Reliability Commands A Premium

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By Rudi Filapek-Vandyck, Editor FNArena

To a man with a hammer, just about everything looks like a nail.

I was reminded about this old saying when reading through the various reviews and assessments of the February reporting season in the week past.

Whereas one market commentator used the avalanche in corporate beats and misses to highlight his personal view that investing in small caps is the best way forward, I spotted at least one other commentator highlighting most disappointments and punishments in the form of share price weakness had occurred amongst, you guessed it, small caps.

My own assessment that this year's February reporting season in Australia has been noticeably better than a number of years prior has been backed up by strategists at Deutsche Bank and Macquarie, among others, but then their peers at BA-Merrill Lynch and JP Morgan point out it has been all about lowering costs, lower tax rates, less spending, low interest rates and a weaker Australian dollar.

In other words: low quality improvements are dominating the picture and it's not like the Australian economy is about to accelerate, and neither is the global economy for that matter, which would compensate for the many question marks that continue to blur the outlook for corporate profits in the year ahead.

Unmistakably, confidence in corporate profits for the six months, if not year ahead, has grown, but there is enough doubt and uncertainty for SMSF operators and professional funds managers to stick with the same lower-risk approaches that have characterised this upswing from mid-2012 lows.

In terms of further growth in profits, JP Morgan strategists probably summed it up best with the suggestion that investor portfolios should focus on:

– non-AUD operators
– free cash flow improvers
– improving market structure

The first two groups, by now, contain few surprises with the likes of Ardent Leisure ((AAD)), Brambles ((BXB)) and Amcor ((AMC)), still popular because of their overseas profits, and with big iron ore plays BHP Billiton ((BHP)), Rio Tinto ((RIO)) and Fortescue Metals ((FMG)), adding prospects for a lot of additional free cash flows, as well as the likes of Suncorp ((SUN)), Adelaide Brighton ((ABC)) and James Hardie ((JHX)).

In terms of improving market dynamics, this still applies to building materials and consumer stocks, while less prominent improvements affecting Tassal Group ((TGR)) and Blackmores ((BKL)) have also risen to the surface. Gold stocks have found new momentum, after two truly horrible years and media stocks -in line with my bold prediction earlier this year- have bounced quite prominently, mostly on the absence of more Armageddon for the sector.

Share prices for all of Nine Entertainment ((NEC)), APN News & Media ((APN)), Fairfax Media ((FXJ)), Prime Media ((PRT)) and Ten Network ((TEN)) have all but bounced heavily in recent weeks. Must be extra painful for the two laggards, Southern Cross Media ((SXL)) and Seven West Media ((SWM)).

Two sectors continue to stand out in a negative sense: airlines and mining services providers. Both are attracting bottom-fishers and algorithmic trading programs and I wish them well as my personal view remains that the first sector is non-investment grade by default and the second sector continues to face prospects of further shrinking capex budgets and increased dog-eat-dog competition.

Instead, I am a man with my own type of hammer and in my view there's one particular type of nail that has once again risen to prominence this February reporting season; the reliable achiever, regardless of what goes on in the domestic economy, or in China, or most elsewhere, otherwise known as All-Weather Performers^*.

It should be clear by now the Global Financial Crisis, and in its slipstream the many structural changes that are impacting on numerous sectors of the traditional economy, alongside the pending retirement of ever more Baby Boomers worldwide, have created a post-GFC focus on performance reliability and less risk.

In practical terms, this means most retirees no longer have a big appetite for fly by nights whose share price rallies by 30% (or more) when the wind blows from behind, but whose business comes unstuck from the moment the wind changes direction. And professional funds managers and financial advisors have increasingly paid attention too.

Those among you who've been reading my market analyses and commentary in recent years know that my focus has been on reliable performers in the local share market, such as Ramsay Healthcare ((RHC)), Domino's Pizza ((DMP)), CSL ((CSL)) and Amcor ((AMC)) and indeed, even if one does not agree with my research or my analysis, it cannot be denied that owning shares in these companies has brought much pleasures and significant outperformance in years past.

It remains my view that this story has not changed. If anything, the February reporting season has again highlighted the importance of understanding why these companies prove such a blessing for investor portfolios.

Witness, for example, how stockbrokers either continue to struggle with performances and/or valuations, or ultimately give up and switch to new methodologies such as "peer group multiples", while these All-Weather Performers continue to report strong performances, with continued promise to do the same in the reporting periods ahead.

Let's be frank about this: how many times have we all heard the observation that Ramsay Healthcare's premium vis-a-vis the rest of the healthcare sector looks BIG, not to mention any comparisons with the broader market in general? How many times have we heard that investors really have priced everything and so much more into REA Group ((REA)) and into Carsales.com ((CRZ))? Surely there's no way a stock like Breville Group ((BRG)) can still be a buy at such elevated PE multiple?

The truth is the Australian share market only has a limited availability of companies that can truly promise and deliver reliable profit growth, without the need for support from either Chinese stimulus, Fed liquidity, the economic cycle or the Australian government, the RBA or a weaker Australian dollar.

At the same time, demand for such reliability has grown exponentially in years past, with both investors and retirees as well as professional funds managers carrying deeply entrenched scars from the 2008 share market meltdown.

While this has pushed up valuations for dividend yielders in years past, a fact that hasn't escaped anyone in the finance industry, it has also pushed up valuations for All-Weather Stocks. The latter has, on my observation, only received piecemeal attention and is today still not well understood by most investors and experts in the finance sector.

Slowly, slowly, this is changing.

Note Morgan Stanley's update on its own Australia Macro+ Model Portfolio:

"High PE Stocks Deliver: The top active contributors to our Model Portfolio are NVT, DMP, SEK and REA – all high PE names. These stocks "demanded" a premium going into results and post strong earnings delivery are "commanding" that premium. Continued execution will deliver further outperformance, in our view."

I couldn't agree more.

On my observation, the group of All-Weather Performers in Australia consists of less than 20 names and they can be categorised alongside two themes:

– non-spectacular, but proven, consistent, reliable growth
– a track record of high growth with ongoing promise for more in the years ahead

The first group enjoys a premium valuation vis-a-vis peers and sector and contains the likes of Woolworths ((WOW)), Amcor and Invocare. The second group is trading on what looks like elevated Price-Earnings (PE) multiples, at face value, but in reality those elevated PEs reflect what can be expected for the 2-3 years ahead (we'll have to see what follows after). The latter group includes names such as REA Group, Domino's Pizza, Carsales.com and Navitas ((NVT)).

Bottom line: these stocks are not going to become available at a "cheap" price, unless they follow in the footsteps of Cochlear ((COH)), at some point, in which case a cheaper multiple represents a value trap, not a buying opportunity.

In other words: stare yourself blind at the premium that is baked into these valuations and you will never be able to enjoy any benefits from these reliable growth companies. Most of these companies looked "expensive" twelve months ago. They looked "expensive" at the correction in mid-2012 and they looked expensive back in 2010.

Yet today share prices are much higher, PE multiples are in certain cases much higher, and owners of their shares, like Morgan Stanley, still feel very comfortable sitting on the register.

What are the risks?

I think the risks are twofold:

– either the market's confidence in the reliability of future performances deteriorates, or;
– growth becomes much more abundant, predictable and widespread in the Australian share market, reducing the need to focus on All-Weather Performers. This could lead to a de-rating from premium valuations

I don't think the general landscape is about to change dramatically, which means risk number two shouldn't show itself in the foreseeable future. As far as risk number one is concerned, I observe the likes of Invocare and Super Retail ((SUL)) have disappointed recently and yet their respective PE multiples today are 25 and 18.

Meaning: investors are willing to give this select group the benefit of the doubt. They see temporary dips as just that. This in itself reduces the risk for serious de-rating. Given their track record, these companies are even allowed to disappoint, now and then – as long as the outlook remains more or less in line with the track record.

How should investors treat this "new" phenomenon?

It is my view that All-Weather Performers are an essential backbone of a well-diversified, long term investment portfolio. This is a view I have expressed consistently in the years post-GFC. Alas, the market has now caught up on the theme and premium valuations are now a fact, and here to stay.

Investors who still have no exposure to this exclusive group of reliable performers should consider adding some, preferably through buying in dips and during times of temporary weakness. Investors who have been wise (lucky?) enough to climb on board earlier can sit comfortably in the knowledge that share prices will be higher in 2-3 years from now, and possibly a lot high.

If anything, the February reporting season has only further strengthened their confidence the latter will be the case.

What's with the banks?

Australian banks are far from cheap. Investors will not get an argument about it from me. But banks' share prices are by far not as expensively priced as some commentators and experts are suggesting (and can we please stop referring to the fact that Westpac almost went bankrupt in the early nineties?!).

One recent development should have every investor's attention. CommBank ((CBA)) has decided to no longer neutralise dilution from its Dividend Reinvestment Plan (DRP), which indicates the bank is intent to use its current valuation premium to further strengthen its reserves/balance sheet, while allowing shareholders to suffer from dilution.

Rules of demand and supply apply inside the share market as much as they do outside of it. Assuming CBA's example will be adopted by the rest of the industry, I think this is the clearest sign that banks' share prices are likely to underperform the broader market this year. This does not mean they are cum a significant sell-off (which they are not).

China

The road of probable consequences from the US Fed's tapering program runs through Beijing, it would appear. China watchers and international funds managers are watching developments in the Middle Kingdom closely with preparations taking place for increased volatility as Chinese authorities and the local finance industry are about to let loose the first victims from the shadow banking sector. At least, that is the general trend of speculation.

Yes, there will be consequences, and volatility is likely to be the easiest consequence to anticipate, but China is not about to experience its own Lehman-moment. The most convincing argument against such claims is the fact that China is still very much a financial island that has yet to be fully integrated into the global finance network, wherein Lehman's collapse was able to cause so much harm.

However, any signs or concerns about anything impacting on Chinese growth, confidence or demand for commodities, will have an impact, no matter how short-lived it might prove to be. Last week, I warned about the increasing threat for such a left field event. See the video HERE

Meanwhile in the background…

The slower than expected start to the new calendar year in the US is causing economists worldwide to rebase their growth expectations for the full year. A second factor remains slowing growth and growing obstacles in Emerging Markets, which is also weighing on growth expectations for 2014. This, one would expect, is weighing upon equity markets post yet another season of market beating corporate results (and this time Australia chimed in).

(This story was written on Monday, 3rd March 2014. It was published in the form of an email to paying subscribers on that day).

*About All-Weather Performers: see further below.

See also last week's "Corporate Reports: Just What The Doctor Ordered"

Paying subscribers should note all my Weekly Insights are archived and accessible via the website. See Rudi's Views in the FNArena Cockpit.

(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. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July this year forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet was released in January this year and is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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