PORTFOLIO POINT: The Australian market is undervalued, but local pessimism will undermine performance. Offshore markets, and local stocks focussed offshore, will deliver better upside.
Having sat down and had a thorough look at things recently, I’m confident that Australian growth prospects are excellent and we’re going to see a strong rebound.
For me, the only question is timing. I suspect we’ll see it in 2013, but maybe that’ll be late 2013. We’ll see as the year progresses.
Now having said that, this week’s GDP numbers were unfortunate. Not so much because they show any economic weakness – they don’t. But it was because the numbers weren’t strong enough to prevent another flare-up in pessimism. They somehow fuelled the debate about the end of the mining boom, non-mining weakness – and there is serious talk of another possible recession in Australia. Again, for what will be the fifth year running!
This is all very recent. Now there has always been this latent pessimism in Australia, but over the last year that hasn’t stood in the way of some fantastic gains on the All Ordinaries – although we have underperformed other global markets over the year and also over a longer time period (see chart 1 below). The problem is, I can’t help but wonder whether this renewed resurgence in domestic pessimism might now mean our market will continue to underperform. Not long term, but over the next three to six months.
Don’t get me wrong. I stand by my research and Australian growth prospects are very good. But the fact is, people are pessimistic here – it weighs – and with most investment banks running around sprouting doom and gloom, what’s an international investor going to think of Australia? They probably won’t.
Another problem for investors is that the fiscal cliff has turned out to be a bit of a fizzer. I was hoping for better value to be presented by the cliff, and we just haven’t seen that. It’s made life a little more difficult as the pickings would have been quite good if the market had panicked more.
So we’re left in a short-term bind. Until we see new growth figures, everyone will be talking about Australia’s coming recession (or growth slump) – no doubt hoping to talk the Reserve Bank into cutting rates further. Pessimism is back in the ascendency, so more likely than not they’ll deliver, which will smash confidence even more.
Now this is where price action becomes important. Overall, the ASX200 is up 11% for the year with nearly all of those gains made over the last six months. Consequently, our market doesn’t look terribly cheap. The trailing price to earnings ratio is at 14.9, which is just above the average P/E of 14.5.
Note the skew though – over the last six months, financials, staples, health, telecoms and tech stocks are the sectors that have gained –and strongly! Their P/Es suggest they’re not terribly expensive though, even after such strong gains, but neither are they cheap. The question I’m left asking is, that with earnings per share growth being revised down, and given the flare-up in pessimism, how much further will the market go over the summer? My thoughts at this stage are that while we’re talking recession, and until the data can dispel this nonsense, probably not much.
I have to reiterate, I’m not backpedalling or backtracking from my fundamental view in any way – but we have to take recent events very seriously. Longer term there is still value, and while we’re not seeing that in P/Es other metrics suggest it to be the case.
For me, the best way to compare long-term value is by using a metric I referred to some weeks ago – Warren Buffett is a big fan. It’s the market capitalisation to gross national product/GDP ratio. It’s certainly not a new indicator as it’s been around for the better part of a decade and is calculated regularly by many investors and large institutions – including the World Bank. Not everyone agrees that it’s a good indicator though. I can appreciate that, and the measure has its critics – mind you, so do P/Es and other metrics like EPS and price earnings to growth ratio, etc.
The value of this metric is that it has a greater macro overlay in a world driven increasingly by macro-thematic themes. The idea is simple enough – if the stockmarket shrinks significantly relative to GNP/GDP over time, without good cause, then it’s cheap. The two should really should move together given both are rough measures of economic activity. As an economy grows so should its stockmarket. Conversely, if it expands significantly then it’s rich. Now there may be very good reasons why the market and the economy don’t move together (structural, tax, or legal changes - preferences for debt over equity etc), but that should come out in the research process.
Looking at Australia first, table two above shows the market capitalisation to GDP ratio is at 91%. Now the size of a country’s stockmarket relative to GDP depends on so many variables – preference for equity finance over debt investment preferences, legal issues (preference for corporatisation) and the like. So we need to compare each country’s market cap to GDP relative to some benchmark – an average for instance. The average for Australia is 114%, so a reading of 91% suggests value. This backs my fundamental view that the Aussie market is cheap on a three-five-year view. I know this doesn’t gel with current P/Es, but as discussed in previous notes I think earnings will likely rise sharply.
However it’s also obvious from the table that Australia isn’t necessarily the best value market around. I mentioned China previously and its market is some 45% below average and about 80% from the peak. Britain’s market is similarly at extreme values, which suggest plenty of investing opportunities there. For the US, markets don’t look cheap but there is still value there and, most importantly, the country is much more optimistic.
Taking all of that into account, I can’t help but wonder if we shouldn’t cast our investment gaze abroad for now. Talk of a US recovery is gathering momentum and China looks to have stabilised. Confidence is rising abroad. Investors should go with that, especially given the strong Australian dollar.
For those who are reluctant to invest in overseas markets, maybe the near-term domestic outperformers will be stocks leveraged to the global growth story – especially the US story. Now there are plenty of stocks with significant US or global operations – for instance stocks like James Hardie (JHX), CSL, or Brambles (BXB). The problem here is that many are already expensive. So CSL has had a very hard run and looks rich, JHX is up sharply this year with a current P/E of 7.5 (although the one-year forward P/E is 21). While BXB looks ok on a P/E of 18 and a one-year forward P/E of 14 – it is still well below the decade average of over 20 though, and stocks like these are certainly worth a look.