David Walker

Written by David Walker, Senior Analyst, StocksInValue

The following article was published in The Australian


If this year’s crucial interim reporting season tells us anything, it’s that companies change less than their underlying share prices. The challenge is to reconcile the volatility in share prices with ­fundamental trends in profitability and earnings, which are less variable.
Investing to benefit from the compounding and growth of earnings has certainly become a longer-term game, which requires more patience than before.
Meanwhile, most companies delivering consistent and reliable growth are fully priced and indeed equity markets are no cheaper than historical averages. The headlines and volatility combined are a negative. What is an investor to do? Here’s the four key changes for a value investor.

1. Returns come in a rush

A cool and calm approach that understands the new distortions driving share prices, and uses these to find opportunities to buy equities trading for less than they are worth, is worth considering. Investors will need to be patient and disciplined.
Value investing has changed. Investors used to be able to trust share prices would trend higher with equity and earnings per share multiplied by a reasonable factor for profitability, growth and risk. Today though, ultra-low interest rates and full pricing of many markets and equities is fuelling the growth of a “volatility industry” of hedge funds, which make money out of share price manipulation and leveraged trading. These hedge funds are certainly not holding companies to benefit from the compounding of earnings. Hedge funds are able to borrow extremely cheaply globally and use this to fund their activities.
For value investors this means their returns are more likely to come in a rush at the end of the holding period, not as a gradual linear rise in the share price. An example is The Reject Shop, where the share price has risen by as much as 158 per cent in eight months even though the company is likely to earn less in fiscal 2016 than it did four years ago, in 2012.
This remarkable small-cap turnaround story at The Reject Shop sorely tested the patience of value investors who backed it because most of the returns came in two sudden short-covering rallies for which investors had to wait months and years. There was no gradual, reassuring unwind of the share price discount for earlier failures.

2. Short sellers have become more powerful

Global fund managers are “de-weighting” Australian equities in favour of other asset classes, reducing underlying buying support on the ASX. This increases the relative weight of short-selling of the stocks value investors are likely to buy: those which are out of favour, misunderstood and overlooked due to problems. Value investors will have to get used to much more volatility as they wait for the market to correctly price their stocks. Other misunderstood and shorted companies I like where the market is taking its time to realise underlying value are: Ardent Leisure Group, Credit Corp and Challenger.

3. Popular stocks get overpriced

Meanwhile, the momentum trade in a handful of fast-growing mid-caps is breaking down. Domino’s Pizza, Blackmores and Bellamy’s were overbought because little else was going up on the sharemarket and investors jumped on the few uptrends they could find. Now, as these companies announce their actual earnings results this reporting season, investors are realising the growth, even where this meets expectations, does not justify earnings multiples of 40, 50 and 60 times and the share prices are retreating. Separately, companies that disappoint, like Ansell, Amaysim and 3P Learning, are being dealt with severely by the market.

4. Good execution is the ultimate asset

Although there are reasons to be positive, this is a bear market that is not over yet and caution is required. The way forward is to prefer companies with records of consistent delivery against strategy (“good execution” in analyst-speak), business models that are less susceptible to financial market volatility and slow economic growth, and which become undervalued in bouts of bear market panic. Our model portfolio distinctly leans towards this kind of “quality” in companies. We have done well with BT Financial, CSL, Caltex, Japara Healthcare, Nick Scali, Magellan and Transurban. This reporting season we are introducing new stocks like Macquarie Group and Ramsay Health Care and we are concentrating our bank holdings in Commonwealth Bank and National Australia Bank, which we far prefer to ANZ and Westpac.
Macquarie has been sold off in the bear market but its asset management business is driven by infrastructure, not equities, and the market is underpricing this. Ramsay Health Care generates some of the strongest cash earnings on the ASX and should trade at our valuation of $69, not a 16 per cent discount.
ANZ’s trading update was not as bad as feared but the strategic error to bulk up in Asia continues to dampen returns. In banking, the place to be was and remains Australia and New Zealand, where profitable growth is available and loan quality remains excellent. CBA is the highest-quality bank with smooth execution of a customer-focused strategy, and National’s return on equity is set to improve post the exit from Britain. National is also leveraged to the acceleration in business lending.