Welcome to the March edition of the Burrell Blog for 2018.
Earnings Growth-The Swing Factor
In last month’s blog, similarities were noted to the 2000 technical bubble and the 1993-94 increase in fixed interested rates. This blog considers the counter balance being strong earnings growth in the USA and to a lesser extent in Australia.
The first table shows the current price earnings ratios (P/E) and the forward P/E for next year. The first part of the table looks predominately at value stocks and stocks which exhibit growth at reasonable prices. The first column shows a number of stocks with P/E ratios over 20, which require 20% annual growth to justify the valuation ratios.
P/E and Earnings
|Walt Disney Co||18.1||14.4|
|21st Century Fox||22.5||16.4|
|Bank of America||18.3||12.3|
|Proter & Gamble||21.6||17.9|
The most interesting feature from the forward P/Es is that many decline materially such that only a handful are over 20x. This is why several commentators are saying that notwithstanding significant increases in stock prices in US markets over recent years, the valuations are not excessive. In seeking to understand the fall in these P/Es, the effect of the Trump tax cuts is thought to have a bearing. There is some debate about the impact of the Trump tax cuts on earnings and whether simply reducing 35% to 20% is in fact a proper reflection of the complicated series of tax measures passed in the USA prior to Christmas. Your diarist thinks the effect of earnings may be less than anticipated. Certainly in the company reports for the December period in the USA, it was difficult to decipher the tax cut impact, as mostly it related to restating balance sheet items for future tax benefits e.g. leave provisions and deferred tax liabilities which reduced by the change in headline tax rate.
Returning to the second part of the table, this includes some stocks that are more clearly growth stocks for example Amazon. The Amazon P/E is currently 329x and the forward P/E is 159x. This stock is clearly overvalued, as is Netflix and reflective of tech bubble valuations in 2000.
Amazon has a dedicated band of followers from its online shopping customer network, who see goods arrive at competitive prices. Clearly Amazon answers the first question of being a good company, but what of the second question: “is it good value?”. Your diarist believes the answer is no. Amazon appears to exist in the internet but in fact has replaced bricks and mortar stores with the electronic Amazon market place. But what is often missed is that Amazon carries many more stock units (SKU’s) than a normal retailer because of all the sellers wanting to transact goods on the internet. Amazon has the second largest area of distribution centres in the USA to Walmart. In order to deliver the goods, manufacturers must supply them to the distribution centres and so there are large distribution costs in the Amazon model, often not appreciated. Your diarist would postulate that Amazon does not recover the costs as well as it might and this is the major weakness in its business model. In fact Amazons profits have historically been generated to a significant extent from its Amazon web services business AWS, which is supposed to be a sideline providing the IT services to drive the Amazon model. In fact AWS is a material supplier of alternate web services to business large and small.
The valuations for Facebook and Alphabet are not as extreme with Alphabet Google forecast to fall from 36 to 25 and even Facebook from 29 to 24. The other companies in that table being Procter & Gamble (Gillette), Siemens and Nestle show forward P/Es under 20. In last month’s blog, it was noted that while the USA market corrected dramatically during the 2000 tech bubble, Australia did not exhibit these elements and chugged along with only modest correction right at the end of the tech bubble. Similarly, the Australian market has not followed the USA market up in the last few years and there is no particular reason from a valuation perspective why the Australian market should face a dramatic correction.
The second conclusion from the table is that while there are elements of overvaluation in the US market, these are not as great as might be thought and so from a valuation perspective, while some downward adjustment may be anticipated, the equilibrium point should not be a 2007 style correction. There is no second Global Financial Crisis (GFC). It is also possible that the US market may adjust on a stock by stock basis rather than an overall market correction of say 20%. While no one knows, your diarist is more inclined to the view that the probability is for 15-25% correction given the breadth of overvaluation.
Timing is unclear as the strong US economy and tax cuts continue to support the US market. The US unemployment is at 4.1%, white unemployment at 3.5%, coloured unemployment at 7%. In some places US unemployment is at 2.5% i.e. the economy is fully employed. Economics 101 would suggest the last thing responsible economic policy would do is to inject a large tax cut to further stimulate the economy which will lead to inflation and interest rate increases.
The two slides above on Australian Earnings indicate that the reporting season which ended in early March saw Australian earnings estimates largely intact for the current year. Some articles have suggested the consensus earnings per share growth as 7-9%, although Bruce McLeary Associate- Senior Research Analyst sees the number closer to 5%. Certainly the Australian reporting season was sufficiently encouraging that the market reacted positively and is currently trading 200 points above where it was prior to reporting.
There are some particular sectoral issues. The banks are subject to the Royal Commission, finding balance sheet growth difficult, have maintained robust margins and bad debts are benign. There is a view that the Royal Commission will provide some further buying opportunities in the banks over coming months, but will not result in major changes to profitability or business models. CBA may be singled out.
In terms of resources, the reporting season was positive with commodities prices having a good 2017 and strong balance sheets leading to attractive dividends and some buy backs as part of capital management. However there is no analyst consensus on commodities prices going forward and several research houses believe commodities prices will soften over the next few years. Mind you they have had this view for some time on the reasoning that China will reduce its growth rate, but there has been no evidence of that.
What we are seeing in the Australian market is that expensive growth stocks such as Domino’s Pizza and Ramsay Health Care have adjusted materially to the downside. There is debate as to the extent to which Dominos is facing a change in landscape with Uber Eats providing consumers with more alternatives. Offsetting this increased competition in Australia, Dominos has significant expansion opportunities in Europe.
Ramsay Healthcare has fallen by $20 to low $60s. Several research reports indicate this to be good buying, although the reporting season was disappointing for Ramsay and as an infrastructure stock, Ramsay may face further headwinds from the increase in long term bond rate.
From the asset allocation view point, the equities reporting season was accompanied by 0.5% increase in the 10 year long term bond rate. These information points confirm our asset allocation as follows:
- Fixed Interest: Avoid long term fixed bonds and look for shorter term and floating rate securities.
- Property: Increase in long term interest rates will be negative for property valuations in the office sector. In particular Sydney office capitalisation rates are down near 4% and likely to increase in line with increasing interest rates. However a number of AREITs (Australian real estate property trusts) have already corrected.
- Infrastructure: Your diarist has the view that Australian infrastructure e.g. Sydney Airports has not corrected for likely increased long term bond rates and the sector should be largely avoided.
- Australian Equities: Valuations remain fair, but with some stocks overvalued and some undervalued as always. Research reports and competent advice are the order of the day.
- International Equities: Generally maintain or reduce international equity allocations rather than increase, although European and Asia valuations appear attractive. The tables above indicate that selective opportunities remain even in the USA. Most active international investment mergers based in Australia are carrying cash levels in the 15-25% range.
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