Diamond in the Rough: 5 Australian Stocks for the Reporting Season
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett, 1992 Shareholder Letter
Over the next four weeks, investment analysts and fund managers will pore over the financial reports of listed companies to determine whether their results are properly reflected in the company’s share price. The process of valuation is never simple and we should all be prepared for a period of increased price volatility across the market.
Unfortunately, the pricing and assessment process may start with an immediate knee jerk reaction based on expectations, shortly followed by a review for quality (sound balance sheets, healthy margins and profit vs. cash flow), then gradually market price will reflect the outlook presented by company executives – does this company still have potential sustainable growth?
Overriding the above is the truism that the valuation of a company (and its shares) is far from an exact science, and subject to much debate and disagreement. Ultimately, the market price is a contest between the believers and the disbelievers. However, even this, is occasionally upset by black swan events, forced sellers and index buyers.
Is there value in ultra-high PER stocks?
Average Australian PERs (Price-Earnings Ratio) are not greatly dissimilar to international PERs, but this comparison is somewhat misleading because of the high level of bank sector exposure in the ASX 200. As banks traditionally trade at much lower PERs than the market average, this suggests that many Australian companies in the ASX 200 are trading above 20 times PER. It is a few of these companies that we review in the next section.
Figure 1. Forward PE Ratios
Source. Bloomberg, MSCI, Thomson Reuters
Assessing the value of a company is obviously more complicated than merely comparing its PER to that of its peers. However, there is little doubt that the maintenance of a high PER over a long period (say 5 years) is difficult to achieve for most companies. This is because the PER reflects the expected earnings growth over the foreseeable future, and earnings growth should not consistently under-perform the PER. If this occurs, then an investor is likely to experience a capital loss because they have probably overpaid for growth. An investor should seek to buy a company’s shares at a fair price that properly reflects the growth opportunity and which compensates an investor for the risk of disappointment or failure.
This week we were reminded of the risk of over paying when the base search business of Yahoo was sold for just 5% of its market value in 2000 (over $100 billion) and 10% of the unsolicited bid price offered by Microsoft in 2008 ($44 billion). Over paying for equity can lead to terrible outcomes and Yahoo is a classic example of how markets can get value totally wrong. There is no doubt that high PERs may indicate a speculative bubble in equity markets and more so when they are observable across the whole market as was the case in 2000.
Yahoo’s Marissa Mayer failed to turn the company around, yet was paid $36m last year. Following this week’s Verizon deal, she could walk away with more than $100m – no wonder she looks pleased with herself!
Source: Fortune Magazine
Individual high PER stocks should show the characteristics of a high return on equity and the proven ability to reinvest their cash profits at a high recurrent rate of return. Indeed this should be the major consideration for investors when they are confronted by a high PER. They should not merely dismiss a stock because it looks expensive, but rather undertake some fundamental analysis to determine if markets are assuming too much.
This fundamental analysis should acknowledge that all companies are unique with different growth potential, margins, gearing and management expertise. However the most important differential is the ability of a company to reinvest capital at a high rate of return going forward. To find these companies, it is often best to review their recent past for evidence of success.
So let’s have a look at some of the high flyers and assess whether their high PERs are justified, are sustainable and whether they are good investments at this point in time.
The companies that we will review are presented in the next table, which shows the current consensus forecasts of earnings. FY1 refers to the profit in the year just passed (2015/16) and FY2 and FY3 for 2016/17 and 2017/18 respectively.
Figure 2. Consensus Forecasts of Earnings
Source. Thomson Reuters
Domino’s Pizza Enterprises (DMP)
In this review we will simply focus on the past and draw some conclusions of the quality of the financial performance over the last five years.
To understand the table below, readers should note that the heading TTM 2016 refers to trailing 12 months to the last reported result. Therefore the trailing 12-month profit for DMP in 2016 is calendar 2015. DMP last reported for its December 2015 half-year result. NROE refers to normalised return on equity and credits ROE for franking credits distributed to shareholders.
The key observations to target on a five-year review are the trend in reported profit, the ratio of operating cash flow to profit, and the NROE performance. A key review is analysing the incremental return on equity to see if the company is generating higher returns on retained capital.
Figure 3. Audited Financial Accounts – DMP
Today DMP is capitalised at about $6.5 billion with current consensus forecast earnings in 2016/17 of $120 million. The PER is over 50 times earnings. Is this justified?
The five-year performance presented above is impressive. Earnings and cash flow have tripled over five years, while equity has also tripled. So while DMP is growing at a dynamic rate, it is not getting economies of scale reflected in the incremental NROE. More importantly, the substantial capital raising in 2014 to buy the Japanese market franchise has yet to generate the returns of the Australian business.
Our view is that DMP has achieved a remarkable performance in Australia that justifies that part of the business being valued very highly. However, the 2015/16 result will be seriously scrutinised to see if the company’s performance in offshore markets has the same potential as Australia. The high PER reflects an expectation that earnings can continue to grow at an extraordinary rate for a sustained period. However 50 times earnings actually exceeds the current market forecast growth rate of earnings in the next 2 years.
Ramsay Healthcare (RHC)
RHC has grown to a market capitalisation of $15 billion and its forecast earnings for 2016/17 are currently $530 million. The forward PER is thus 30 times earnings.
Reviewing the past five years shows that earnings have doubled against equity that has risen by 60%. RHC is achieving a consistently higher return on incremental or retained earnings. Operating cash flow greatly exceeds reported profit, meaning that the company is a self-funding machine.
On this basis, RHC is an exceptional company and has a superior five-year history than DMP. However, is it a better growth opportunity? And, does it have the offshore growth potential of DMP? Further, is the PER of 30 times – that is double the expected earnings growth rate for the next two years – a fair price for the growth opportunity? We think it is, which is why we hold RHC in many of our portfolios.
Figure 4. Audited Financial Accounts – RHC
REA Group (REA)
This company’s market capitalisation has moved to a record high of $8.4 billion in recent weeks, with forecast earnings (2016/17) of $270 million giving a PER of over 30 times.
The table below shows an excellent financial history with earnings and operating cash flow growing strongly. However, earnings have grown slower than capital and suggest that incremental return on equity has probably peaked. That in itself is not a serious issue because the return on equity is truly exceptional, and capital has recently been diverted into bolt-on acquisitions whose true potential is yet to be realised.
While cash flow exceeds reported profit, it does not do so by a great margin and so the earnings presented are not as conservative as for RHC. While earnings are projected to grow by 30% in 2017 (partly due to acquisitions), this seems fully captured by the PER of 30 times. Further, the 30% growth rate will be challenged at some point. We view REA as a high quality company whose price appears to more than fully reflect its growth potential.
Figure 5. Audited Financial Accounts – REA
COH’s market capitalisation has bolted higher this year as growth has apparently jumped significantly in its business. A weaker $A is also of some benefit.
However, the valuation of $7.4 billion is about 35 times projected earnings, and to some extent belies a fairly chequered history. The table below makes for interesting reading: while earnings have grown, they have done so in an inconsistent fashion. The company has self-funded its growth while it has actually depleted capital due to various operational problems. Cash flow exceeds reported profit, but not by a great margin. The NROE is excellent (on depleting capital) and the market clearly expects this to be maintained. While there is solid growth projected, this is to some extent a bounce back from a disappointing financial performance over recent years.
COH is a difficult company to assess and its premium rating is inconsistent with its most recent 5 year performance. Unlike DMP, REA and RHC there is much for COH yet to prove to justify its current premium rating, and this next result is likely to be heavily scrutinised for quality.
Figure 6. Audited Financial Accounts – COH
CSL Limited (CSL)
CSL is another stock that has raced upwards in the last year with its market value leaping to $55 billion against forecast profits of $1.7 billion. The resultant PER of over 30 times is much higher than either forecast or historic earnings growth, suggesting that there is risk for a share price correction.
The unique feature of CSL is that it has grown earnings while reducing equity. Unlike COH, the depletion of equity has been deliberate and driven by share buybacks. The resultant NROE is impressive, but driven by capital management and the introduction of debt. CSL is following the precedent of many US companies that are using cheap debt to buy back equity, in order to drive up the share price.
While operating performance has been good, the underlying growth in the business is more than reflected by the earnings multiple. Operating cash flow has consistently exceeded profit, but not by a great margin. Growth in the profit is not a function of retained earnings. CSL has a number of growth avenues and is a world leader in plasma products and influenza vaccines. We hold the shares in a number of our portfolios.
Figure 7. Audited Financial Accounts – CSL
There is a price for everything. As Buffett famously says, “It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.” Provided the company is truly wonderful, it is fair enough that the market values it at a substantial premium to the average PER. However, even star companies and market darlings occasionally disappoint, and you don’t want to be there when that happens.