“Buy low, sell high” is the classic investor’s tactic and one used by Wilson Asset Management’s investment team when hunting for undervalued and under-researched growth companies.
Recently however, we have witnessed a very different tactic. Investors are instead purchasing fashionable shares, which are trading at premiums. Why is this happening?
A possibility is that the market has found itself short of investment options. Many Australian businesses are facing a combination of operational restructuring, soft demand, high capital expenditure requirements, and flat revenues. This has perhaps resulted in slim pickings amongst a handful of companies that have performed favourably over the last year and have displayed resilient business models. The problem with this is that the market is already aware of most of these opportunities.
Too expensive
Recent evidence from the February reporting season just passed found that premium rated stocks were the best performers. Some fund managers are happy paying high multiples for perceived earnings certainty given the current fragile and patchy nature of the Australian economy. For the month of February, Seek Limited (SEK) rallied 38% while another market darling, REA Group (REA), rallied 22%. These companies trade on price to earnings (PE) ratios of 30 times and 39 times respectively.
The average 12-month forward PE multiple of a basket of 10 premium-rated industrial stocks, now sits at approximately 28 times. Historically, the market trades on an average PE of around 15 times. These premium-rated stocks are: REA Group Limited (REA), Domino’s Pizza Enterprises (DMP), Navitas Limited (NVT), Seek Limited (SEK), Cochlear Limited (COH), Ramsay Health Care Limited (RHC), James Hardie Industries (JHX), Carsales.com Limited (CRZ), Breville Group Limited (BRG) and CSL Limited (CSL).
In recent years, some of these stocks have experienced significant earnings growth however, their share prices have run well ahead of this growth in most cases. For example, Domino’s Pizza has delivered strong growth of 15-20%, in recent years however its PE has moved from 18 times two years ago, to 37 times currently. That’s an increase of more than a 100%. Some of these premium rated stocks are now the most expensive they’ve ever been in their listed lives.
Overvalued stocks under-deliver
A recent research report from Goldman Sachs, highlighted that buying stocks that trade on a PE of 25 times or above, generated an average return of -5% for the year after. Goldman Sach’s research went further and pointed out that as the multiple moves higher, these stocks are more susceptible to large underperformance.
My observations are that when an adverse event occurs with a high multiple stock, the pain on the downside can be large. Generally for profit upgrades or downgrades, all else being equal, the share price of a company should move by that same amount. A recent example of this was the downgrade by Coca Cola Amatil (CCL), which trades at a digestible PE of 13 times.
The company announced a 15% earnings downgrade and CCL stock fell by 15% on the day. If you see a high multiple stock deliver some negative news, it’s highly likely that the share price will fall by more than the earnings downgrade, as the PE premium re-rates lower on the lower growth expectations from investors.
A valuable lesson lies in the cautionary quote by Benjamin Graham: “In the short run, the market is a voting machine but in the long run it is a weighing machine.”
Investors should be aware that they may be paying too much for Australia’s most coveted businesses.
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.
