Valuations

There are some simply stunning equity market valuations out there.

The below table (which we get to in just a moment) attempts to work out what earnings growth expectations are embedded in any given companies’ valuation.

First, let’s do a worked example.

Example

We take the current market cap, of a given stock, and grow it at a “market-like” rate of return of 7% (maybe a high hurdle these days, but stick with it for the example) for 10 years.

This gives us a “10 year forward implied market cap”. We can then decapitalise it using a range of different multiples. We can take a historical average PE. We can take a current PE. We can apply a “market” PE, here set at 18x.

Having decapitalised the market cap, we’ve now got the resultant 10 year forwards’ net income level, which we can compare to a range of different earnings bases.

A simple visual will make sense of that. Here’s one for TNE, a tech company, in log terms for ease of visual comparison. Key idea is the red line connects the future earnings, to the earnings base.

For the earnings base, we can compare to current earnings, or to the median historical “eg mid cycle” earnings base, or to the expected earnings over the next year (blended forward 12 months earnings). The red line itself is drawn to the current earnings base, but you can easily eyeball mid-cycle, and the forward consensus estimates for earnings from brokers are also shown.

Given that in 10 years time, it is probably fair to say that a company has “matured” by then, and so often our eye is drawn to the earnings trajectory required for a “market” multiple.

You can see from the graph above that the only way to make plausible sense of TNE’s growth assumptions is if you value TNE at 36x 10 years from now.

Which strikes us as unlikely.

Now, let’s put all that in table form.

Table form

Using this methodology, and sorting by the “market PE” measure, and the “forecast earnings” as the chosen base, we see a c70% required CAGR for APT. It’s gotta do that each year, every year, for the next 10 years to produce the 7% market like rate of return.

Wowsers. Not one for us, and we think Square will probably do their dough. That’s Jack Dorsey’s problem (or more accurately, the person he just handed over to, or even more accurately, for shareholders).

Some stocks have a high hurdle, like CWN (Crown), but this really reflects earnings recovering from lockdowns.

The earnings hurdles aren’t as dramatic if you use the “normalised” earnings measures, which is what the other columns in the table highlight (you however, can’t see those other columns; WordPress is very unforgiving about table size, with decent resolution, so I cut them off/out, even though they are very relevant to the analysis and context).

Mind you, the graph conveys the idea of what base to use, easily enough.

The “gaps” that you see above are when the company had negative earnings, which we exclude here, because we are looking at earnings in log terms. Don’t let the logs put you off, it’s just so you can see the compounding assumptions more clearly. We use them all the time in econometrics.

For a stock like CSL, the estimate hurdles are pretty aggressive, but at least CSL has a chance of being valued at 33x in 10 years time, and they’ve got the historical track record of growing at this implied rate. We own CSL, albeit at a small underweight, and this is the sort of graph one can use to justify the position, amongst other reasons.

Woolworths’ required earnings trajectory looks very unlikely to us, and needs to grow vastly fast than think is feasible. The potential for earnings disappointment is very high. We prefer Coles, and although we don’t own it, Metcash.

Similarly market darling Wesfarmers only makes sense if you think it should trade at 30x. In the future. We do not think it should trade at 30x in the future, Bunnings or no Bunnings.

Sonic, although we think it a phenomenal business, is likewise going to struggle to hit those earnings targets. Not impossible, but hard.

RMD, also a great company, needs to be valued at ~40x forward, 10 years from now, and will have the headwind of a competitors’ eventual return to the market. Sleep disordered breathing will quite possibly have reach saturation by that stage. For our healthcare exposures, we prefer ANN and RHC. Lower quality, but a valuation we can live with.

Where’s is the value, you ask? What sorts of stocks have comparatively modest implied earnings hurdles?

You already know the answers.

Woodies. If you value the earnings 10 years from now at 8x, well, then they don’t need to grow, to achieve the target return. If you get confused about how that works, recall that we are working in reverse, from implied market caps to implied forward earnings based on decapitalisation multiples, and comparing the resultant trajectory (slope) in log terms.

On historical multiples, say 15x, the market implication is that earnings will fall from normalised (i.e. non-COVID) levels by about 30%.

Given that most of their LNG volumes are contracted, and for lengths between 5-20 years, and that LNG consumption has risen each year every since the 2000’s, in the developed countries, let alone the emerging, that seems unlikely.

As such, it seems likely that WPL is both cheap from a headline perspective, but also from an embedded expectations perspective.

You should see the graphs for NHC, or WHC. We will probably never buy those companies, but it is remarkable how incredibly profitable they are at the moment, such that they are on a PE of 2x. The market doesn’t care a whit about their growth projects, and both companies should just hover up their stock and go into run-off mode.

TWE really only just needs to recover from COVID.

Same with Vicinity. Turn the malls into apartments, if no one wants to shop in them. Or logistics hubs if required. Mind you we think that life returns to much the same post-COVID as pre-COVID, in other words off to Westfield (or here, Chatswood Chase) come the weekend, which will be more than sufficient, we think, for VCX to grow their earnings.

With any investment, but here, stocks, the only way to outperform with long only portfolios is if the true earnings trajectory turns out to be higher than the market expected, or, if the true earnings multiple turns out to be higher than the market expected.

That’s it.

Stocks like MND, AMC, BXB, WOR, DXS all have relatively modest expectations, are of reasonable quality, and are in turn reasonably priced.

At the moment, the market bifurcation is extreme. The winning strategy has been to sit tight in secular growth narratives, like XRO, DMP, APT, UWL.

But at some point that will turn. Paying 50x forward earnings for a pizza maker (no matter how good the pizza!) is not a winning investment strategy, we think, over the long run.