One of the year’s main investing lessons is not to buy stocks with too much expectation in their share prices. TPG, Vocus, Blackmores, APN Outdoor and the aged care stocks all priced in a rosier future than the reality. This is pertinent, as many direct investors give investing away not because they don’t find some winners but because their losers either outweigh their gains or make their net returns too small to be worth the effort. This year, avoiding those stocks has been a large part of being successful and staying motivated.
It follows satisfactory returns, and staying hopeful and excited about investing, depend on buying stocks with little or no expectation in the share price. Let us explain how to know this and how to do it using a stock currently performing well in the StocksInValue model portfolio.
We recently bought QBE Insurance Group at $9.37 for the model portfolio because the 15 per cent discount to our $11 valuation, in which we had conviction, meant there was next to no expectation in the share price. The stock sold off because first-half Australian CTP claims disappointed after a surge in fraudulent claims in southwestern Sydney (this is also why NSW motorists are paying $150 more to renew their CTP policies than interstate vehicle owners). The selloff had the flavour of capitulation selling because it entrenched QBE’s reputation for frequently finding new ways to disappoint and many investors then gave up on the company for good.
We seek situations like this because there is far more upside in a stock of which the market expects nothing than a stock priced for perfection. And as every investor knows, the ASX has too many expensive stocks which have to keep upgrading their guidance to retain their rating – and indeed the whole market is more expensive than history. More than ever it’s essential to find the few stocks where the market is overreacting to temporary disappointments. Indexing and index-hugging only guarantee mediocrity. Far better to have rational return targets for companies with various tradeoffs between growth and risk, for example CPI plus six per cent for slow growth, higher-yielding large-caps, and to pick stocks which can meet these targets.
Despite QBE’s recent rerating to over $10 the market is still missing key developments ahead. Aggressive rectification of NSW CTP portfolios – premium hikes, withdrawal from unprofitable market share and a crackdown on fraud – should restore margins whether or not the NSW Government proceeds with legislation to reform the sector. Meanwhile, claims on QBE’s longer-dated policies are falling further below forecasts due to low inflation. The cost of reinsurance will fall in the January renewal season because reinsurance rates have declined this year with the low number of expensive catastrophes. QBE also can find further operating cost savings, in our view.
The share price jumped over $10 because QBE is strongly leveraged to higher global bond yields, for two reasons. First, the policyholders’ and shareholders’ funds are 90% invested in fixed interest, so higher yields increase interest income. Second, a quirk of QBE’s balance sheet means the value of the liabilities (mainly claims) falls more than the assets (bonds) when rates rise. And we have conviction the lows in global bond yields have been seen, so the macro environment favours stocks with positive leverage to yields.
Finally, we point to QBE’s strong surplus capital position, sufficient to justify a AA credit rating. Following the increase in the dividend payout ratio policy and an accompanying 5% rise in the interim dividend, we think QBE will consider an on-market buyback as its next step towards improving return on equity to the targeted 10%. The lack of franking credits due to offshore earnings rules out an off-market buyback with a fully franked special dividend. As long as QBE pays less than its intrinsic value, the market should respond well.
David Walker and Stephen Wood are Senior Analysts at StocksInValue. StocksInValue provides model portfolios, stock valuations and research covering Australian and international markets. Start making better investment decisions by registering for a trial at or call 1300 136 225.
Originally published in The Australian, Tuesday 18th October 2016.