Investment Matters

Reverberations from rising yields

A quick note this week with 3 key messages that relate directly to your portfolio

  • High P/E (price-to-earnings ratio) or “expensive” stocks, are “expensive” due to a mixture of high growth expectations, certainty of dividend streams, and assumptions about the long-run cost of money, i.e. the “discount rate”. The cheaper money is, the more expensive growth stocks can be.
  • In the past few weeks, the cost of money, represented by government bond yields have reversed their seemingly inexorable fall, making growth stocks appear less attractive, and value stocks more so. In addition, the bastions of sustainable dividends (i.e. the banks) have begun to reflect their deteriorating profitability in lower dividends streams.
  • We retain a high exposure to cash in your portfolios – the market is expensive and there will be better times to deploy this cash, when individual stocks or the market as a whole is “on-sale”.

These 3 messages are presented within 2 critical contexts for portfolio management

  • A portfolio is more than just a list of stocks. A portfolio offers diversification along with exposure to a range of themes and factors driving performance. 
  • One of those factors, “value” has always been highlighted at First Samuel, but your portfolios have always had other features that may have been included at various times;
    • Overweight or underweight exposure to resource names
    • Exposure to stocks that have higher or lower yield (dividends)
    • Foreign currency, especially USD, exposure
    • Exposure to isolated thematics such as advertising, oil or an aging population.

Today, the combination of cash holdings, exposure to value stocks, less USD exposure, a tilt towards sustained oil prices at current levels, and the idiosyncratic newsflow of the individual companies we own will drive performance in the coming 12 months.

Over the past 10 years, and particularly since the middle of 2018, the market has concentrated the vast majority of positive performance in these high P/E names. For a number of stocks such as Xero or Nanosonics, the market’s expectations for growth have been easily met, driving these stocks and their P/E ratios higher still. For others, especially the yield plays such as Transurban, Sydney Airport or property REIT’s, their prices rose somewhat independently of the underlying growth of the companies and/or dividends payout. The falling cost of money, lower bond yields, did the majority of the work.

im 1

The Orange line on the chart above shows the expanding P/E ratios for the most expensive 20% of non-resource stocks in the market. Since 2018 the P/E ratio has risen from 30x earnings to 40x earnings – a 33% rise in the value of the stock for the same underlying business fundamentals.

The principal driver of this outperformance since mid-2018 can be seen in the chart of Australian bond yields below.

IM 2

Since the low point in Australia bond yields near the start of September 2019, the highest P/E names in the large-cap space have underperformed by 2.9% (non-weighted) and the lowest P/E names have outperformed by 4.1%. Names in your portfolio which have been advantaged by this movement include Origin Energy, Boral Limited and Challenger Limited which have risen by more than 10% on average.

Banks, which we have no exposure to, have, on average, have fallen 0.3% in the same period, and when combined with limited exposure to property names, have contributed positive relative performance.

In a rotation towards value, companies that can deliver sustainable cash flows, the majority of the companies we own, become more valuable than companies that have purely relied on P/E expansion to drive share performance.

Should the rotation towards value continue we would see your portfolios respond in a couple of different ways. In part due to low liquidity, and in part due to relatively small size, individual success at the stock level will be delivered partly through patient appreciation in share prices and partly through corporate actions such as takeovers, mergers and acquisitions.