During the first quarter of 2019, we have observed an acceleration in the outperformance of growth over value. This can be seen in the chart below provided by Deutsche Bank which illustrates that the price to earnings multiple (P/E) differential between growth and value stocks is close to the largest it has been since 2003. This dynamic has been well documented by the investment community however as we will highlight below, the outperformance of the growth names has been largely driven by a select group of very high P/E names that have continued to re-rate despite minimal changes to their earnings outlooks (in cases negative).
Source: Deutsche Bank
Source: Deutsche Bank
Being a value manager in this market can be challenging. Despite this market dynamic, we continue to focus relentlessly on finding opportunities to invest in quality businesses at the right price. This may come at a cost to short-term performance, however we believe being disciplined and paying the right price for a business and its risk profile will pay dividends to unitholders over the long-term.
Earnings or multiple expansion driving share price strength?
The recent strength in the growth names has been largely driven by the strong share price performance of a select group of very high multiple names. Below is a list of some of the strongest performing stocks in the four months to April 2019. The question is ‒ what has driven such a strong share price reaction? Has it been upgrades to short-term earnings or the market upwardly re-rating the multiple on the stocks? Well, as can be seen by the table below, it most certainly has been the latter.
Source: Bloomberg , PPT analysis
As can be seen from the above, the Market Cap/Sales and P/E multiples of these businesses has increased significantly since January. The average Market Cap/Sales multiple of the group of stocks has increased from 9x to 14x and the average P/E has more than doubled in the last four months from 39x to 85x!!!! Clearly these stocks have benefitted from a change in interest rate expectations. Generally speaking, the lower the interest rates the more valuable long duration assets become. However, we feel that this only partially explains what we are seeing. What is interesting from the re-rating of the aforementioned stocks is that it has occurred at a time when some of these companies have had downgrades in consensus earnings expectations. Below are a few specific examples of what we are talking about:
- Afterpay (ASX:APT) – Share price is +120% since 1 Jan 2019. FY20 consensus sales has increased by 4% yet EPS forecasts have fallen from 22cps to 12cps. The Market Cap/Sales multiple has re-rated from 6x to 14x and the P/E has increased from 53 to 228x.
- Wisetech (ASX:WTC) – Share price is +38%. FY20 EPS forecasts have fallen 11% from 30cps to 26 cps. The Market Cap/Sales multiple has re-rated from 12 to 17x and the P/E has increased from 52x to 86x.
- HUB 24 (ASX:HUB) – Share price is +28%. FY 20 EPS forecasts have fallen from 36cps to 31cps, yet the P/E ratio has re-rated from 30x to 50x.
What is the Conclusion?
So, the conclusion from the above is that it has NOT been an improvement in short-term sales or earnings which has led to these share prices exploding. There are therefore two potential explanations for these moves. The first is that the market has become substantially more confident about the medium to long-term prospects for these businesses. This could be driven either by new evidence that the growth will be stronger, or more confidence that the already lofty growth expectations will be met. The alternative explanation is that fear of missing out (FOMO) has engulfed the market and market participants are chasing whatever is hot for fear of underperforming.
How will the industry look in 10 years?
One common mistake value investors make is to place too much emphasis on short-term earnings multiples. Buying low P/E and selling high P/E is over-simplistic and can easily be done by computers rather than humans. What is much more important is truly understanding the business which generates those earnings and how the industry in which this business operates is changing. Understanding the quality of the earnings being generated, where we are in the cycle, industry growth outlook and sustainability of these earnings is far more important in determining the medium to longer term earnings outlook.
Market perceptions about growth, quality and ability to eventually turn that into earnings are generally key drivers to what P/E the market is going to assign in the short-term. Therefore, a flaw in our argument above and a general flaw of most value investors is placing too much focus on the short-term earnings and not enough focus on the medium to longer term quality and growth of the business. A company could have a high P/E but still be good value if it is currently at the low end of a cycle, over-investing in the short-term to improve their long-term franchise or for a variety of other reasons are under-earning in the short-term relative to potential.
However, if you are paying 30x P/E or more you would want to be very confident that the earnings will be materially higher in ten years’ time (less important for a company on 10x P/E).
You would want to be extremely confident that the industry grows as you expect and that the perceived barriers of entry that your company possesses are really as high as you think. The perception may be that that a disrupter in a certain industry continues to take market share, but what actually happens when a disruptor eventually wants to start generating earnings? Is their product still as attractive?
The most important and least analysed aspect of every industry generally and business specifically is the prospect of future competition. More specifically future unknown competition. A lot can happen in ten years. Several market participants in ten years will not have even been formed yet. I would also make the point that future competition is more likely to spring up in hot sectors where valuations are through the roof rather than out of favour sectors. For instance, there will likely be hundreds of more competitors in the buy now pay later space but the same or less competitors in the lottery or health insurance sectors.
This massive re-rating of P/E’s MUST be as a result of the market becoming more confident and upbeat about the medium to longer term prospects of these companies. So individually something has happened over the last few months which has given the market more optimism. What is interesting is that despite the strong share price runs, the sell side analysts mostly continue to have buy recommendations on these companies. We thought that we would explore the valuation justifications from these analysts to see what we were missing.
How are these valuations being justified?
Below we consider a few recent examples we have observed of market participants using what we consider extreme assumptions to arrive at a target price that is close to the current share price.
Afterpay Touch Group (ASX:APT)
APT has been a massive success story to come out of Australia. Management has developed a consumer financing product which has caught the imagination of not only Australian but also US consumers. Enabling consumers to pay for a good in four equal instalments but receiving the product up front is extremely attractive for the consumer, especially if there are limited credit checks. The revenue model revolves around the retailer paying a merchant fee of around 4% to APT as well as late fees being paid by the consumer if they miss an instalment. Originally retailers loved this concept because the seamless approval process and less immediate payment by the consumer meant that there were fewer consumers drop out and they would tend to buy more.
With such punchy multiples the market is betting that APT will be able to replicate its success in Australia over in the US and the UK.
The bulls on the stock will argue that first mover advantage is all important in this industry and as millennials see the benefits of buy now, pay later, they will demand the retailer have this option available which will continue to drive demand for APT which will continue to take market share from incumbent financiers.
Questions we are asking ourselves are whether or not responsible lending obligations might start extending to the buy now pay later sector or whether or not the regulators will enable this regulatory arbitrage to continue indefinitely. If the latter, what will the competitive environment look like in five years’ time? Already we are hearing large retailers in Australia paying half the merchant fee to competing buy now, pay later products. I would argue the market value of APT will likely attract a plethora of competitors over the next five years (most of which have not even been formed at this point). The question we need to ask ourselves is whether or not consumers are buying a pair of shoes because it can be financed by a certain consumer finance company (on this occasion APT) or they are buying the shoes, because they like the pair of shoes and the financing is an afterthought. The bulls would argue the former. This increase in competition would bring into question the sustainability of the 4% merchant fee. Finally, one would need to ask themselves the question what the quality of the receivables are. In any fast-growing consumer finance company, analysing quality of credit is extremely difficult and can be flattered by the denominator. This is no different. Whether or not unsecured credit, where there are limited credit checks required with a young cohort is high quality credit has yet to be really tested. A credit cycle would be very interesting.
IDP Education (ASX:IEL)
Another hot company on the ASX is IDP Education (IEL). It is a student agency business but most of its earnings are generated from doing English Language tests for students and other visa applicants into Australia. One would argue doing English language tests is an OK but not a ridiculously good business. However, IEL trades on an FY20 P/E of 47x. One of the bulls of IEL recently upgraded the valuation by 32% from $11.50 to $15.20. The upgrade was to reflect a 5% upgrade to their FY20 NPAT forecasts from $69 million to $72 million. As part of the explanation for this the analyst wrote:
“We factor a further multiple re - rating into our updated valuation in order to reflect prevail equity market conditions (quality/secular growth bias) and relative “scarcity premium” (ie. Comparatively limited ASX - listed stocks demonstrating such characteristics).”
So, to translate this, the analyst has put a higher multiple, not because he sees a better growth or quality of medium-term earnings but because the current market is paying higher prices for growth stocks AND because there is scarcity of English testing companies in Australia. It would follow from this logic that if a heap of English testing company’s initial public offering (IPO) on the ASX that this company should get a de-rate as the scarcity premium disappears. We won’t hold our breath.
In all seriousness, what this shows is just how hard the analysts have to try to justify the current valuation being assigned by the market. It is pro-cyclical. He is upping his valuation because the current sentiment towards high P/E stocks is strong. If this were to reverse, by this logic, he would have to downgrade his valuation.
Another stock where analysts have had to try very hard to justify the current market valuation is Transurban. One analyst includes in their valuation $1/share of value which is a total of $2.4 billion in value for “potential projects”. So basically, the analyst is saying that we are going to gift TCL $2.4 billion of value for projects which have yet to be announced. We believe that there will be heightened competition for new potential projects in this environment of cheap money and with infrastructure in favour. Therefore, any new project will be keenly bid for by a multitude of parties with extremely low cost of capital. Bearing any value created by Transurban by bidding these projects is a pure value transfer away from tax payers to Transurban. We feel that adding $2.4bn to Transurban’s value for future as yet unannounced projects is a little heroic. One would argue the cost of capital of these state governments is lower than that of TCL so we have difficulty believing that in the current or future environment, state governments will allow a value transfer from tax payers to Transurban.
The point being, that valuations are getting so stretched that the analysts have to continue to be very creative to not only justify the current valuation but to try and convince their clients that these stocks are still cheap.
We are operating in unusual times, but we have seen these sorts of markets before. We will keep an open mind, but we will not chase hot stocks just because the share prices have gone up. What we have tried to demonstrate above is the lengths sell side analysts have gone to continue to justify the valuations at the current levels for a few of the hotter stocks in the market. We would argue that the buy side, which seems to be capitulating and buying these stocks, are using similar flaky justifications for buying these stocks.
We will continue to invest in companies where we have a strong conviction on the medium to longer term outlook and we believe due to various shorter-term issues we are buying them at a discount. There is always risk in any investment, but we believe that risks are much more elevated in these hot stocks which everyone seems to be chasing (especially in Australia). We would argue that the quality of a lot of these stocks is materially lower than what is perceived by the market.