Rudi’s View: Forecasts, Not Valuations

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

Dear time-poor investor: are share markets egregiously overvalued? Is Biden as President a problem? Can Telstra create value through structural separation?

In this week's Weekly Insights:

-Forecasts, Not Valuations
-Is Biden A problem?
-Telstra, There Is Another Way
-FNArena Talks

Forecasts, Not Valuations

By Rudi Filapek-Vandyck, Editor FNArena

Once again it has become a popular opinion that share markets are pricing in too much exuberance in light of what the economic recovery story can possibly deliver.

One way to illustrate this year’s euphoria-gripped markets is by measuring the average Price-Earnings (PE) ratio and concluding this year’s swift recovery is off the charts, with PE ratios higher than at any other time in history, beating 1929, 1987, 2000 and 2007.

But is this really the most accurate measure available? Is it even appropriate to guide our views about the status and prospects for equities today?

I beg to differ.

Apples Versus Oranges

Let’s start with the most obvious observation: comparing today’s index valuation with history is not comparing apples with apples.

Indices change because their composition changes. Back in 1987, the two most important constituents of the ASX200 today -CSL ((CSL)) and CommBank ((CBA))- weren’t even listed yet.

In fact, there was no ASX200. All we can compare with is the All Ordinaries, and that index looked a lot different from its successors today.

Back in 2000 the most important index movers were two listed shares in News Corp. By late 2007, resources were trending towards peak index weight.

In 2020, the largest index constituent is CSL and it always trades at a premium versus the broader market. In-depth analysis by UBS earlier in the year established that having CSL as the top index weight in Australia adds around 100 basis points to the average PE for the ASX200.

News Corp doesn’t even feature anymore.

In the slipstream of CSL moving to top spot in Australia, we have numerous index climbers that have grown in index weight over the past one or two decades, and they all trade on much higher multiples than the stocks they replaced.

Think of Macquarie Group ((MQG)), Aristocrat Leisure ((ALL)), Fisher & Paykel Healthcare ((FPH)), REA Group ((REA)), ResMed ((RMD)), and Cochlear ((COH)) instead of Westfield, Mayne Nickless, Pacific Dunlop, Harvey Norman, and AMP.

And that’s not even mentioning the new business models that have risen to the challenge, and to investor’s attention, over the past five years or so. In 2020, all of Afterpay ((APT)), a2 Milk ((A2M)), Magellan Financial ((MFG)), and Xero ((XRO)) are on par, or even weightier, than household blue chip names such as QBE Insurance ((QBE)), Suncorp Group ((SUN)), Origin Energy ((ORG)), and Lendlease Group ((LLC)).

One does not necessarily have to agree with the valuations of these new kids on the block, but simply an acknowledgment that indices have changed significantly renders that simplistic comparison on the basis of a simple average PE calculation invalid.

PE Methodology Misunderstood

Societies are going through transformational changes; they happen fast and remain irreversible. Today’s ASX200 index is as much a reflection of this transformation taking place as it is of the extreme polarisation that is occurring as a result of these changes.

When the average share market PE is the result of combining Afterpay, trading on an unknown multiple because the company is not profitable, with Unibail-Rodamco-Westfield, Scentre Group and Janus Henderson, all trading on single digit PE multiples, surely one must question the practicality of using one all-encompassing, generic average for the market as a whole?

Even then, it seems to me many investors don’t appear to understand the essence of how Price-Earnings (PE) ratios work.

To put it simply: back in all of 1929, 1987, 2000 and 2007 share markets were priced on high PEs based on peak forecasts, which subsequently turns into a nasty problem when those forecasts fall and PEs need to reset at a more appropriate, risk-adjusted level.

In 2020, forecasts have fallen deeply since the global pandemic hit. Most economists and other forecasters, be they bullish or cautious, expect a recovery to emerge.

We can still debate the strength and exact duration, even the shape of the recovery, but not the fact that looking forward to a recovery from a trough in the economic cycle automatically translates into high PE ratios.

Allow me to illustrate this with a practical recent example: when shares in BHP Group ((BHP)) fell near $13 in early 2016, the PE on Macquarie’s forecast rose to 100x. This was not an indication that BHP shares were amazingly expensive (as we’ve all witnessed since).

That PE of 100x (80x on other analysts’ forecasts) was merely an indication that, looking beyond the immediate outlook, and assuming recovery was to follow, the PE for BHP at that time was appropriately high.

A similar observation can be made for, among many others, Blackmores ((BKL)) shares, currently trading on consensus FY20 PE of 67x, declining to 38x on next year’s forecasts.

Sure, the whole notion that these forecasts can be too rosy and this pushes the multiple even higher, and thus the share price might have to come down might be valid, but it will not translate into Blackmores shares trading on single digit PE multiples.

That’s simply not how this works. Unless we all collectively give up on any prospect of a recovery, which is what happened during the GFC.

Incidentally, and as highlighted in the BHP example earlier, PE multiples for both miners and energy companies fluctuate often between extremes, which is yet another reason why a general average market PE in Australia is seldom the right tool to use.

Low Yields & Inflation

Lastly, the key difference between 2020 and prior historic reference points is made up by extremely low sovereign bond yields, which reflects favourably upon other assets, including equities.

Detailed analysis from historic data had already established that periods of low inflation and low cash rates/bond yields translate into higher valuations, on average, for equities.

The current environment of extreme low bond yields, alongside low inflation, has simply added another step on top of this basic principle, without even mentioning the truly unprecedented liquidity and support measures from central banks and governments.

So where does all this leave us?

There is no denying parts of equity markets are exhibiting unbridled euphoria and extreme momentum focus as is typical for every bull market. 2020 is not an exception.

Share prices surging higher by double digit percentage, on multiple consecutive days, more so in the US than here in Australia, is not indicative of a rationally behaving market.

But is it indicative of broad, widespread irrational exuberance?

Ultimately, whether today’s share prices can be maintained and justified hinges on the macro-outlook (economic recovery) and on what individual companies can achieve in terms of cash flows and profits.

Within this context, ResMed trading on more than 40x times this year’s and next year’s consensus profits may not necessarily imply the stock is set-up for a big correction, just like shareholders in Treasury Wine Estates, Vicinity Centres and Japara Healthcare might have to be a lot more patient, and even endure ongoing share price weakness for a while.

Instead of getting spooked by apparent elevated valuations, I think investors will be better served by focusing on the achievements and the outlook for individual companies.

The upcoming August reporting season will not answer all questions, but it might provide lots of clues and insights.

At the macro level, there remains the potential for another period of extreme market rotation in case of vaccine success; out of “expensive” and into “cheap”, similar to what happened in late 2016.

Ultimately, I believe forecasts, not today’s valuations, will decide the direction of shares in the short and medium term. Which is why macro developments remain crucial.

And a guarantee for ongoing volatility, and many more attempts for portfolio rotation.

Investors better get ready. This show is only half-way through, at best.

Is Biden A problem?

Occasionally, the question lands in my inbox: Rudi, what do you think will happen with Trump in November? If he loses, will it be a problem for the markets?

From the surveys and the commentaries I have read to date, the answer is a firm negative.

It appears Wall Street has already resigned in the fact that Trump will likely lose the election, and this means a partial winding back of the extremely favourable tax cuts, plus a number of other changes in healthcare and for the wealthy 1%, etc

But in place of Trump’s mishandling of the current health crisis, and the uncertainty caused internationally, comes a much steadier hand, and that will be welcomed by businesses and their leaders.

Not to be dismissed: Biden has answered Trump’s focus on fossil fuels and other traditional parts of the economy with the intention to invest in tomorrow’s infrastructure with more emphasis on renewables and sustainability.

Investors in the share market already made that switch.

Telstra, There Is Another Way

Once again I had to find out the hard and painful way that Telstra ((TLS)), simply put, is not a world-class operator.

But, lucky me, I also discovered there are many people working at Telstra under not so ideal circumstances, in a far from idyllic environment, and they are motivated, hard-working angels, putting in their utmost to right whatever went wrong, in the quickest and most practical way possible.

This has to be acknowledged, and today I bow my head to you all. I admire your mental strength and your fortitude, your persistence and your sheer personal sense of responsibility to not let Telstra customers disappear in that self-created giant sinkhole, never to be heard from again.

Under different circumstances, I would by now emphasise that a company like Telstra simply cannot be an excellent value creator for long-term shareholders. It is simply not running well enough.

But then analysts at Wilsons publish their view that Telstra is, in their suspicion, quietly preparing for a structural separation into two or more separate companies (the analysts think there is a case to create four separate companies).

Such an unbundling, says Wilsons, could unleash as much as 50% in added shareholder value between now and 2025.

And this, I say, fits in perfectly with the narrative I started this story on. There is always room for another side to the story.

In case anyone wonders: Fiber, Infra, Retail & Tower.

FNArena Talks

-One of my recent interviews is now available as a podcast via Spark Your F.I.R.E. buff.ly/3j0A1Gm

-Webinars in September: CPA SMSF Discussion Group (16^th) and Australian Shareholders Association (ASA) on 22nd

(This story was written on Monday 20th July, 2020. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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