It feels good to own shares trading at high prices in the sharemarket. One’s net worth is buoyant, there is the confidence which comes from success, and one’s portfolio is the envy of friends and family.
Problems arise when investors extrapolate those share prices or their recent growth into the future. It is human nature to do this. We all tend to give a greater weight to the recent, and the now, than the more distant past. If a stock we own is strong now we tend to assume, at least partly due to our hopes for sustained wealth and our fears of loss, that it will remain strong. These understandable and powerful feelings introduce a ‘recency bias’ to our thinking.
The problem is the participants meeting in the sharemarket to set the prices of securities don’t know and don’t care about our hopes. Participants are motivated by fear, greed, persuasive advice and stock tips, trading volumes, momentum, tax considerations, other personal financial circumstances, a desire to be part of the crowd by owning popular securities, embarrassment about owning securities out of favour, and value – anything but our hopes for our investment.
Over time, however, share prices gravitate towards a company’s intrinsic value, which is typically more stable and acts as an anchor for share prices. This means serious investors should aim to accurately assess value and then act accordingly, buying at sufficient discounts to value for the risks assumed and selling when fundamentals cannot justify prices. The popularity of a stock should not guide decisions about which securities to own.
We opened with this discussion because there is one popular stock which is sufficiently overvalued and we cannot recommend owning it at current prices. Wesfarmers (ASX:WES), the eighth-largest company covered by StocksInValue with a market cap of $50 billion, traded at $43.26 at the time of writing. But in our view WES is worth only $29.30 per share now and just $29.69 by the end of FY16. This means the theoretical forward return over this period of more than two years, assuming the share price converges to value and including grossed-up dividends to be paid, is -17%. This outlook should clear any recency bias out of shareholders’ thinking and trigger a search for alternative investments.
Our valuation is a strong bearish call, so let us explain its derivation.
The central frustration for WES shareholders is the company’s profitability. In FY13 normalised return on equity, or NROE (“normalised” means the inclusion of franking credits), was just 12.6% – a contradiction of the scale economies and funding advantages from being a conglomerate owning national businesses with large market shares. We think sustainable NROE is just 15% pa (green in Figure 1 above), which compares with NROE for Woolworths in last week’s article of 35%.
The profitability problem began with the acquisition of Coles for $22 billion in 2007, which continues to haunt shareholders seven years on despite management’s success at lifting the supermarket chain’s sales and profit margins. Shortly after the acquisition, which remains the largest corporate takeover in Australian history, WES raised $2.5 billion of equity via an entitlement offer in 2008. Then, in 2009, another $4.6 billion of equity was raised in a rights issue and placement. The recapitalisations reduced gearing but heavily diluted NROE and equity per share. Since 2008 WES’s profitability has averaged 9% and is in uptrend, but remains well off the pre-2007 levels.
Companies are worth more the greater their premium of sustainable NROE to a reasonable required return (RR). Our 15% adopted NROE is only slightly greater than our RR of 12.0% (red in Figure 1), which is a low rating of business and financial risk to reflect large market capitalisation, long listed life, low gearing and consistency of group performance underpinned by the discretionary nature of Coles’ sales revenue.
An adopted NROE of 15% is more generous to WES than the consensus of broker analysts covering the stock, who forecast 13.5% for FY14 and 14.4% for FY15 (blue box). Our 15% also exceeds the five-year average of 12% to acknowledge improving profitability from the turnaround in Coles and strong sales growth at Bunnings and Officeworks.
The small premium of NROE to RR retards intrinsic value, earnings and dividend growth, especially given the high dividend payout ratio implied by the metrics in the purple box in Figure 1. WES reinvests just 13% of its profitability (reinvestment rate of 2% divided by NROE of 15%) to grow intrinsic value. The dividend payout ratio is 100% – 13% = 87%. As a result we forecast negligible intrinsic value growth of just ~1% pa in coming years (brown box).
Though management has substantially improved Coles’ profitability, there is a long way to go before shareholders are rewarded for their dilution in acquiring Coles. Future profitability could be enhanced by accretive deployment of the $3 billion proceeds from the recent sale of the insurance operations. However, there is also the risk of another dilutive acquisition.
Current pricing of WES in the sharemarket implies a 21% NROE or 8.5% RR, neither of which is justifiable in our view.
By David Walker, Senior Analyst StocksInValue, with insights from Adrian Ezquerro of Clime Asset Management.