Investment Strategy: It’s Rational to Expect the Irrational

Investment Strategy: It’s Rational to Expect the Irrational

How do you go about valuing a company?

Do you even try?

Or do you just settle for the old P/E ratio and dividend yield as a rough guide?

If you’re like most people, you probably have a rough guess. That’s because most people don’t have the framework or the tools to do proper valuation analysis.

And even if you do, it then takes time and experience to understand that a valuation model is just that. There is no such thing as absolute value. No model, no matter how good, will provide you with ‘the answer’ to a company’s true, or ‘intrinsic’ value.

You can make a good educated guess, of course. This will improve your chances of generating superior investment returns. But to do that consistently you need a decent framework for thinking about how companies actually create shareholder value.

Today, I’ll give you such a framework. But then I’ll apply it to the Aussie market, rather than a particular stock. It’s relevant because of the ongoing  ‘underperformance’ of the Aussie market, especially in relation to the US.

For example, the Financial Review today bemoans the performance of the Aussie market. But as I’ll show you in a minute, there is good reason for that.

Even the most blatantly bullish sharemarket investor would have to admit that as Wall Street hits another record high, it’s simply a case of groundhog day here as the major S&P/ASX 200 Index struggles to trade too far away from 5700.

‘Maybe the local sharemarket is about to be let off the leash after four months of zigzagging around that level but it has underperformed the Dow Jones and S&P 500 over the past year and has a fair bit of ground to make up.

‘Indeed, the major index has lagged Wall Street over the past two years, the past five years and even over the past 10 years.

‘With little more than three months to go the local sharemarket is staring down the barrel of a lost decade.’

With that quote in mind, let me explain…

The optimal way for a company to grow shareholder value, and therefore its share price, is to generate high returns on equity and reinvest those returns at those higher rates.

If a company can do this, it will trade at a much higher price than a stock that generates an average return on equity and pays out a large portion of profits as dividends.

Put simply, the former company is a ‘growth’ stock and will trade on a P/E multiple of around 20 times. The latter is a ‘value’ stock and will trade on a multiple of, say, around 12 times.

That means the growth stock trades at a 66% premium to the value stock.

In other words, the market rewards companies that can retain earnings and keep generating a high return on these earnings. Through the magic of compounding, it’s the best way to create value.

On the other hand, a company that doesn’t have strong growth prospects pays out its profits as dividends. As it doesn’t retain earnings, there is little to no compounding effect. Obviously, the market won’t pay up for growth.

In the same way, the market views the United States as a growth ‘stock’ and Australia as a value ‘stock’.

US companies reinvest their earnings. Or if they don’t, they use their earnings to buy back shares, rather than pay a dividend. Buying back shares is effectively the same thing as reinvesting.

Aussie companies, on the other hand, operate in a smaller market and don’t have the same growth prospects as US companies. That’s why they tend to pay out more of their profits as dividends.

This is the fundamental reason why the performance and current valuation levels between the two countries are so different.

But the above quote from the Financial Review doesn’t take into account the impact of dividends. The Aussie market adds about 4.5% per year in dividend payments. If you reinvestment those dividends, the performance of the Aussie market isn’t as bad as it looks.

Which is best then, the US growth market or Aussie value stocks?

There’s a technical answer, and a simple answer.

The technical answer relies on valuation metrics. I won’t go into it here, but let’s just say the S&P500 now trades on a price-to-book ratio of 3.2 times (meaning stock prices are 3.2 times the value of shareholder equity). This is the highest ratio since 2002.

That reflects the US market’s ‘growth’ characteristics. But is it priced in?

Probably, yes. But the ‘simple answer’ I referred to above comes down to what everyone else is doing. And if ‘everyone’ thinks the US is a better investment option than Australia, that’s where the cash will go, and prices will follow.

This is how prices go from rational to irrational. And this is where you stand to make the most gains if you don’t get sucked into believing the hype.

Too many value investors sell out early in a rally because prices don’t make sense to them. Fair enough. But they’re giving up large gains in their desire to stay rational.

In my view, it’s rational to expect the irrational, and you should try to profit from it. So while the US market might be overvalued based on most ‘rational’ measures, it doesn’t mean that it can’t get much, much worse…or better, depending on what side of the trade you’re on.

Regards,

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan

Greg Canavan

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

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