Excessive volatility since the sharemarket started tanking late last year has made investors suspicious of stock themes like ‘deep-value’. To make matters worse, the war between fear of future earnings downgrades and cheap valuations isn’t about to end.
Adding to investor weariness, some stocks that allegedly represented ‘good value’ earlier this year – like paper merchants, Paperlinx and forest products company, Gunns Ltd now look decidedly expensive following greater balance sheet disclosure. Similarly, investors attracted to uranium explorer, Monaro Mining at low PEs recently watched the company fight for its survival with the share price now a fraction of what it was.
However, the prospect of a significant, albeit short-lived market rally which some predict could add 500 points to the S&P/ASX 200 by year’s end has made ‘value-plays’, based on pure ‘market arithmetic’ even harder to dismiss.
According to Graham Harman equities strategist with Citi Smith Barney, what we’re now witnessing is decade levels of “good value”. He says excellent equity market valuations are becoming increasingly extreme as simultaneous sharp falls in both share prices and interest rates (which are positive for valuations), outpace crumbling earnings (which are negative for valuations).
When the penny finally drops that the market has built in too much bad news, Harman expects a sharp initial recovery in equities to follow. From a market-wide perspective, Harman says one obvious hallmark of ‘value stocks’ is to compare a prospective earnings yield with the current bond yield (in effect, adjusting the market PE for the current interest rate/inflation environment). “Current equity valuations relative to interest rates look highly attractive. It’s very rare for the market dividend yield to exceed the cash rate,” says Harman.
Due to forced selling, the market now looks cheaper than both the day after September 11, and at the start of the Iraq war. And Harman says longer term investors could be rewarded with a sudden share price recovery once certainty returns on the earnings front. Equities may continue to struggle under the weight of earnings downgrades in the short-term. But Harman warns, missing the start of the inevitable recovery could be very costly in terms of future returns.
So when bargain hunting, he urges investors to look for stocks with market re-rating potential by virtue of their earnings recovery prospects, low valuation relative to assessed worth or a relative discount to their peer group.
While Harman sees selected value emerging within some banks, REITs, and media his favoured value stocks include: Ascianco Group, Alumina, Harvey Norman, Wesfarmers and Santos. Trading on an 09 PE of 12.2x – half what it was on 07, Harman expects Santos to continue attract investor/corporate attention due to its increasingly positive international profile.
Offering 40%-plus EPS growth in 08-10 with a long-term LNG story behind it, Arrow Energy is also a recent addition to Harman’s value stock picks. And due to cyclical trading at the lower end of cycle multiples, plus additional short-term interest rate cuts, Harvey Norman is also a recent addition to the list. “We see Harvey Norman as a counter-cyclical buying opportunity, with the share price currently reflecting a lot of bad news,” says Harman.
Assuming earnings and cash-flow stack up, Simon Rutherford portfolio manager with valuation-focused, boutique fund manager, Northward Capital starts (searching for value) by looking at PE relative to its trading history. When unearthing value, Rutherfurd says it’s also important to take into account a stock’s price to NTA, plus its dividend yield and payout ratio. In other words, a stock with a 4% yield, paying out 90% of earnings probably has insufficient retained earnings to have the whiff of value-play about it.
Based on these criteria, Rutherfurd is currently attracted to Brambles, News Corp, Crown Casino and Worley Parsons – all net beneficiaries of the falling A$ for at least 12 months.
He says Brambles, currently trading at market PE multiples (for industrials) of around 11x (half its historical highs) and close to NTA – looks like the classic value-play. Based on internal modeling around the stgalued A$ (against the US$, £ and €) Rutherfurd currently prices Brambles at US$5.36 on a PE of 12.2x. He started buying Brambles back in August and will continue acquiring stock up to the $9 level (or US$6.10). “Given its 30%-plus ROE and ROIC over 25%, I don’t think current multiples look expensive, and Brambles will definitely outperform the market,” Rutherfurd.
And following down-graded earnings at 11x and EBITDA and cash-flow multiples of around 3x (compared with Fairfax on 5.5x), Rutherfurd regards News Corp as an attractive contrarian play with earnings growth in Europe (notably Italy) offsetting lower revenue figures in the US.
He’s also been acquiring more stock in Crown Casino and mining services company, Worley Parsons, two traditional growth stocks now priced as value-plays. Assuming there’s strong disclosure into a healthy pipeline of work in 09, he says Worley Parsons, (which saw its share price fall off a cliff following the commodity downturn) looks attractive at $17 a share and a PE of around 10.5x.
Similarly, following a de-rating in gaming stocks, he says investors are not paying much for Crown Casinos upside investment in Macao. “Investors paying an EBITDA of around 6x for Crown and Burswood assets are effectively getting Macao and US assets free.”