscriber and you have not as yet received your copy, send an email to info@fnarena.com

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