Markets vs Central Bankers: The great valuation debate (Part 2)

Articles 18/05/2022
Markets vs Central Bankers: The great valuation debate (Part 2)

Last week we discussed our thoughts on the acceleration in inflation and added some context to the moves in bond markets. Please refer here for a refresher.

 

The moves in bond markets have clearly impacted equity markets, particularly high growth sectors such as technology. However, if we delve a little deeper, many tech-focussed companies are delivering real (and substantial) revenues, profits and cash: a vastly different scenario from the year 2000 tech wreck. While the NASDAQ is off 23% year-to-date, the Goldman Sachs Non-Profitable Technology Stock index is down 51% year-to-date (and down 69% from its February 2021 peak) illustrating the impact that higher bond yields have on businesses whose value is predicated on the hope of profits in the very distant future. Meanwhile, many of the big household technology names remain in rude health and retain a bevy of growth opportunities.

 

To illustrate this point we provide some high level metrics on US-listed global tech giant Microsoft and local retailer Coles. Each operate in a cosy (duopoly or oligopoly) market structure yet offer vastly different services to their customers and prospects for growth.

 

 

PE

Avg EPS Growth

Net Cash / (Debt)

ROE

Market Cap

Microsoft

26.0x

16.0% pa

US$53 billion cash

39.5%

US$2 trillion

Coles

25.0x

5.5% pa

A$9 billion debt

34.0%

A$25 billion

PE = current share price as a proportion of the next 12 months' earnings

Avg EPS Growth = average earnings per share growth over the next 3 years

ROE = return on equity

 

Heading into an inflationary environment, investors have once again sought safety in consumer staples stocks like Coles, trusting the ability of a supermarket to hike their shelf prices. After all, everyone still needs to eat! However in a purely binary decision, we would argue Microsoft is the more attractive opportunity.  Purchased on a similar valuation to Coles, we would be accessing three times the rate of earnings growth, all the while without needing to utilise debt!  Furthermore, in a world where the cost of goods and services is rising, we would expect the global technology players to retain their dominance. Would you or your business be willing to stop using Microsoft Office or Sharepoint because of a 5% or even 15% price increase? What would the cost of making a change be to yourself or your business?

 

What are business leaders saying?

Macquarie's prestigious Australian investment conference was held a fortnight ago, with management from over 100 companies providing both trading and strategic updates on their businesses. It was a real-time pulse check on the economic and business environments. Unsurprisingly, there was one topic of focus: inflation. Whether you were a heavy consumer of fuel, an importer of retail goods, a healthcare provider or even an investment manager; everyone was feeling the effects of inflation. However most companies were optimistic on their ability to pass on higher costs. Of course, history suggests not everyone will be as successful as they'd envisaged.

 

Scott Charlton, CEO of toll road operator Transurban, provided investors with a strong degree of comfort (unless you're a toll road user) noting that over two-thirds of its revenues are inflation-linked under contracted toll arrangements. Furthermore, its entire debt balance is fully hedged against rising interest rates for a number of years to come. Interestingly during Q&A, Mr Charlton noted that inflation had made investment decisions on building new roads more challenging. However, the company's discussions with the states were looking for governments to take on some of the price risk around key materials such as steel. He added that the problem in delivering new projects wasn't necessarily accessing materials (albeit at higher prices) but rather there remained insufficient labour given closed borders and COVID-related absenteeism. We hope this issue will ease as migration recovers following a relaxation of border arrangements.

 

Wesfarmers' managing director, Rob Scott acknowledged that cost pressures were indeed becoming more widespread across their retail and industrial businesses. However in Wesfarmers' true entrepreneurial spirit he added "we see inflation as an opportunity…an opportunity to grow (market) share profitably". In other words, Wesfarmers intends for its businesses (including Bunnings and Officeworks) to minimise shelf price rises where possible, to retain their price (and market) leadership in their respective categories. How? The conglomerate is once again flexing the might of its internal product sourcing team (located throughout Asia), purchasing inventory at prices that still enable the Group to deliver attractive operating margins.

 

Only a day prior to his presentation at the conference, Ron Delia, chief executive at consumer goods packager Amcor, delivered another outstanding quarterly result. Despite the cost of resins and paper rising by double-digit rates, it countered this impost by fully passing on the impact via price increases to their customers. Furthermore, Amcor's plants (operating near full capacity) were struggling to keep up with demand with Mr Delia noting "a sentiment echoed by our customers on their end-consumers, we too have seen far less price elasticity than even we expected".

 

Inflation is here and while the jury is out on its absolute level and longevity, our focus remains unwavering: looking to own companies whose business models afford them the ability to mitigate the impacts of pricing pressures.

 

How are we positioning portfolios?

As we noted in February, we entered 2022 with our portfolios modestly underweight their target allocations to growth investments (predominantly equities) and strong tactical cash and liquid fixed income investments. With the takeover of Sydney Airport settling since that time, we decided to hold off on reinvesting the cash proceeds, effectively lifting our cash holdings while reducing our growth allocations further.

 

In light of our expectations for headline inflation data to stabilise over the remainder of 2022, we would expect bond markets to progressively unwind some of their more aggressive expectations for interest rate rises and in doing so, recover. Concurrently, we seek further clarity on corporate profitability as we're keen to understand how higher inflation and interest rates are impacting. August's company reporting season will be an important signpost. Finally, while we're keeping a keen eye on the Federal election, we don't expect the result to have a material lasting impact on our local market.

 

Should we reach a point where we feel markets have become overly emotional (fearful) relative to the underlying fundamentals, we will not hesitate in opportunistically participating in markets. With the benefit of hindsight, periods like 2008-09 and early 2020 can setup long-term investors' future returns for many years to come.

 

However as it stands today, the range of potential outcomes remains wide and we don't feel markets are offering us sufficient margin of safety to warrant making material new investments just yet. Given our continued focus on the long-term preservation of our clients' wealth, we believe it prudent to retain an underweight allocation to growth investments for the time being. We remain watchful of key inflation data points, actions from central bankers and the response in markets.

Share facebook twitter google plus linkedin