All-Weather Performers: Understanding The Dynamics

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By Rudi Filapek-Vandyck, Editor FNArena

The Australian share market's conundrum showed up once again in Morgan Stanley's recent strategy update: it appears stocks trading on a high Price-Earnings (PE) multiple are only getting more "expensive" while, conversely, those stocks on a low PE remain unable to close the gap, getting "cheaper" instead.

On Morgan Stanley's assessment, high PE stocks are now trading at a seldom witnessed 20% premium against the decade average versus their low PE cousins in the local share market. This explains why some experts have started warning investors about continuing to buy market favourites. Herd behaviour is part and parcel of what goes on every day in the share market and no doubt there's ongoing desire among investors to lift their exposure to better conditions for building materials in the US and here in Australia, but PEs for the usual targets Boral ((BLD)) and James Hardie ((JHX)) are well into the twenties for the current financial year. And that's just one example.

Australian banks are not part of the local High PE Club, but they remain a popular destination regardless and apart from noticeable weakness throughout January, those supposedly over-inflated share prices do not seem to have it in them to weaken a lot, without bouncing back in a heartbeat.

The connection between High PE stocks and Australian banks is that both represent a higher degree of confidence and reliability. Contrary to what one might expect, both also represent a lower degree of volatility. Combine these elements and what you get is a more consistent performance; exactly the target for bear market-scarred investors post GFC. Most who have reached, or are approaching, retirement stage today have seen Big Bear Claws hacking into their investment funds twice within the space of one single decade and they have decided that whatever goes into shares will go into lower risk options with lower volatility, a higher degree of reliability and a track record of consistent performance.

Apart from the abovementioned banks, and solid dividend payers amongst the relatively safe infrastructure owners, utilities and Real Estate Investment Trusts (REITs), companies also singled out by investors (and their advisors) include Invocare ((IVC)), Ramsay Healthcare ((RHC)), Domino's Pizza ((DMP)), Woolworths ((WOW)), Amcor ((AMC)) and CSL ((CSL)). What all these companies have in common is they maintained a positive performance throughout the disappointing years 2010-2011. They also all have in common that when the rally took off in mid-2012, none of them looked particularly "cheap".

In 2013 they all looked rather "expensive". Yet in 2014 they still all look "expensive", in many cases even more so than last year, but in most cases the performance, beyond day-to-day fluctuations, has remained positive, and none has seen a permanent sharp fall in profits or share price.

At face value, these observations are counterintuitive. The share market, so goes the old adage, is all about finding undervalued stocks and waiting for the share price to recover to its potential. Popular stocks become too expensive and then by default too much potential has been pulled forward and thus potential return is reduced, if not negative.

So how come this hasn't happened in this case?

What we are witnessing, in my view, is a major shift in the investor psyche post-GFC. Not only do SMSF trustees represent an ever bigger part of fund flows, and in decisions as to where those funds should flow, but Baby Boomers reaching retirement are also becoming an ever larger and more influential group of investors in the local share market.

More savvy advisors and fund managers have already changed their strategies and policies to meet the specific changes in demand from their clientele, which can be summarised as: I am happy to forego some of the upside, as long as I also miss out on the downside.

Recent feedback from the financial advisory industry is that only now, in 2014, there's a noticeable flow of wealthy investors seeking to redeploy some of their cash into equities. And then, still, only part of it. General appetite for BHP Billiton and Rio Tinto is low, not to mention smaller resources plays.

But that's only half of the story. The experience since 2009 has revealed large parts of the Australian economy, and thus the share market, are undergoing structural change, challenged by a higher Australian dollar, slower growth in China, climate change, the Internet and Mobile applications, new competitors and changing consumer behaviour. The result is only few in the local share market can claim reliable and consistent growth in either profits and/or dividends. And those few have by now well and truly been identified.

Welcome to the era of the All-Weather Performers.

Alas, in a relatively small economy, with a share market dominated by high risk and underfunded resources and energy stocks, the pool of truly reliable and consistent performers is not large. And that's a serious understatement. Making matters worse is that some of the reliable go-to stocks from the past have by now fallen victim to changing market dynamics themselves, and thus their membership has been revoked: Blackmores ((BKL)), Reckon ((RKN)), McMillan Shakespeare ((MMS)) and Monadelphous ((MND)) are out and unlikely to return soon, if ever. Coca-Cola Amatil ((CCL)) is probably still a member but its growth outlook is under serious challenge right now, and it may take years for the new CEO to right the ship.

We cannot all buy shares in Woolworths, CSL, Ramsay Healthcare and the banks into perpetuity. So what gives?

Wherever there is a demand, the share market will find a way to provide a solution. In this case, investors have broadened the concept of "All-Weather reliability" by zooming in on a horizon of the next two to three years. Which companies can be relied upon to deliver in the next three years? Mr Market has already identified them and, by now, confidently pushed these stocks onto a premium valuation. What is rare deserves a commensurate price tag.

Enter companies including REA Group ((REA)), Carsales.com ((CRZ)), Flight Centre ((FLT)), Breville Group ((BGR)), Navitas ((NVT)), G8 Education ((GEM)), and a handful others.

What all these companies have in common is that confidence is high they will deliver on current growth expectations and they might even surprise to the upside, which is why they all trade at a premium against historical averages: against the broader market and against their peers. Value-minded investors who like to hold on to the concept that premium PEs are by definition the death knell for future returns now have a serious dilemma to overcome. Stick to low PEs and you are guaranteed never to be able to own a piece of the most solid, reliable growth stories the local share market is able to offer.

Or, as shown in the case of ex-members Monadelphous, Reckon et al, it is far more likely that when any of these stocks becomes truly "cheap" again, it's probably time to really worry about what possibly lies ahead.

What all these companies have in common is that delivering on profit potential is not dependent on interest rates staying low, or on AUD weakening, or China announcing new stimulus, or consumer spending picking up further, or economic growth surprising to the upside this year and next. This is why these stocks truly resemble investors' new mindset post-GFC.

I am obviously hoping many among you have taken note of my research and analyses in years past, and that your portfolios already contain a healthy exposure to these stocks.

The main question that is now waiting to be resolved is whether demand for such reliable and consistent All-Weather Stocks is nothing but a temporary fad. If the answer is "yes" then it is probably time to start saying goodbye to the star performers from the years past as mean-reverting PEs can inflict a lot of damage to portfolios with significant exposure.

This is why some experts are warning not to go there anymore. The Herd has spoiled that party, so to speak.

I remain as yet unconvinced this is the case.

Apart from the boom that is presently occurring in retiring Baby Boomers, and the number of SMSFs keeps on rising too, the outlook for corporate profits in Australia continues to come with many question marks attached. China in itself harbours a lot of uncertainty and this, in my view, is not going to fundamentally change in the years ahead. The outlook for the domestic economy is fairly resilient now that volumes are replacing investment in the mining industry and with consumers and housing rediscovering their mojo, but the underlying picture remains uneven and fragile. Non-mining businesses are not spending and the government's infrastructure plans will require another 18 months. Old school media companies and bricks and mortar retailers may be experiencing reprieve from the abyss, but long term industry challenges remain.

Amidst all these uncertainties there is very little doubt that REA Group will continue to report strong growth numbers for the coming year, and for each of the years thereafter. We're talking 20% per annum, and more. As a consequence, there is a lot of confidence today the REA share price will be higher in three years' time. Possibly a lot higher. It then simply becomes a matter of what price am I prepared to pay for this outlook?

To a large extent, investing in All-Weather Stocks has become a matter of "value lies in the eyes of the beholder". On FY13 reported profits, REA Group shares are today trading on a PE of 51. On prospective FY14 numbers the PE falls to 42. On FY15 numbers the PE drops further to 33. The same principle applies to all other members of this exclusive selection of prime quality Aussie reliability. In all other cases the numbers are lower, but that's because prospective growth expectations are lower too (apart from the fact that we'll probably never see a supermarket operator on such high PEs. Woolworths' PE peaked above 27 in the crazy year that was 2007).

There is, of course, a genuine chance the likes of REA Group can temporarily overheat. After all, today's share price is near its all-time record high of $52. Price charts for Woolworths and Wesfarmers ((WES)) clearly show that avoiding excessive peaks has become a strategy that pays off if investors want more than just two times a dividend as their annual return. This may be easier said than done for most of us, but the share market is setting the rules and we can only apply them in the smartest way possible.

Throughout my live presentations since 2010, I have constantly expressed my wish that I hoped the low quality, the higher risk and the less reliable cyclicals would have their moment under the sun so that the Herd can forget about what is secure and jump on what moves upwards instead. It is my view such a shift is probably required to de-rate the small selection of All-Weather Stocks, opening up opportunities for investors who are able to value such treasures in a long term investment portfolio.

The alternative is, of course, when expectations cannot be met (like in the case of Coca-Cola Amatil). This is no different from buying lower PE stocks, see smaller resources and mining services providers. If anything, market confidence suggests the chances of All-Weather Stocks having to issue a profit warning are much lower than for the rest of the share market. This is why these stocks trade on a premium, remember?

Iron Ore In Focus

Word has spread that one of the most popular features in the UBS research universe this month has been an attempt to calculate breakeven production prices for all Australian iron ore producers. UBS analysts have subsequently followed-up with a broadened exercise, including major international producers as well. First observation is, of course, that most breakeven price levels remain well below the current spot price, no matter how much weakness has been seen in past weeks, indicating growth may not be secured, but cash flows remain high and production remains profitable.

Second observation is that Brazil's Vale, once the undisputed number one in this sector, has now moved to the centre of the cost curve, which has a lot to do with higher transport costs from Brazil compared with Australia. Currency values are also increasingly important. The overview below should also explain as to why both Rio Tinto ((RIO)) and BHP Billiton ((BHP)) show no hesitation in continuing to expand their supplies. It's our production increase, but it's the competition's problem!

Ardent Leisure's Re-Rating

It was only a few years ago the Ardent Leisure ((AAD)) share price was hovering around the $1 mark and implied forward looking dividend yield (no franking) was well above 10%. Fast forward to today and present FY14 consensus estimates put the yield no higher than 5.2%. Maybe the real focus should be on the 5.8% that appears to be on offer according to FY15 estimates, showing the strong growth profile that is increasingly been ascribed to the operator of theme parks, marinas, gyms, bowling centres and -the current engine of growth- Main Events in Texas, USA.

The share price has rallied strongly after lingering around $2 for a while, lifting the Price Earnings ratios to 20 (FY14) and to below 18 on FY15 projections. Ardent Leisure's ascent is an indication that reliable, consistent growth remains a rarity in the Australian share market, hence the continuous re-rating. Main question: how far exactly can this re-rating go? 

Flexigroup Weighed Down By Solar Panels

I have previously pointed at blatant share price weakness for financing services provider Flexigroup ((FXL)) and it would appear investors are increasingly taking a very dark view on the future for solar panel installations in Australia. The fear/speculation revolves around the Abbott government's many attacks on government-sponsored incentives to install solar panels and then feed excess power back into the grid. Utility owners such as AGL Energy ((AGK)) and Origin Energy ((ORG)) have the ear of the government in Canberra and soon there will be no more incentives for anything related to solar panels. At least such is the market's fear when it comes to Flexigroup.

Why Flexigroup? Probably unknown to most investors, Flexigroup has been one of the major financiers behind installations of solar panels in recent years. In fact, analysts at Morgans recently pointed out solar panels are the single biggest asset concentration inside Flexigroup, representing no less than 20% of annual revenues. The market is obviously taking the view that changes put in place in Canberra are about to decimate this fledgling green energy sector in this country. This is why the share price is now well below $5, the peak from last year, and also well below analysts' price targets.

To be fair to Mr Market: a complete removal of the solar panel financing revenues would instantaneously damage the steady rhythm of double-digit annual increases in earnings per share that has been the company's legacy over recent years, and it was expected to remain the key feature for the years ahead. The question is thus: how deep an impact will we see? Only the future will tell.

(This story was written on Monday, 17th March 2014. It was published in the form of an email to paying subscribers on the day).

Special Message to Paying FNArena subscribers: we have compiled an excel spreadsheet with five year history for 23 stocks that can be considered a member of the exclusive All-Weather Stocks club. Send us an email at info@fnarena.com to receive your copy.

(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 of last 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 2013 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 last 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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