Rudi’s View: The Big De-Rating – A Guide Through The Minefields (2)

This story features WOOLWORTHS GROUP LIMITED. For more info SHARE ANALYSIS: WOW

By Rudi Filapek-Vandyck, Editor FNArena

This may come as a surprise to many, but today's process of de-rating in the stock market finds its origin in the year 2000, not in November 2007. As is clearly shown in the historical chart below, based upon excellent research conducted by professor Robert Shiller (*) in the US, times of new technological achievements and economic prosperity foster exuberant investor optimism and both can be rather easily proven and illustrated: through long term trends of Price-Earnings ratios.

For those readers not familiar with P/E ratios (PEs or PERs), the measure is often used by professional funds managers and investors to gauge whether individual stocks are too expensively priced. Equally important, the average PE calculation for key equities can be a helpful tool whether the share market in general is running ahead of itself or might be undervalued, or somewhere in between. A PE is nothing more than the calculation of how many times today's share price is incorporating the earnings per share (EPS) for the company. In other words: how many times this year's profits are investors willing to pay?

While differences occur between sectors and at different times, PEs are an ideal instrument to gauge whether equity markets are in an secular uptrend or in a downtrend. Schiller's PE ratios are less straightforward as they try to incorporate inflation and longer term trends, but they clearly show that when optimism knows no boundaries our perception of what is "cheap" and "expensive" makes a substantial shift to the upside (we are willing to pay more for perceived value), but when we run scared and turn more cautious, the pendulum swings radically to the other side.

The impact of this on the prices of equities is huge as higher PE multiples effectively act as a super-booster on the upswing, but lower PEs in combination with falling profits are devastating during the hangover period. Examples that immediately come to mind are the three years post the bursting of the internet-bubble in March 2000 and the relentless downswing from early January 2008 until March 2009. Alas, that still does not provide us with the full story.

What Shiller's analysis also shows is that such peaks in "irrational exuberance" don't come without longer lasting consequences. They are, without exception, followed up by a prolonged deflating of the bubble which manifests itself through a long-term, gradual de-rating process. As is clearly apparent on the chart above is that the peak of 2000 went much higher than the three precedents since the beginning of the twentieth century. What is also apparent is that, historically, PE ratios have fallen a lot further before they started trending upwards again.

An important observation to make is that this de-rating process does not imply that share prices will only become cheaper. This is only the case if companies cannot remain profitable or if the pace in their profit growth decelerates significantly. Equally important is this is not a straight line process. There will still be rallies and downswings, probably plenty of them, and they will continue to obscure the gradual process that is taking place in the background. Don't forget today's de-rating process is already in its 12th year. In between we have witnessed four years of above average 20%-plus annual returns from 2004 till 2007.

Odd, isn't it, to realise that unsustainable cheap credit in the US and the emergence of China as a major consumer of the world's resources caused a temporary spike in global profits and overall optimism, which thus allowed share markets to post big gains? However, in-depth analysis remains unequivocal: global equities, the Australian share market included, were already going through a de-rating, it was just that investors never noticed because of the big profits that were reported during those years by miners, energy companies, banks and others. (This de-rating turns up in other measurements of equity valuations such as price-to-cashflow levels for big miners and the disappearance of premiums to Net Present Values).

Once we fall out of Bubble territory, and we might as well include 2007, what happens is the direct link between growth in profits and a rising share price disappears. This can be a rude shock for investors who have become used to this close relationship. One example that comes to mind is supermarket and liquor store operator Woolworths ((WOW)). The name Woolworths has been mentioned quite a lot in recent years by share market experts and commentators alike who until today maintain they cannot understand why the share price refuses to go up when the company's return on equity remains high, profits grow each year and shareholders continue receiving higher dividends. Isn't Woolworths supposed to be one of the safest stocks in the share market when the overall climate goes pear-shaped?

The answer is -of course- that a falling PE ratio continues to exert downward pressure on the share price. I have tried to illustrate this in the following chart:

The Big problem for Woolworths is that its shares moved into the post 2007 crisis on a PE ratio higher than 27. As I write this story, in late October 2011, the forward PE has fallen below 13.5, more than 50% below what it was in 2007. Viewed from this angle, loyal shareholders have only limited reasons to complain. Imagine what would have happened to the share price if Woolworths had lost its profitability or had the company grown at low single digit percentages only since 2007.

The case of Woolworths is interesting from multiple points of view. Back in 2007, the company had grown extremely dominant in its core Australian grocery markets, margins were at world record highs, growth was consistently in double digits, board and management could do nothing wrong in the eyes of the many admirers and happy shareholders. Assisted by the resurgence of a combatant Coles, the mature Woolworths then fell prey to the fact that such growth becomes ever so difficult to maintain. In other words: there are company specific reasons as to why Woolworths shares have gone through a de-rating since.

Similar company specific reasons are behind de-ratings for former market darlings Leighton Holdings ((LEI)), Macquarie Group ((MQG)), CSL ((CSL)) and ResMed ((RMD)). One can argue, and with plenty of ammunition, that even within a different context, these equities would still have gone through a de-rating.

The Bigger Picture De-Rating, however, the one that Shiller is referring to, is one that takes place because of increased risks and less appetite for it among investors. In today's context it is easy to determine where those risks are: too much debt, too many inter-linked, leveraged troubled assets in the banking system, too much reliance upon and interference from politicians (not exactly experts in the field when the subject is "economy" or "banks") and from an economic view: shorter cycles. Which is why, in my view, today's de-rating process is best compared with the previous one which ran from 1966 to 1982.

During these 17 years share markets intermittently rallied and sold off heavily, but in the end it lasted 17 years before equities managed to rally above price levels from 1966 without subsequently pulling back. As shown on Shiller's PE ratio chart above, by then the de-rating process had pushed PEs low enough to start a new uptrend, and thus the next bull market. It just so happens to be that the bull market that started in 1982 turned out the longest and the most powerful one in modern history.

In the meantime, sharply reduced risk appetite means all risks are being extrapolated and priced in, through guilt by association or otherwise. This is why de-ratings for Australian banks have gone much further than seems justified by the slowing in profit growth alone. We could use similar arguments as to why every single company with exposure to discretionary consumer spending in Australia has been de-rated savagely. Resources stocks have been de-rated too, despite their extra-ordinary growth in profits and cash flows, as investors are no longer willing to accept there are only negligible threats to growth in China. Shorter cycles weigh on overall confidence too.

It has been a regularly recurring mantra these past years: stocks are cheap by historical standards. The problem with most historical calculations is they don't go further than 10 or 20 years back, loosely ignoring they thus carry the heavy mark of the biggest bull run ever. Between 1966 and 1982 valuations and PEs dropped a lot lower than where they are today, still. This suggests we might be hearing the same "cheap by historical standards" observations for a while yet.

Macquarie market strategist Tanya Branwhite is one of few in Australia who has regularly published research and analysis on the current de-rating and on the many similarities with 1966-1982. The following chart, published in October 2011, offers plenty of food for thought in terms of where we are today and the likely road ahead:

Shiller's analysis focuses on the return of equities vis-a-vis inflation which makes for interesting data crunching and insights. Take the period 1966-1982 for example. During these 17 years US equities lost 60% adjusted for inflation, if we leave inflation aside the share market effectively moved sideways. Branwhite's research could prove more practical for contemporary purposes in Australia: are we on our way to 1970s style of ultra-depressed PEs or will we instead oscillate around the 50 year average?

The relentless guilt by association sell-offs and the ostentatious disconnect between share prices and earnings growth is simply too much for most investors, leading many to pull out of the share market in despair. Others try to reinvent themselves as "traders", only to discover that "trading" and "investing" are what indoor volleyball and beach volley are to each other, or to put it in an Australian context: rugby league versus AFL. Mastering one doesn't automatically mean one can easily switch to the other code.

Regardless, if the period 1966-1982 can be taken as a guide, there will be plenty of rallies and of pull-backs, so both investors and traders better take this in their stride. Here's another way of looking at that reference period:

One other obvious observation to make is that lower PEs and still growing profits translate into higher dividends. Certainly, historical analysis has revealed dividend strategies worked if executed well and given enough time both in the thirties as between 1966-1982. I have written regularly and extensively on dividend investing in the years past, so I won't again delve into this subject here.

Last but not least, for those who've by now given up on buying shares with the aim of generating sustainable returns from both dividends and share price appreciation, this is still possible, believe it or not, just not in the same manner as in the nineties or during 2004-2007. That'll be the subject of future stories, starting next week.

The above story is the second in a series titled "The Big De-Rating – A Guide Through The Minefields". The first story was published on October 19, 2011. The next one will be published next week.

(*) Robert J Shiller is probably better known as co-founder of the Case-Shiller US home price indices. He's Professor of Economics at Yale University

(Do note that, in line with all my analyses, appearances and presentations, all of 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.)  

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P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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