The stories of two sectors – Banks and Industrials – illustrates that while some current PE ratings are at levels not seen since before the dotcom bust, others are falling into line with long-run expectations.
It is now passé to say the Australian equity market is becoming fully valued, led by the TIHCs – Technology, Infrastructure, Healthcare and China-facing consumer stocks – where multiples are at record levels. The bigger question is whether this is, in fact, just a natural state of affairs. Shouldn’t investors always be prepared to pay a higher multiple for higher growth? Isn’t the game over? The disruptors have won, whether they be Amazon or Netwealth or Hub24 or Kogan; albeit not Blue Sky or EML Payments (so 2017) or Xenith IP or Vocus (so 2016) anymore. The vanquished – whether they be Myer, bank-owned platforms, or AMP or Telstra – lay strewn, commercially gasping as investors debate only the timeframe for their demise. It’s a new world order, it seems, that requires new world thinking – and multiples.
There is a tale of two cities between multiples and earnings. The market face value multiple (p/e of 16 for F18) is not far from long-run averages. It is, however, masking the extremes of Industrials (led by the TIHCs) at above 20, which is the highest level seen since the TMT (technology, media, and telecom) bubble almost 20 years ago; against Banks at 12 times (their lowest level relative to Industrials in the same period); and Resources, which are trading at multiples in between these two market bookends and are broadly in line with long-run averages.
Within Industrials, Technology and Media, Staples, Healthcare, Services and Gaming are at or very close to their highest multiples in 20 years. Telcos are at the other extreme. Both sides reflect current earnings momentum, albeit the high multiples are being paid for relatively modest earnings growth, with Industrials ex-Financials doing 6% earnings growth in 2017 and only 5% this year. Banks earnings growth has been non-existent for three years now and we forecast them to decline materially to mid cycle.
In short, investors in Australian equities have to choose between two risks. Buying low multiple stocks are bringing with them earnings risk. Alternatively, buying earnings growth is bringing with it unprecedented multiple risk. Clearly, earnings risk is being shunned at all costs; multiple risk is being embraced, to an extent only seen before in the lead-up to the GFC and prior to that in the TMT bubble.
The TIHCs are winning, and some investors get this more than others. Jim Collins has been at the forefront of the commercial application of technological change in the US for three decades. He described the environment well: “… In this era of dramatic change, we’re hit from all sides with lopsided perspectives that urge us to hold nothing sacred, to “reengineer” and dynamite everything. To fight chaos with chaos, to battle a crazy world with total, unfettered craziness. Everybody knows that the transformations facing us – social, political, technological, economic – render obsolete the lessons of the past…”.
The only problem is that Collins wrote this in 1995, as part of his summary of his first book Built to Last; Successful Habits of Visionary Companies. The book detailed visionary companies that embodied six timeless fundamentals and had both endurance and sustained performance; names such as Hewlett-Packard, 3M, Motorola, Proctor & Gamble, Merck, Nordstrom, Sony, Disney, Marriott and Wal Mart. Twenty years later, none of these names are seen as innovative; that they were ever seen as innovators appears quaint. And while 1995 seems a long time ago – at 23 years ago it is roughly half the p/e multiple currently being ascribed to many leading “growth” stocks on the ASX. When paying 40 times earnings or more, one truly does need companies that are “Built to Last”.
If experts were so out with forecasts of the great companies of the future 20 years ago – and indeed many of the top 20 companies by market capitalisation globally today either did not exist or were nascent at that time – why would an investor be confident in paying more than 25 years’ future earnings, today? Will the future be less disrupted than has been the case through the past 25 years? Even more mysteriously, as disruption has accelerated through the past 12 months, reinforcing the fragility of traditional business models, investors have only paid even higher multiples again for those ASX listed companies promising the elixir of growth, now, and by extrapolation, into the future.
A further examination of market leadership rotation highlights that what happened between the time Collins wrote Built to Last and his successor books, and now, is not unusual. Most decades through the past century, market leadership has rotated in terms of the largest companies in an index, decade after decade. What appears impenetrable at a point in time soon falters and fades, at least in terms of its multiple if not its social use and impact.
Ray Dalio, the founder of Bridgewater, nominated a focus upon valuation and not just momentum as one of two pieces of advice for investors as part of a Reddit “Ask Me Anything” interview in recent weeks, stating “… don’t make the mistake of thinking that investments that have been good over the past few years (will perpetuate). Rather than more expensive investments … think about how to rotate your portfolio to buy that which is cheap and sell that which is expensive …”. Any rotation in the past year along these lines has been painful, but this premise is undeniable for any investor that has a philosophy that even hints at valuation.
Several years ago now, we suggested that BHP should replicate the South32 process and create South33, South34, all the way through to South38. The same remedy may be relevant for Telstra, and all of the banks would be better served by refocusing upon being good rather than just being big. Wesfarmers has recently been preaching the same faith, just as Woolworths did two years prior. Major ASX companies across sectors are starting to react to the corporate wastage of resource abundance; relative resource constraint is consistently generating better operating performance and returns for shareholders.
Resource availability is not as much an advantage as it could be, in life as well as commerce. Wade Gilbert is a Professor in the Department of Kinesiology at California State University at Fresno. His specialty is the science of sports coaching; he is globally renowned as the “coach of coaches”.  Gilbert makes the fascinating observation that half of the US population lives in cities of more than 500,000 people, and a quarter in cities of less than 100,000. And yet, across the major professional sports of basketball, golf, hockey and baseball, the ratios are broadly reversed, with the vast majority of players coming from smaller cities. The availability of physical resources, it would seem, are not the key to success in sport, just as in commerce.
Outlook
After sources of return within the ASX dispersed by sector and stock through 2016 and 2017, the past year has increasingly seen the TIHC stocks hold sway on the ASX. While providing more growth, albeit still often relatively modest growth, this cohort of stocks are now trading on higher multiples than any seen on the ASX since 2007 and before that 2000, when the TMT bubble was in full flight. Their valuations are hard to justify and require a prolonged period of flawless execution. Regular bouts of insider selling suggests that management does not believe such a prospect a better-than-even chance. There is no denying the rest of the Australian equity market faces earnings risk, and that risk has only become more pronounced as the year has progressed, however multiples for that risk now appear accommodating. This is especially the case in the banking sector, where despite ongoing bad news flow – which can only be expected to continue so long as a Commission into Misconduct continues to operate – relative multiples are now as attractive as they have been in 20 years.
Published by Andrew Fleming, Deputy Head of Australian Equities, Schroders