The False Comfort Of Cheap Versus Expensive

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In This Week’s Weekly Insights:

– The False Comfort Of Cheap Versus Expensive
– Investing In All-Weather Model Portfolio
– Are Investors Too Sanguine About US Interest Rates?
– Danger Lurking For Orica
– Hosting Your Money, Your Call
– Radar On Buy-Backs
– Rudi On TV
– Rudi On Tour

The False Comfort Of Cheap Versus Expensive

By Rudi Filapek-Vandyck, Editor FNArena

Today’s story is about crocks, the unfashionable footwear that appeared to be conquering the world by stealth only a handful of years ago.

Actually, it’s not. Today’s story is about investing in the Australian share market. But first, let’s stick to the crocks. We’ll get back to investing later. That’s a promise.

It wasn’t until 2005 that I genuinely paid attention to what, at that time, was the latest footwear sensation coming from the US. Well before I had actually seen my first crock, local shops in my neighbourhood were flooded by cheap look-a-likes from China, costing virtually nothing to purchase and they looked just as “ugly” as the fashionistas among my friends said they looked.

To me buying these cheap Chinese copies was a no-brainer. Sure, they were not of the same quality product, and they certainly did not come with the marketed anti-bacterial qualities, but they looked just like the real thing, were comfortable to wear and cost next to nothing. After trying out my first pair, I quickly went back and bought a few spare pairs. In case the stores would sell out (which they did).

I don’t drive. I don’t have a bicycle. Especially in summer I walk around and I walk a lot. Soon I discovered these cheap copies weren’t that good when walking a lot meant every day in use. After a relatively short time I started feeling tarmac underneath one foot. Before long I had a widening hole in each of my soles.

I walked through my spare pairs at relatively quick pace. Disappointed, thinking I should have bought more, I noticed how my size had sold out far too quickly. Soon the final make-believe crocks were on sale. Even cheaper.

The experience reminded me of an old Scottish joke we used to tell when I was a young kid.

One Scotsman asks another: what’s in the pocket of your shirt?
The second says: that’s my special pen. Guaranteed to last a lifetime.
Hey, says the third, I have never seen you using that pen!
Exactly, responds the second, and that’s why it’ll last a lifetime.

Those cheap copy-crocks certainly gave you the feeling you had just secured the bargain of a lifetime, but unless you spent the whole day on the beach, the feeling didn’t last long.

But my interest had been piqued and I decided to bite the bullet and pay a lot more for a genuine pair of crocks, coloured in stylish outback brown instead of black, now my fashionista friends are no longer covering their eyes when I meet them outside the local coffee shop.

The biggest difference, however, has been that I genuinely don’t remember when I bought them. I am still walking around the neighbourhood, accumulating kilometers along the way, and even though one of my soles is starting to reveal a little hole on the right foot, I am sure it’ll be a long time still before I have to start looking for a replacement.

Investors Are Obsessed About ‘Cheap’

Ever since Benjamin Graham published The Intelligent Investor, share market experts and investors are obsessed about buying cheaply. Offer anyone the choice between two stocks in the same sector and chances are they make a decision based on which one is perceived to be the cheapest.

And yet, Santos has not outperformed Oil Search in recent years, or Woodside Petroleum. And Commonwealth Bank has just about beaten every other bank in the total investment returns department, despite offering lower yield and a premium valuation, shorter time catch up rallies notwithstanding.

The same can be said of CBA versus BHP Billiton. Of BHP versus Rio Tinto. Of Nine Entertainment versus Southern Cross Media. Of Ramsay Healthcare against every other healthcare stock.

Buying the cheapest option does not mean we have secured a bargain. In all of the examples I just mentioned, it wasn’t even the smartest decision as the more “expensive” stock proved the better performer.

To draw a direct parallel with my crocks experience: cheap can keep you happy in the short term, but also very, very dissatisfied in the longer run.

One obvious example that comes to mind is that of Toll Holdings ((TOL)). The company has been on my radar for years since it has been steadfastly recommended by many an expert, mostly on the basis of the macro-assessment that if and when the Australian economy shifts into a higher gear, Toll Holdings should be a major beneficiary. In-built leverage. Cheap valuation. I’ve heard it so many times, I can almost dream the exact wordings behind the justification.

Of course, one morning we all woke up and Japan Post had agreed to pay the truly incredible premium of no less than 48% for Toll shares. There are quite a number of happy smiling stockbrokers and their customers around since. Admittedly, such is the luck that can occur only when the price is cheap.

We will never see a similar premium being offered for a high multiple stock such as Ramsay Healthcare or Domino’s Pizza. In fact, we will likely never see a bid for these companies, full stop. But should this distract us from the fact that Toll Holdings was a dog of a stock? It had been a dog for a long while and if it wasn’t for the luck of a Japanese suitor, the share price would have again weakened following yet another less than inspiring, below-expectations profit report in February.

I suggest investors take a good long look at Toll’s share price chart going back to 2010 (use yahoo!Finance if no price chart available). Witness how Toll’s share price prior to the Japanese offer was lower still than where it was in early 2010; that’s five long years ago.

Admittedly, over the period the shares have traded as high as $7.43 and as low as $3.76 and Toll does consistently pay a dividend to shareholders. But for the shares to have been a good investment without the assistance of Japan Post required exquisite timing.

There are many comparable “cheap opportunities” in the share market. BHP Billiton comes to mind. Transpacific Industries is another one. Certainly, QBE Insurance has disappointed far more investors over the past five years than it has pleased with its rally post the February results.

Each of these stocks has had their short term rallies post 2010, but this merely implies they have been more suitable for traders than for investors, despite showing up as “cheap” on valuation surveys and PE multiple tables.

Thus far in 2015, just about every other week I run into an investor who confesses he or she (mostly he) either owns shares in Atlas Iron, or knows someone who does. No doubt, the shares looked ridiculously cheap when they were acquired. Looking “cheap” no doubt plays a role as to why so many punters keep asking questions about UGL, Monadelphous, MMA Offshore, Bradken, WorleyParsons, Emeco, et cetera. They all look “cheap”. So does Lynas Corp.

None of these names has been a good investment during years past, apart from the occasional short-term rally. I very much doubt whether any of them might prove a good investment anytime soon.

Don’t get me wrong: I do accept that buying a good asset at a cheaper price is the ideal starting point and certainly some of recent success stories -Qantas comes to mind- started off from a cheap valuation and therefore offer significant upside when the reversal in fortune arrives. But just like in the book (or movie) He’s just not that into you, it is my observation investors far too often use the exception -airlines- to create a rule that only serves to self-delude.

“Valuation” without proper context is nothing but a head fake, a sucker’s trap. When economic conditions are patchy and demanding, as they have been over the past five years, flawed and vulnerable business models reveal their weaknesses and therefore command “cheap” valuations. These “cheap” valuations are not a sign Mr Market is leaving a free lunch for anybody to pick up and walk away with.

The Contradiction Between All-Time Highs And Lows

The above observations are not genuinely “new”. I use them often in my live presentations on stage. Imagine when I visited Europe back in 2008, many of my friends had bought shares in Fortis since they had fallen so deeply. A few weeks later their shares were near worthless. Something investors in Australia who were left holding Forge Group shares certainly can relate to.

Equity analysts in the US long ago discovered the apparent contradiction between stocks that hit all-time highs and those that hit all-time lows. As obsessed as they are with buying “bargains”, investors instinctively tend to shy away from the first, while jumping on the latter. Further analysis shows, however, the first group of stocks is likely to generate more winners than the second. Cheap is not by definition a good buy.

A few weeks ago, Shawn Hickman of local newsletter Market Matters, published a similar observation supported by data analysis. Here are his words:

“It has been confirmed to me on an almost daily basis that investors are far more comfortable buying a stock that has fallen 10-20%, rather than one making a new all-time high. Unfortunately, human psychology is often an enemy for investors who struggle at rule number 1 of investing/trading:

Run your profits and cut your losses.

“Consider the below analysis of stocks in the US S&P500 over the last 100 years:

– after the stock market hits a 52-week high, the compound annual gain over the next year is 9.6%. That is an impressive outperformance over the long term “simply holding” return, which yields 5.6% a year
– buying when stocks are within 6% of their 52-week lows leads to compound annual gain of 0%. No gain at all 12 months later!

“The above history illustrates perfectly that investors are far better buying new highs than new lows.

“Readers will not be surprised to learn that when I look at “beaten up” stocks, I am far fussier than buying stocks that are advancing strongly.”

Don’t Ignore The ‘Strong’ Opportunities

So where does all this lead us to? At the very least it shows original crocks are worth a lot more than their cheap, Chinese manufactured copies. This should not stop anyone from buying at discounted prices. It should not stop anyone from buying, full stop.

This doesn’t mean there’s no advantage to be had from buying the cheap copies. Going to a rock festival and the forecast is for rain and mud? Don’t mind just leaving your muddy shoe wear in the nearest bin afterwards? By all means, don’t go with your newly bought originals.

In similar vein, there’s something to be said for trying to pick up stocks that are temporarily too cheaply priced. Flight Centre shares fell from $55 to below $32 between March last year and December. They are now trading above $39.

But don’t automatically dismiss an opportunity just because it doesn’t look “cheap”. A high PE multiple does not mean “too expensive – don’t touch”. It means investors have a lot of confidence the future is rosy and the company will live up to expectations. It is true that in some instances this confidence is misplaced. But then stocks like Xero ((XRO)) or Sirtex Medical ((SRX)) are not of the same ilk as are Ramsay Healthcare ((RHC)) or CSL ((CSL)) or Amcor ((AMC)).

Most investors talk themselves into a mental funnel which prevents them from owning star performers such as Ramsay, CSL or Amcor because these stocks are “always too expensive”. Yet, what all these investors are essentially doing is excluding themselves from the strongest and most solid, proven and sustainable, less risky growth stories available in the Australian share market.

Consider the following observations:

– Domino’s Pizza ((DMP)), widely seen as one of the “most expensive” stocks listed on the ASX, is up 42% for the year thus far. Domino’s Pizza shares were “expensive” on January 1 too

– Ramsay Healthcare shares are up more than 13% thus far this year, excluding one interim dividend paid out. Ramsay shares were equally expensive on January 1

– Technology One ((TNE)) shares, always the most “expensive” among local IT stocks, are up more than 21% for the year thus far

In addition, open up a five-year price chart for Amcor. Admire the beauty of a steadily rising share price (don’t compare with BHP Billiton if you have a heart condition) and then consider:

– Amcor shares haven’t been genuinely “cheap” for many years now
– Amcor spun-off Orora ((ORA)) last year, which has equally performed strongly so total performance is much stronger than shown on the price chart

Bottom line: there is as much room in everyone’s portfolio and strategies for strong proven growth stories that by now have been recognised as such (or at least: there should be) as there is for picking up stocks that are temporarily out of favour. Concentrate on “cheap” bargains alone and you will pick the occasional Forge or Fortis, while excluding yourself from proven success stories such as Ramsay, CSL and Domino’s Pizza.

If you wait until these latter stocks turn genuinely “cheap” you might as well acknowledge you will simply never own any of them. In fact, and such is the irony of the share market, on the day these shares look “cheap” it’s probably time to run for the hills. See Coca-Cola Amatil, Monadelphous and more recently Woolworths.

Investing In All-Weather Model Portfolio

Regular readers of my Weekly Insights stories are by now probably all too familiar with my research into the above and into “All-Weather Performers” in the Australian share market.

What is new is that FNArena, through partner Pulse Markets ( www.pulsemarkets.com.au ), now offers the possibility for investors to invest in a Model Portfolio that is based upon this specific market research and recommended by FNArena, through self managed accounts (SMAs) on the Praemium platform.

For all enquiries: info@fnarena.com

For more info on All-Weather Performers: see further below.

Are Investors Too Sanguine About US Interest Rates?

The calendar shows we have moved past mid-March and US equities are struggling to stay in positive territory for the year. The reason as to why, of course, is not difficult to pinpoint: investors are increasingly convinced the US Federal Reserve is about to start raising interest rates. There are quite a number of economists around who predict a steady pace of increases once the first hike has become a fact.

The main justification for this view is that the US labour market appears to be going from strength to strength. It is but a matter of time, so says the vox populi, before wage inflation shows up and the Federal Reserve is more likely wanting to stay ahead of the game.

But are investors too focused on US non-farm payrolls data?

On my observation, US economic data on just about anything other than the US jobs market are slowing down, and they have been signalling a slowing economy since the beginning of the calendar year. Note, for example, GDP growth for the first quarter is widely expected to start with a 1 by the time the final estimate is released. Hardly the kind of number one would expect to see from an economy that is widely described as in “good health” and “growing solidly”, let alone “the real deal”.

This is not just me nitpicking. I observe a growing number of economists is starting to pay attention. While indications from the US bond market are the Fed is almost certain to lift rates by the September meeting of the FOMC (odds more than 80%), and they might start as early as June (odds less than 50%), all of a sudden questions are being asked what the implications might be if economic data and indicators continue to surprise to the downside? Is the Fed really going to raise no matter what?

One problem with the market’s expectation this year will finally see Janet Yellen and Co abandon the zero rates policy is that such prospect has already been priced in. In the US dollar for example. Earnings forecasts on the back of weaker oil and a stronger USD have steadfastly fallen in the US and the recent Duke CFO poll revealed 60% of US CFOs are now citing the USD as a negative for their business.

Glushkin Sheff’s strategist Dave Rosenberg pointed out over the weekend the USD Index is already up by 15% year-on-year, which on its own equals some 200 basis points of Fed tightening. Add 25 to 100bp in de facto tightening because of financial tightening by Fed banks and it truly should be no surprise as to why the US economy cannot get away from sluggish growth numbers, not in a sustainable manner (despite so many economists predicting the opposite).

There is some irony involved as well since recent USD strength might be all about euro weakness more so than US strength, but what does this tell us about the temperature and the confidence during FOMC meetings?

Let’s not forget this still is the biggest monetary experiment in history. Any unwinding exactly according to plan might be a little too rose coloured. Not that US markets seem to be paying much attention thus far, but this, history shows, can change in a heart beat.

I would not be too confident the Federal Reserve will be lifting interest rates in June. I certainly would not be too confident US interest rates will go up in a steady and measured pace in the years ahead, just like Janet Yellen has it mapped out on her bathroom wall. This is going to be a game of many tricks, twists and surprises and one can only hope it won’t end with having to deal with the ultimate dilemma: inflation or economic growth?

In Australia, at least in the months ahead, this implies the RBA might have more leeway at its disposal, probably to its own discomfort. It means the Australian dollar might require an extra push to sustainably move to a lower trading range against the greenback. It means Australia’s high yielding stocks are not out of favour by a long shot, even though it might look like this is the case post-February.

Above all this means the outlook remains a lot less certain than most economists would have us believe. Don’t take their confidence for granted. Before long, we might all be reading and talking about the Fed’s true dilemma. Volatility is pretty much guaranteed. A predictable outcome, alas, is not.

Can the mightiest central bank on earth being held captive by global FX markets? It surely can, and it just might.

Danger Lurking For Orica

What is moving the Orica ((ORI)) share price?

Is it the relative yield in comparison with peers such as Incitec Pivot? Is it strategists’ calls to add more portfolio exposure to domestic cyclicals?

The question seems but appropriate since Orica shares are up strongly since falling to $17 in December and again near $17 in January, trying to leave the $20 mark in their slipstream in their post-reporting season rally. (Admittedly, they were trading above $22 in July last year).

The reason as to why this particular rally has caught my attention is because analysts at Morgan Stanley have been doing their best to attract investors’ attention to the fact that competition for ammonia nitrate on Australia’s East Coast is increasing at a time when actual demand/consumption is experiencing somewhat of a slump. The combination of these two can never be a good thing for local market leader Orica’s margins.

Last week, Morgan Stanley issued a report that contained pretty scary subtitles such as “Conviction to the downside” and “The east coast continues to lead the downturn”. Yet, investors were simply not paying attention. For some reason they all of a sudden did pay attention on Monday when the shares severely underperformed an already bleak looking share market.

So what changed on Monday? Maybe my Tweet on that morning might give us a clue:

Trading Tip from Morgan Stanley: Orica shares to underperform the ASX200 over next 60 days as ammonia nitrate prices under pressure #ausbiz

It’ll be interesting to see whether any of the other stockbrokers joins Morgan Stanley with a detailed follow-up. No less than three stockbrokers (out of eight) have yet to release a research report on the company in 2015. Orica runs on a September 30 fiscal year. Of those who updated in March, three (including Morgan Stanley) rate the stock an equivalent of Sell. Deutsche Bank is the current high marker with a price target of $26.25 and a Buy rating.

The sale of the company’s chemicals operations is supporting a $400m share buyback. That same sale has also turned Orica into a full mining services provider. However, as far as I am concerned this makes the stock more yuck than yummie, at least for as far as the eye can see into the future.

Hosting Your Money, Your Call

Some readers of this weekly analysis might have already picked up on it, but in 2015 I have become one of the regular hosts on Sky Business’s Your Money, Your Call. The formula for this program consists of three experts sitting in the studio and responding to calls and emails from viewers, pretty much on the spot.

So far so good, except that when I am hosting the program we do things a little differently. Probably the best way to describe what’s going on under my supervision is “edutaining, organised chaos”. I like to challenge other experts’ views and bring more depth and public debate into the mix. Thus far I hosted two programs, both in February, and the feedback has been remarkably positive.

I am not just saying this to blow smoke up my own a**se (gotta love a good Australian expression) but I have noticed people making the specific effort to look me up and congratulate me with the two shows. From studio guests, to viewers, to peers and commentators elsewhere, the most heard expression I come across these days is: Rudi, I really loved your last Your Money, Your Call. Clearly, I am onto something.

Three weeks ago we had the luck of the calendar on our side, debating heavily and with passion about the pros and cons of owning Woolworths ((WOW)) shares only two days before the company released its worst public announcement in at least a decade. No doubt, this factor has also played a role as to why so many viewers liked it so much.

I cannot promise the show will hit the jackpot every time, but I can promise freewheeling entertainment, filled with in-depth knowledge, insights and expert observations on investing in the Australian share market and on certain individual stocks in particular.

If you have access to Foxtel payTV, maybe check it out. I am hosting again this week on Wednesday, 8-9pm, on Sky Business. Your Money, Your Call – Equities. I should be on every month for the rest of the year (details included in this weekly email – see Rudi On TV further below).

FNArena Sponsors ASX Investor Series

ASX Investor Series, Sydney March 17, 12:30pm -2pm

Don’t miss the next opportunity to hear from CEOs over lunch with an informal meet and greet session at the conclusion of presentations. Speaking at this event are ALE Property Group, Blue Sky Alternative Investments, eBET, Lifehealthcare Group, and Money3 Corporation.

These events are free to attend however registration is required as seating is limited. Register here ?

Radar On Buy-Backs

Companies that buy in their own stock are more often than not rewarded with share market outperformance. Below is an incomplete overview of companies buying in their own shares this year. All suggestions and contributions welcome at info@fnarena.com

– Amcor ((AMC))
– DWS Ltd ((DWS))
– Fairfax ((FXJ))
– Fiducian ((FID))
– Finbar Group ((FRI))
– GDI Property Group ((GDI))
– Logicamms ((LCM))
– Nine Entertainment ((NEC))
– Orica ((ORI))
– Rio Tinto ((RIO))
– Seven Group ((SVW))

Wants to buy in own stock (but still awaiting shareholders approval): Intrepid Mines ((IAU))

Rudi On TV

– on Wednesday, Sky Business, 5.30-6pm, Market Moves
– on Wednesday, Sky Business, 8-9pm, Your Money, Your Call
– on Thursday, Sky Business, noon-12.45pm, Lunch Money

Rudi On Tour

I have accepted invitations to present:

– August 2-5, AIA National Conference, Surfers Paradise Marriott Resort and Spa, Queensland

(This story was written on Monday, 16 March 2015. It was published on the day in the form of an email to paying subscribers at FNArena).

(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 2013 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

Odd as it may seem, but today’s share market is NOT only about dividend yield. Post-2008, less risky, reliable performers among industrials have significantly outperformed and my market research over the past six years has been focused on identifying which stocks, and why, are part of the chosen few; the All-Weather Performers.

The original eBooklet was released in early 2013, followed by a more recent general update in December 2014.

Making Risk Your Friend. Finding All-Weather Performers, in both eBooklet versions, 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

For paying subscribers only: we have an excel sheet overview with share price as at the end of February available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms