Good afternoon,

Struggling this week to find much exciting to write about, so I’ll do my best to keep it interesting. ASX200 closed down last week but has recovered some ground this morning to be up 45bps since last week’s note. Resources led the gains, though Healthcare and Energy stocks were also strong contributors.


Indices are for morons

Though looking at sectors in a market as thin as ours can be a little deceiving. As many of you already know, I like to analyse the market in a couple of key dichotomies:

  • Resources VS Non-Resources
  • High Valuation VS Low Valuation (Value vs Growth)
  • Cyclical VS Defensive
  • Large VS Small

These kind of delineations allow for us to remove the effect of indiscriminate averaging which is a feature of indexing, media coverage and most market commentators.
“The average human has one breast and one testicle.” 
Des McHale 
Resources earnings are really holding up the index right now and as you can see below, courtesy of Citi.

Earnings growth (EPSg) is certainly slowing across the board. Though, particuarly for less cyclical non-resources companies, it’s important to realise that in percentage terms, we’ve had a large ‘rebound’ in earnings after a protracted period, post-GFC of flat or negative EPSg.

The red box shows this period and as you can see, only recently (in the green box) has more broad-based economic growth begun to benefit the majority of our companies (rather than a select few).

Mining companies on the other hand have been through another boom-bust-recover cycle which has resulted in a period of synchronized growth in both resources and non-resources companies.

The trillion dollar question remains “Will this continue?” Can commodity prices go higher and sustain this >8% EPS growth? Here’s BHP vs the copper price. You tell me?

Based on history, you’d argue the strength in commodity prices and mining company share prices is similar to the pre-GFC, China-boom years. Though this time around, China isn’t booming. This kind of exuberance does have me worried. Perhaps the pure scale of development in China is beyond the comprehension of my simple brain, perhaps you can just build apartments and bridges and tunnels for a population that doesn’t yet exist, ad infinitum. Then again, maybe you can’t, maybe it’s fueled by unsustainable suppression of free markets, huge expansions in credit and rampant speculation. But then again, who knows.


Warren Buffet Groupies

In recent years, the narrative of our market has been driven by growth stocks. These stocks typically have earnings and sales growing at double digit rates and subsequently, the market places their stock on high valuations, anticipating these rates of growth to continue (and subsequently, the valuations to come down).

The opposite of growth stocks are value stocks. Value stocks are essentially just anything that’s not growing its revenues and profits fast.

A lot of Warren Buffet groupies like to pretend there is something special about ‘value investing’ or labeling yourself a ‘value investor’. To be honest, if you aren’t a value investor I’d be worried. What are you? An investor who likes overvalued companies?

Anyway, value stocks typically offer some other form of prospective return, beyond growth in the size and scale of their business. Consider an apartment in South Melbourne (or some other heavily oversupplied suburb near you).

To most investors, depreciating property prices and reduced Chinese buyers are a turn off. However, a value investor might see an opportunity to generate good rental yield and buy at under the cost of constructing new. They might have a novel application (student accommodation or Airbnb for example).

In the stock market, some features value investors consider:

  • dividend returns
  • asset plays (value of assets in business is greater than share price)
  • transaction opportunities (merger, divestment or restructure to release shareholder value)
  • transaction opportunities (merger, divestment or restructure to release shareholder value)

I bring all this up because for the past almost 3 years, growth stocks have outperformed value stocks dramatically (below charts from UBS).

High PE has been a fantastic style to invest in, with total returns in excess of 220%. This has been a function of not only a faster EPS growth but also a significantly higher valuation.

Why? Well as interest rates go down, all long duration assets go up. Don’t know what a long duration asset is? It’s just something that generates returns for a long time. Think toll roads, railways, property, and bonds. Also, high PE stocks. Those stocks are essentially saying to you “hey, buy me today, because in a far away future, I might generate a lot of profit.”

Financial theory says we need to discount the future, so those far away profits are worth more today (from a valuations perspective) when the discount rate (interest rate) is lower.

High PE also outperforms during a falling interest rate environment because they have growth when growth is scarce. Falling interest rates imply slowing economic activity and economic growth, so if you can grow a business in that environment, you’re probably doing something that not many others can do.

Finally, the much over-hyped Momentum. The phenomena that what goes up, keeps going up (until it doesn’t!). I’m not doing the momentum-thing today (I’ve had enough trouble writing this bloody note today as it is!).

Look, long story short, the valuation differential between high PE stocks and low PE stocks is as high as it’s been since pre-GFC and the bond yields are also rising. This implies that high PE stocks are due for a de-rate and unless they can deliver earnings growth ahead of already lofty expectations I’d be super careful investing here.

Oh, and one more thing, based on consensus numbers, stocks with over 20x PE have mean 6M earnings revisions of -12% and have returns over that period of 10% (on average). So analysts are trimming their numbers and don’t think, on aggregate, they can meet those lofty expectations.

Meanwhile, those under 20x have earnings revisions of +7% and have only gone up 2.5%. And your broker tries to tell you that there’s no opportunities and that it’s hard to find value in this market? Ahhhh, he’s not working very hard for you!

I can hear you all at home “okay Laretive you spud, that’s great, but which bloody stocks do I buy!!!” Well, surprise surprise, I’ve put together a nice little table for you all. Here’s the stocks on the All Ordinaries with positive revisions over 1% and share price returns under 5% over the last 6 months. I’ve highlighted a few that might be worth looking into. It’s pretty clear though, you’ve got 5 types of stock in here:
Property/REITs – everyone worried we aren’t going to go to shopping centres anymore
Stuff that’s had earnings misses (BXB, BLD, LNK)
Contractors (MIN, CIM)
Health Insurance
Fund Managers


Winners & Losers

This is literally the most boring weekly note I’ve written in ages. I hope there is a nugget of gold in here for someone! Anyway, MYX making a bit of a comeback. I spoke to a fundy who owns it and reckons the US business is turning around. All the technical traders will be all over it on a ‘breakout’ as well. Hrmmm… not so sure. Good management, generics are super hard though.

Outside of this, IEL continues on its merry way. Domino’s fighting back on World Cup fever. Otherwise… not much interesting.

MYO battling whilst XRO is killing. Elsewhere, AYS just had their european major shareholder increase to 15%. I smell a takeover. At what price, who knows!

Next week, I promise, I’ll get my mojo back!
Have a good week,
LL


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