Are small and mid-cap stocks good value?
Are small and mid-cap stocks good value?
Let me start by making something clear. The best returns will not come from the large-cap blue chips that so many baby boomers are invested in. Nor will satisfactory returns come from leveraged, over-supplied property apartments.
They will come from the stocks that have been beaten up the most in recent months. The reason I suggest the most beaten-up stocks will provide the best returns is because those stocks are the very same that we regard as some of the highest quality and those with the best long-term growth prospects.
Let’s start with the large-cap blue chips.
Have you ever wondered why Telstra’s share price today is lower than it was 17 years ago? Are you surprised that the National Australia Bank’s share price is the same as in 1999?
Are you surprised that BHP Billiton’s share price is no higher than it was in January 2007 – 10 years ago? These are the so-called blue chips. How can this be?
Business economics explains the reason.
Take Telstra as an example. Since 2005, the company has been paying most of its earnings out as a dividend, retaining very little for growth. Unsurprisingly, earnings have not grown.
When we look at the data for Telstra over the past 10 years or more, it has delivered nearly flat earnings per share (EPS), averaging around 30 cents per share. FY14 was a bit better than average, with EPS hitting 37 cents, but this is only slightly more than the result achieved in 2004. On a 13-year view, Telstra’s EPS growth has effectively been nil.
A hundred thousand dollars invested in Telstra in 2005 has grown to just $105,000 at the time of writing (mid-December) and the $5,970 of dividend income in 2005 has grown to just $6,500. Neither has kept up with inflation, meaning your purchasing power has been reduced by this supposed “safe” blue chip.
A company that pays most of its earnings out as a dividend might show an attractive dividend yield today, but unless the dividend income grows, owners of this asset are setting themselves up for reduced purchasing power and therefore a decline in their quality of life.
For the large-cap blue chips, this is an important point. It means that unless the future looks very different from the past, high-dividend-paying companies are unlikely to deliver material growth in intrinsic (true) company value.
And as the Reserve Bank of Australia reported a year ago, the most expensive stocks listed on the ASX have been those paying most of their earnings (greater than 85%) out as a dividend. The most expensive group of stocks has been those offering the lowest growth.
Those two conditions cannot co-exist for very long. Eventually, either growth needs to return (but it cannot if dividend payout ratios remain high), or prices need to decline. And if interest rates on bonds keep rising, the decline in prices for low- or no-growth companies could be harsh.
As Ben Graham once observed, in the short run the market is a voting machine, but in the long run it is a weighing machine. In other words, the share price in the short run is just a popularity contest. In the long run, however, prices will follow the performance of the underlying business. If the underlying business performs with mediocrity, over the long run so will the share price.
What about property?
The next asset class I believe will offer mediocre returns, if not capital losses, is property, particularly apartments.
Australia’s east-coast capitals are facing a tidal wave of apartment supply and developers will not be able to sell all their inventory at current prices. Indeed, they are already trying to offer carrots to lure potential buyers. These carrots, such as millions of frequent-flyer points, holidays to Asia or ten-year rental guarantees are forms of discounts designed to try to preserve the ticket price.
As the supply of apartments increases, however, the discounting will become more aggressive simply because the developers owe their lenders money and need to pay back the loans – many of which have also capitalised interest (something to think about when owning bank shares, too).
Investors who borrowed to buy an investment apartment are at particular risk. Look at Brisbane where in the first nine months of 2016 just 5,200 apartments were completed in the inner 5-kilometre ring from the CBD.
Investors who bought outside that inner ring – five to 15 kilometres from the CBD – have seen aggregate vacancy rates climb from 2.3% to 4.7%. And that number can only keep rising when another 13,000 apartments are due to be completed in the next 18 months. A unit without a tenant has a yield of zero per cent and a unit earning zero, with a mortgage attached, could put its owner in financial stress.
With record levels of mortgage and credit-card debt in Australia, we expect there will be some financial stress ahead. Want to buy some bank shares?
Finding better opportunities
Finally, we turn to a group of listed companies that appears to provide the best opportunity for positive returns over the next year or two. But first a little background.
Over the last year or two, a lack of expected growth from the banks and resource companies meant large institutional fund managers migrated down the market-capitalisation spectrum, looking to boost their returns. High-quality, mid- and small-capitalised company shares, those with bright prospects and economics, benefited.
More recently, however, that perception of prospects for the banks and resource companies improved and those institutions found themselves underweight these sectors. Needing to “catch up”, they were forced to sell down their holdings in smaller, high-quality growth companies to fund their purchases of the banks, BHP, RIO et al.
The result has been a bloodbath in the share prices of smaller high-quality, high-growth companies. ISentia has declined more than 30 per cent in the last month, as have APN Outdoor and Vita Group. Healthscope has fallen 32 per cent from a high of $3.14 to a low of $2.15, REA Group and Carsales are down 27 per cent and 28 per cent respectively from their highs.
Many investors ask me how high-quality companies could ever be cheap if everyone knows they are high quality? Well, occasionally, scenarios such as the one just described occur and the market treats that which is temporary as permanent. And value emerges.
Our inability to identify good value earlier in 2016 meant Montgomery Funds had built cash levels placing them in the enviable position of being able to take advantage of lower prices, and in some cases, the first opportunity to acquire value in a long time.
Perhaps most interestingly, the companies that score the highest on our quality matrix have been the very worst performers. This can be seen in the illustration of returns for quality deciles of the S&P/ASX300.
Being somewhat obsessed with quality, we maintain a database covering the entire ASX300, scoring every business in terms of its pricing power, barriers to entry, industry structure, switching costs, and many other factors. This allows us to calculate an aggregate quality score for every business we may be interested in and, using that, we can sort the market in order from best to worst.
Our objective is to rank businesses by the sustainability of their propensity to create shareholder value by investing incremental capital at rates of return above the cost of capital. The underlying rationale for this is reasonably self-evident. Over long periods, a business that has the ability to create genuine value for its shareholders should be able to generate good investment returns by the accumulation of that value.
Importantly, however, this is a long-term dynamic. Value creation only reveals itself over a number of years and as the business reports growing shareholder equity while sustaining a high return on that growing equity.
Over shorter periods, the share prices for good businesses can decline and the prices for inferior businesses can surge, and we believe we are currently witnessing just such a period.
As shown in the above chart, the businesses with our very highest-quality scores (at the left of the chart) have delivered the worst returns since August 1, 2016. Meanwhile, the strongest returns have been found towards the low end of the quality scale (the right-hand side of the chart). The index at far right returned minus 0.6%.
Once again, this combination of circumstances does not coexist forever. In the long run, quality (as defined by Montgomery as the sustained ability to generate high rates of return on incremental equity) always wins.
Investing in the future will look very little like the recent past. Because we are so inadequately armed to pick turning points, most investors will continue to believe property and conventional blue-chip shares will be where the best returns will continue to come from.
Our own view is founded on the basic investing tenet that the lower the price you pay, the higher your return. Combine this investing truism with quality and the recent sell off in high-quality mid-cap company shares starts to look very attractive. Rather than appearing like a risky place to invest, a market that has just suffered a bout of volatility starts to look like the safest place to be.
An observation, famously ascribed to Jesus of Nazareth, notes: “…many who are first will be last, and many who are last will be first.” This may just be true for investors in 2017 and beyond.
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