Proponents of international investing argue that Australians should allocate more of their portfolio to overseas stocks to improve diversification and access opportunities. A stronger argument – better relative valuations for some offshore stocks – is less considered.
With several star Australian stocks on nose bleeding Price Earnings (PE) multiples, the opportunity is to take profits before June 30 and reinvest in similar overseas companies that are trading on much lower valuation multiples. And, in some cases, are larger, higher-quality companies with bigger global footprints and more diverse product ranges.
Consider the outstanding Australian fast-food franchisor, Domino’s Pizza Enterprises (DMP). Great company, great product, great management. Few CEOs know their product as intimately as Don Meij at Domino’s, or have as much capacity to disrupt local and offshore markets.
The market is abundantly aware of Domino’s growth trajectory. At $68.48, it trades on a whopping PE multiple of 51 times forecast 2016-17 earnings, using consensus analyst estimates. Domino’s is priced for perfection and then some.
DMP
[1]Source: Yahoo!7 Finance
Now consider the US fast-food gorilla, Yum! Brands Inc. (YUM), operator of Taco Bell, KFC, Pizza Hut and other prominent consumer brands. At US$81.25 share, Yum! trades on a forecast 2016-17 PE of about 20 times, using consensus estimates. McDonald’s Corp, too, trades on a forecast PE of about 20 times.
Yum! is about 10 times larger than Domino’s by market capitalisation and has more than 43,000 restaurants in over 130 countries and about half a million employees.
Yum! is well placed to capitalise on the coming boom in Asian middle-class consumption and rising demand in Western-style fast food. It has 16,500 restaurants in emerging markets, more than double its nearest competitor. The top 10 emerging markets have 2.5 restaurants per million people; the US has 57 restaurants per million.
YUM
[2]Source: Yahoo!7 Finance
Domino’s exposure to Asia is through its Japanese business, a terrific acquisition that has exceeded expectations and taken the pizza operator to new heights. But Domino’s does not offer anywhere near the same leverage to emerging market consumers as Yum!
That does not mean Domino’s investors should dump all of their stock and rotate in Yum! on a whim. Nor does it suggest Yum! is a screaming buy; consensus analyst estimates suggest Yum! is slightly undervalued at the current price. But this simple comparison reinforces the need to compare star Australian stocks with their closest overseas peers, in the search for better relative value.
Domino’s deserves some valuation premium. But is it worth paying two-and-a-half times more compared to the much larger, more diversified Yum! Brands at the forecast PE multiple? On a relative valuation basis, Yum! looks the superior investment at current prices.
Granted, buying US stocks over Australian ones adds a layer of currency risk and PE multiples can be a crude, flawed way to compare stocks (given the metric relies on market price as an input).
But compare several star Australian stocks to their nearest overseas peers and the valuation gaps are stark. It makes no sense for local investors to pay so much more for companies when their overseas equivalent is bigger, better and cheaper.
That is the price of investing only in an Australian market that, frustratingly, resembles Noah’s Ark in too many sectors: a pair of overvalued elephants in their industry and not much else. This market’s small size and limited choice in high-growth industries arguably adds to valuations premiums in fast-growth companies.
Offshore medical device companies appeal
Investors who want Australian healthcare exposure, for example, have a handful of large companies to choose from.
The same is true of medical devices, once one gets beyond Cochlear (COH) and ResMed Inc (RMD).
Compare Cochlear with US medical devices giant Medtronics Inc. At $118 a share, Cochlear trades on a forecast PE multiple for 2016-17 of 31 times, using consensus analyst estimates.
At US$81.89, Medtronic Plc is on a forward PE of 17 times next financial year’s earnings.
COH
[3]Source: Yahoo!7 Finance
Like Domino’s, Cochlear is a great Australian company. But it focuses on one main area: implantable hearing devices. Medtronic (MDT), the world’s largest medical devices company, develops a wide range of medical technologies, operates in more than 140 countries and has 86,000 staff.
MDT
[4]Source: Yahoo!7 Finance
Medtronic’s product and geographic exposure, far superior to any Australian medical device company, means it has less risk if something goes wrong. A similar argument can be made comparing ResMed Inc, which focuses on sleep apnoea technology, with Medtronic. Like Cochlear, ResMed trades at a significant valuation premium to Medtronic, which is many times larger.
Hospital stock valuations look healthier overseas
Similar valuation gaps appear between Australian and offshore hospital operators. Ramsay Health Care (RHC), one of this market’s best long-term performers, trades on a forecast 2016-17 PE multiple of 27 times, using consensus estimates. HCA Holdings Inc, the largest private hospital owner in the US, trades on a forward PE of 11 times.
Another US hospital giant, Universal Health Services, trades on a forecast PE of 16 times. Tenet Healthcare Corp., owner of more than 80 US hospitals, can be bought on a forward PE of 12 times. Ramsay has good long-term prospects, but it is hard to argue it warrants a valuation multiple more than twice that of several of the largest US hospital stocks.
Australian investors partly pay more for Ramsay because it is so hard to get hospital investment exposure in this market. US investors, meanwhile, are paying low double-digit valuation multiples for some outstanding hospital companies in one of the great long-term growth industries.
RHC
[5]Source: Yahoo!7 Finance
Comparisons between Australian healthcare stocks and exchange-traded funds over global healthcare companies also highlight extreme valuation gaps.
An Australian investor who buys CSL, for example, could instead gain exposure to a basket of the world’s best healthcare companies through the ASX-quoted iShares Global Healthcare Exchange Traded Fund (ETF).
CSL trades on a forward PE of 34 times. The iShares Global Healthcare ETF (IXJ) trades on a historic PE of 21 times (forward forecasts are not available).
The ETF provides exposure to 1200 of the world’s largest healthcare, biotechnology and medical device companies, and its top holding include giants such as Johnson & Johnson, Novartis, and Pfizer.
IXJ
[6]Source: Yahoo!7 Finance
Long-term investors, who want to add healthcare exposure to portfolios and are content with index exposure and aware of currency risk, will find superior diversification and value in the iShares ETF compared to the largest Australian healthcare stocks.
Stronger appetite for overseas consumer staples companies
Consumer staples is another long-term growth industry as emerging market consumers upgrade their diets in coming years.
One can buy Wal-Mart Stores Inc in the US on a forward PE of 15 times or plump for the underperforming Woolworths (WOW) on 17 times 2016-17 earnings.
Those who prefer conglomerates can pay 18 times for Wesfarmers (WES) or 17 times for General Electric Company, one of the great global conglomerates, based on consensus forecasts.
Entertainment is another example. I am bullish on the prospects for entertainment companies in Asia as consumers there allocate more disposable income to leisure.
Investors can buy Village Roadshow on ASX on a forward PE of 14.5 times or The Walt Disney Company (DIS) on 16 times.
VRL
[7]Source: Yahoo!7 Finance
No offence to Village (and apologies for comparing to the US giant), but its entertainment footprint is Mickey Mouse compared to Walt Disney.
DIS
[8]Source: Yahoo!7 Finance
The Walt Disney Company is killing it with its investment in the Star Wars franchise and never-ending superhero movies, yet trades on roughly the same valuation premium as several larger Australian entertainment or leisure stocks. Nothing in Australia’s entertainment sector comes close to the long-term potential of Walt Disney in Asia.
I could go on with other valuation discrepancies between star Australian companies and their closest overseas peers. Yes, using PE multiples is only one way to compare stocks and there can be good reasons for a higher PE if the Australian company has superior growth prospects.
This market’s concentration in banking and resources stocks, and lack of choice in healthcare, information technology, consumer staples, alternative energy and other growth industries, is adding to valuation premiums and widening the gap between Australian and leading offshore companies in certain sectors.
Before buying star Australian companies on big PE multiples, compare them to their closest offshore peer. Ask if the local versions deserve to trade at a significant premium to larger, more successful offshore companies. Perhaps the Australian company deserves its higher price, but being blind to offshore value is a sure way of paying too much for stocks.
– Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at May 19, 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.