The Difference between ‘Good’ and ‘Fair’ Value in the Stock Market

I’ve just come back from a brief family holiday.

We spent about 10 days at Broadbeach on the Gold Coast. Doing absolutely nothing.

It was good to get some warm spring weather in. Every day was sunny and between 25 and 30 degrees.

It was a nice change after going through a long, cold and wet winter in Melbourne. Apart from a few days here and there, winter hasn’t really left us yet.

After departing on Friday in 30 degree heat, we descended into Melbourne with the news that it was 14 degrees at Tullamarine.

Welcome home…

WARNING: Here’s two reasons why the AUD could collapse in 2020

A lot has happened in the past few weeks. Stocks in the US are making new all-time highs. The stock market is clearly ignoring the impeachment circus playing out in the House of Representatives in the US.

This is pure theatre, staged by corrupt Democrats and promoted by a corrupt establishment media.

I’ll have more on this tomorrow.

With the rally in stocks, bonds and gold have sold off. This is a reflection of investors re-pricing the likelihood of a recession.

The pendulum has swung from fear to greed pretty quickly. Aussie stocks are close to their July highs. It seems investors have gone from fearing a fall to fear of missing out on the rally.

And while much is made of the ‘struggling consumer’, the market isn’t in agreement. The Consumer Discretionary index is trading at the highest level since January 2008. It’s up over 30% since the December 2018 low.

The Rum Rebellion 18-11-19

Source: Optuma

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The Consumer Staples index is strong too. It just broke out to a new all-time high. Strong population growth feeding the business models of companies like Woolworths Group Ltd [ASX:WOW] and Wesfarmers Ltd [ASX:WES] will do that.

Finding Value in the Stock Market

Throw in the promise of easy money forever and the market values these stocks like bond proxies.

Take WES. It trades on a price-to-earnings (P/E) ratio of 24 times expected earnings in FY20. It pays out nearly 90% of its earnings as a dividend. In other words, it’s not much of a growth stock.

The forecast yield is 3.60%. Not bad if you’re comparing directly with government bonds. But you better hope the share price remains elevated. Because you could lose 3.6% in one bad day on the market.

Furthermore, WES trades on a price-to-book (P/B) multiple of 4.75 times, and a forecast return on equity of 19.6%. This means the market value of WES is 4.75 times the equity (or book) value. Dividing 19.6% by the book value gives 4.12%.

This is the return long-term investors can expect from WES. It represents the value of the dividend and the small amount reinvested to grow the business.

Sure, the share price could continue to rally, delivering a greater return than that to shareholders in the short term. But absent an earnings upgrade, a higher share price simply reduces the long-term expected return from the business.

Let’s do the same exercise with WOW. Based on forecasts for FY20, it trades on a P/E of 28.5 times and a dividend yield of 2.7%. It pays out around 75% of earnings as a dividend, so it has more of a ‘growth’ aspect than WES.

However, it’s not quite as profitable. The expected ROE is 16.8%. The P/B is 4.6 times.

Therefore, the long-term return from the business, based on current forecasts, is around 3.65%. That’s just a rough estimate. It doesn’t allow for the compounding effect of reinvesting 25% of earnings back into the business so it’s probably a little higher than this.

But still, you’re looking at around a 4% long-term return from these ‘consumer staple’ businesses. The equity value of these companies is trading more like a corporate bond. In other words, more risk, less return. That’s what insane central banking will do to equity prices.

People say that stock prices are irrational. I disagree. I believe the stock market is reacting rationally to irrational central banking policy.

When the Australian Government bond yield is 1.16%, a 4% expected return from a blue chip company doesn’t sound too bad. And with earnings growing over time, it’s probably not too bad.

But it doesn’t leave much room for unexpected risks. Bond holders receive their payments ahead of equity holders. The equity investor takes the bulk of the risk. If costs blow out, or there is an asset write-down, the equity investor takes the hit.

I would wager that none of this risk is priced in right now. Sure, value in the stock market is probably fair here if you think it’s all smooth sailing and nothing ‘bad’ is going to happen. But ‘good’ value it ain’t.

If you want to beat the market, you have to search for ‘good’ value, and not be content with fair. Unfortunately, with the stock market where it is, there isn’t much value around at the larger end of the market.

Regards,


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Greg Canavan,
Editor, The Rum Rebellion

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Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own.

Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts.

At The Rum Rebellion, fake news and unethical political persuasion are not in the least bit tolerated. It denounces the heavy amount of government influence which the public accommodates.

Greg will help The Rum Rebellion readers block out all the nonsense and encourage personal responsibility…both in the financial and political world.

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