Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 150

The value opportunity in Australian equity

Two interrelated topics have been occupying much of our thoughts in recent months. The first is the deep discount currently available in many areas of the market, including in energy and mining stocks. The second is the underperformance of ‘value’ as an investment style over recent years.

The opportunity in resources

The current valuations of some of the major resources stocks present an opening to buy high-quality companies at levels well below our assessment of their intrinsic worth. The major miners represent value even with commodity prices expected to be lower for a considerable period.

We were resources ‘bears’ at the height of the commodity boom, but since then there has been dramatic de-ratings of commodity share prices. In 2010, resources companies were significantly overpriced, but this has since reversed due to a dramatic decline in resources prices relative to the S&P/ASX 200 Index.

In our valuation process we calculate a fair value for all stocks. This fair value is calculated over three years, assuming all stocks trade at our valuation in three years’ time. Using our methodology in 2010, we estimated that resources stocks were almost two and half times overvalued. Today, however, this same is trading at a 33% discount to fair value.

Or looking at it another way, as of the end of January 2016, the approximate 11% weight of resources in the Index is the lowest in 50 years (we have adjusted the financial weight to allow for the listings of CBA, AMP and IAG and added in Telstra, but not adjusted for changes in News Corp, to make the comparison as meaningful as possible). Even allowing for the bounce in March 2016, resources are still trading at the lower end of the historical ranges today.

Does this low resources weight not only reflect cycle low prices, but also the declining importance of mining in a more diversified economy? In reality, the reverse is actually true, in the sense that from 1967 to today mining exports as a percent of GDP have risen, particularly over the last ten years, as Asian demand has grown faster than the local economy.

Not all miners are created equal

Within the resources sector, we currently favour large diversified miners with cost advantages. In contrast, companies with high cost structures or high leverage may face greater stress during the post-China boom downturn. Junior miners and mining services companies generally have both higher debt levels and more volatile earnings.

This view is not based on any recovery or strong bounce-back in commodity prices. We have factored in the next couple of years of severely depressed commodity prices followed by a reversion to long-term equilibrium. The major miners remain cheap even if commodity prices remain lower for longer.

However, the major miners represent just a small part of the overall opportunity set. The kind of valuation distortion we have highlighted is available in other sectors and with other companies as well. We believe we are in an unusual period of history where the market is not focusing on ‘value’.

Valuation matters, now more than ever

For the purpose of illustrating this point, we will define ‘value’ as low price/book value stocks, and ‘growth’ as high price/book value. Put simply, ‘book value’ is a company’s assets minus its liabilities, broadly giving the equity value or net worth of the business.

Historically, over the long term, buying companies based on cheap valuations has led to better returns. Since 1927, the cumulative return of the lowest 30% price/book value US stocks (a common measure to assess the cheapest stocks) has been 16 times higher than those with the highest valuations (Exhibit 1).

Exhibit 1 - Value outperforms growth in the long run

Source: Kenneth French, Lazard. For the period July 1926 to November 2015 using data defined in Kenneth French’s library.

However, in recent years, in a reversal of the long-term historical trend, cheap securities (or companies with high dividend yield, low price-to-earnings multiples, or low price-to-book ratios) have significantly underperformed expensive securities in Australia and around the world. Investors seem to have prioritised possible earnings growth and recent positive market performance (driven by momentum factors) over traditional value fundamentals.

Bouncing back

The good news for value investors is that while there are periods when value can underperform the market, it has always bounced back. In fact, historically, the best periods for value investing have been in the years following poor value returns.

In the recession year of 1990, the market sold down cyclical stocks to very low levels, which led to a long period of high value returns during the recovery. From 1998 to March 2000 the market inflated the prices of tech stocks and sold down so-called ‘old economy’ stocks to low levels, setting up dramatic outperformance for valuation-driven investors over the next four to five years. By June 2008, the valuation of mining stocks reached high levels, and these mining stocks subsequently collapsed. The unravelling of these price distortions enabled many value managers to outperform their benchmarks by a considerable margin in the years that followed.

We believe this cycle will ultimately be no different. When value metrics return to favour, value managers should be well placed to benefit given the valuation discrepancies currently in the market.

A company’s valuation matters and it is going to matter even more after the market has ignored it for a considerable period of time. Making decisions that go against those of the market is not always easy, yet sometimes sentiment does give the long-term valuation-driven investor the investment equivalent of a long hop down the wicket for a cricketer. Now is one such time.

 

Dr. Philipp Hofflin is Portfolio Manager and Analyst in the Lazard Australian Equity Team. This article is general information and does not address the needs of any individual.

 

RELATED ARTICLES

Invest in Australian value stocks before it is too late

Is the market’s recession conviction warranted?

Reece Birtles on selecting stocks for income in retirement

banner

Most viewed in recent weeks

Is it better to rent or own a home under the age pension?

With 62% of Australians aged 65 and over relying at least partially on the age pension, are they better off owning their home or renting? There is an extra pension asset allowance for those not owning a home.

Too many retirees miss out on this valuable super fund benefit

With 700 Australians retiring every day, retirement income solutions are more important than ever. Why do millions of retirees eligible for a more tax-efficient pension account hold money in accumulation?

Is the fossil fuel narrative simply too convenient?

A fund manager argues it is immoral to deny poor countries access to relatively cheap energy from fossil fuels. Wealthy countries must recognise the transition is a multi-decade challenge and continue to invest.

Reece Birtles on selecting stocks for income in retirement

Equity investing comes with volatility that makes many retirees uncomfortable. A focus on income which is less volatile than share prices, and quality companies delivering robust earnings, offers more reassurance.

Comparing generations and the nine dimensions of our well-being

Using the nine dimensions of well-being used by the OECD, and dividing Australians into Baby Boomers, Generation Xers or Millennials, it is surprisingly easy to identify the winners and losers for most dimensions.

Anton in 2006 v 2022, it's deja vu (all over again)

What was bothering markets in 2006? Try the end of cheap money, bond yields rising, high energy prices and record high commodity prices feeding inflation. Who says these are 'unprecedented' times? It's 2006 v 2022.

Latest Updates

Superannuation

Superannuation: a 30+ year journey but now stop fiddling

Few people have been closer to superannuation policy over the years than Noel Whittaker, especially when he established his eponymous financial planning business. He takes us on a quick guided tour.

Survey: share your retirement experiences

All Baby Boomers are now over 55 and many are either in retirement or thinking about a transition from work. But what is retirement like? Is it the golden years or a drag? Do you have tips for making the most of it?

Interviews

Time for value as ‘promise generators’ fail to deliver

A $28 billion global manager still sees far more potential in value than growth stocks, believes energy stocks are undervalued including an Australian company, and describes the need for resilience in investing.

Superannuation

Paul Keating's long-term plans for super and imputation

Paul Keating not only designed compulsory superannuation but in the 30 years since its introduction, he has maintained the rage. Here are highlights of three articles on SG's origins and two more recent interviews.

Fixed interest

On interest rates and credit, do you feel the need for speed?

Central bank support for credit and equity markets is reversing, which has led to wider spreads and higher rates. But what does that mean and is it time to jump at higher rates or do they have some way to go?

Investment strategies

Death notices for the 60/40 portfolio are premature

Pundits have once again declared the death of the 60% stock/40% bond portfolio amid sharp declines in both stock and bond prices. Based on history, balanced portfolios are apt to prove the naysayers wrong, again.

Exchange traded products

ETFs and the eight biggest worries in index investing

Both passive investing and ETFs have withstood criticism as their popularity has grown. They have been blamed for causing bubbles, distorting the market, and concentrating share ownership. Are any of these criticisms valid?

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.