Investment Matters

An expensive market? Let's look more deeply

The share-market is not homogeneous

In the investment world 'the market' is referred to as if it is a homogeneous thing. 

But there is actually a high degree of dispersion within the market.

The following graph provides an example of this dispersion - a sector-by-sector P/E for companies in the ASX-200 index (i.e. the largest 200 companies listed on the ASX).  As can be seen, there is a wide variation between the most expensive sectors: utilities and healthcare at a prospective P/E of over 25x, to the materials sector at a prospective P/E of 12.4x.  This compares to the current market (ASX-200) average prospective P/E of 16.3x.

ASX200

 

An expensive market

At the moment, the market is considered expensive.  Not everything is expensive - but on average it is.  The long term average P/E is about 14.5x, versus the current 16.3x noted above. [This means that investors buying the market are paying 12.4% more than average for the same level of expected profits.]

Note that the materials sector includes resource companies such as BHP Billiton and Rio Tinto.  There are a variety of inter-related reasons for the lower-than-market P/E of this sector, including the outlook for commodity prices at greater than a year away (prospective P/E considers earnings in the next year only), and risk factors such as the outlook for Chinese economic growth and commodities demand, and currency.  Interestingly, the market would be quite a bit more expensive without this sector, at 17.3x.

Occasionally, a high P/E market can occur in advance of a general earnings upgrade (with the upgraded earnings acting to bring the P/E down).  We consider this unlikely to occur in Australia at the moment, given the moderate economic conditions.

Warnings of a high P/E

Considering the current market P/E versus the long term average, is important in that is does highlight the higher risk of a market correction.  But markets can remain over (and under) valued for considerable periods of time.  As Keynes said, "The market can remain irrational for longer than you can remain solvent."

The other point of note is that a higher market P/E does point to a lower than average outlook for investment returns.  This is driven by the future capital component of returns being lower than average, as P/E reverts to long-term average. And certainly, an investor should not expect to receive capital gains associated with a market P/E re-rate.

Given all this, it is not just luck that we don't invest in 'the market'.

Stock picking example

In an expensive market, looking even deeper than sector level is important.   To achieve investment success, what is referred to as stock picking - a focus on individual company opportunities - is even more crucial than usual.  At First Samuel, this means seeking out companies that provide earnings growth and dividends, whilst minimising the risk of a P/E de-rate.

For example, we added a new investment to your equity portfolio around the same time as last company profit reporting season (Feb-17).  As such, it seems to have not received the focus that it ought have.  The investment was APN News & Media.

A brief recap: APN News & Media is a major Australian focused media company with two key business lines: Radio and Outdoor Advertising.  We are attracted to both Radio and Outdoor advertising and see them as complementary, for example running integrated media campaigns.   As they quickly become the only surviving effective mass media advertising methods in an increasingly digital age, revenue growth should match or exceed economic growth.

Additionally, the prior JV structure has left the outdoor assets (Adshell) unloved and under-invested, and gives the scope for above market growth for APN's Outdoor business.  This will be assisted by APN's move to match the number of digital screens that their peer groups have.  This will entail quite substantial capital spend, but the returns from this business are expected to be high and long lasting.

APN News & Media has a prospective P/E of 11.7x.  We expect it to achieve average earnings growth of 25.6%p.a. over the coming 3 years, and a dividend yield of 4.6%.  As such, we assess it to be a clear example of a sound investment opportunity in an expensive market, and a market with a high degree of dispersion.