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It's a bubble! (But not one you think)

It's A Bubble! (But Not The One You Think) Mention the term "investment bubble" and investors mind wanders off to the Nasdaq pre-March 2000, the Tulip-mania in the Netherlands hundreds of years ago, or in more recent times to uranium in 2007, crude oil in 2008, US real estate prior to 2007 and possibly even to Quantitative Easing stage 2 and its potential consequences for financial assets next year. In other words: what instantly comes to mind are mass-blinded speculators-on-steroids driving prices ever higher, until the day of reckoning arrives, with negative consequences for all that would seem so obvious, in hindsight. But those are just the most obvious and excessive examples. Investment bubbles are much more common than investors would instinctively think. As a matter of fact, the Australian share market probably harbours at least a few speculative bubbles every year or so, and in places that are far less obvious than "coal seam methane" or "rare earths". The problem with "investment bubbles", no matter what time, size, duration or shape, is that in the early beginnings there's always a solid fundamental story, but one that gradually attracts an excess of liquidity (investment funds). This is why it is so difficult to distinguish bubbles in real time. Where does the fundamental justification stop and where does the flow of money take over? Ask international property analysts. They will tell you every property bubble -every single one of them- is always justified by local owners, analysts and investors, right up to the point of reversal. This is why international investors remain skeptical towards Australian banks and local analysts dismissing the idea that Australia is experiencing its own property bubble. Today's story, however, is not about property. It is about the share market. It is an attempt to show how easy it is to be drawn into a buoyant fundamental story, while neglecting the fact that valuations have gone through the roof. Because, no matter time, place and circumstances, this is what always happens in bubbles: prices run up too high, leaving an extended tail of underperformance for those investors who joined in too late and hang on, once the tide has turned. To surprise you all, I have chosen one stock on the Australian share market investors would never link to investment bubbles, yet its underperformance since peaking in late 2007 has the same underpinnings and basic characteristics that led to a bubble first and then a pop later in the examples cited above. The stock I am talking about is Woolworths ((WOW)). Remember, in the beginning there is always a fundamentally attractive story. In the years leading up to late 2007, Woolworths had plenty of fundamental credentials to become one of the darlings in the Australian share market with company profit results consistently beating market expectations. The company's average annual growth in earnings per share between 2000 and 2010 stands at 17.75%, which is a great achievement by anyone's standards, but the skew is very much towards the three years around the share price peak: 19.8% growth for earnings per share (EPS) in fiscal 2006, followed by 19.4% growth in 2007, and then followed by 23.8% in 2008. Returns for shareholders were similarly spectacular: nearly 50% in 2005, then 26% in 2006, then 38% in 2007 and even in 2008, when the world as we knew it was coming to an end and share markets dived into a deep quagmire, loyal shareholders lost only 7% after accounting for company dividends. Woolworths has been one great investment for those investors who were on board throughout the noughties. Remember, it always begins with a fundamentally sound story. Let's have a look at Woolworths from a different angle. One that starts with growth and then translates into price and valuation. As stated above, EPS growth for Woolworths has averaged 17.75% over the eleven years in between 2000-2010. The company finished 1999 with growth of 2.7% only, but have a look at what transpired since: - 2000 = 18.7% growth in EPS - 2001 = 24% - 2002 = 22.75% - 2003 = 16% - 2004 = 16.5% - 2005 = 13% - 2006 = 19.88% - 2007 = 19.4% - 2008 = 23.78% - 2009 = 12.13% - 2010 = 9% These truly were golden years for Woolworths as a conglomerate of retail oriented businesses and the sharemarket rewarded the company and its shareholders accordingly, leading to an ever increasing Price-Earnings multiple (P/E). By the year 2007, Woolworths' forward PE ratio had been steadily above 20 and it was about to make that final jump, whole the way up to 27. It was at that point some analysts observed Woolworths had become the world's most expensively priced supermarket operator. Nice achievement, but it should have rang warning bells for shareholders and investors. Time for a brief time-out: at face value one could argue a PE ratio above 20 seems justified for a company whose EPS growth is consistently near 20%. There are plenty of past and present examples of companies who have been rewarded similarly under similar circumstances, including CSL ((CSL)), Cochlear ((COH)), ResMed ((RMD)), ((WTF)), Leighton Holdings ((LEI)) and ((CRZ)). But a PE ratio of 27? The world's most famous value-investors, Charlie Munger and Warren Buffett, seem to hold the view that stocks trading on PEs above 16 are seldom worth their attention. The reason as to why is probably linked to one of those savvy market observations for which both are well-known and oft quoted across the globe: companies ultimately find it impossible to keep growing above 20%. The problem is that when growth ultimately does slow below 20%, those PEs above 20 start contracting too - often with devastating consequences for shareholders who stay on board, unaware of what is actually taking place underneath daily share price movements. I have tried to visualise this phenomenon for Woolworths since 2006 on the following price chart. The red line is roughly the PE ratio, which started falling since late 2007 and has kept falling since: woolworths Remember, bubbles always start with a great fundamental story. While it is difficult to determine what the real, non-bubbly value is for property in Sydney, or for tulips in Holland, or crude oil on international futures markets, forward looking Price-Earnings ratios can be a relatively reliable guide for investors in the equity market. The chart above shows exactly what I mean when I say: investors who buy too expensively, will pay for it later. Woolworths is a great company. Not even the Global Financial Crisis could trigger a year of negative growth, but while profits for shareholders kept growing, year after year, the Price-Earnings ratio has been falling and this has negated all progress for the share price. Today, and seemingly trading inside a $26-$30 trading range, Woolworths shares at $27-something are still well below their $34 price peak. In fact, Woolworths shares haven't made any progress at all since January 2008, which makes for a nerve-testing 35 month long side-ways movement. In my view, this is solely because Woolworths is intrinsically a great company, with a great growth story, as witnessed by the fact recent market updates proved once again better than market expectations. But, and similar to bubbles elsewhere, the shares continue struggling with the legacy of what once was: a bloated share price valuation because of temporarily too high a popularity. Between late 2005 and late 2007, the stock's forward PE multiple rose from around 20 to beyond 27; a very high multiple for any well-established retailer-supermarketoperator as is Woolworths. JB Hi-Fi ((JBH)), for example, which has been the most successful retail story in Australia in the past decade, hardly ever saw its PE rise above 20. Within this framework it can easily be established why Woolworths shares have remained stagnant for nearly three years: as EPS growth slowed from nearly 24% to 9% in FY10, the Price-Earnings ratio contracted from 27 to below 16. And investors in Woolworths have been relatively lucky given the company is still growing strongly and in great shape. Others (see Wotif, Leighton, and others) have been far, far less lucky. Many investors use balance sheet assessments or past calculations, like Return on Equity (ROE) and trailing PE ratios, to find suitable candidates for their longer term investment portfolios (if they use valuation assessments at all). One popular observation about Woolworths shares is that the average annual return for shareholders has been 19.9% over the past twenty years. However, as shown in the example above, if investors neglect to look forward and to take into account the intrinsic valuation of what they are actually buying, they risk buying into a great company with a great story, but at the wrong price at the wrong time; the inevitable consequence then becomes disappointing investment returns. There are some valuable lessons to this story... but also, what can we say about the future for Woolworths shares? While I have used Price-Earnings multiples to illustrate why Woolworths shares have in essence experienced the same exuberance as crude oil and other assets at the peak of their bubble, history shows Woolworths shares tend to command a market premium, and they still do so today. As a result, pure PE ratio analysis on its own doesn't seem appropriate in this case. Further analysis has shown that PEGY, a valuation technique that combines EPS growth with prospective dividend yield, has been a fairly accurate predictor over the past twelve years of where the Woolworths share price is heading. For example, at its peak, PEGY would have justified the peak share price by combining near 24% EPS growth with 3% dividend yield (makes for a PE of 27 combined). Current consensus forecasts are that Woolworths will continue growing EPS at 9-10% over the two years ahead. Given that the dividend yield has now increased to 4.7% (5.1% one year out into FY12) and Woolworth's forward PE ratio at $27.08 is exactly 15, it would appear the gradual de-rating for the shares is maturing. After all, 10% EPS growth plus near 5% in prospective dividend yield is close to a PE of 15. (We will all find out along the way whether these consensus forecasts need to move upwards or further downwards as time passes along). On this basis, it seems but a fair assumption that Woolworths shares are likely to remain inside their $26-30 trading range in the year ahead. But if above assumptions prove correct, the share price should be closer to the higher end of the range, which, combined with a much more attractive dividend yield, should make for a total return of 10-12%. Not attractive enough at a time when certain resources stocks seem to offer a similar return in two months, or even in two weeks? Consider the average long term investment return for equities is between 9-10%, but also that Woolworths shares are highly unlikely to fall below $26, no matter what lies ahead (not even the GFC could keep the shares below $26 for an extended time). For those shareholders who are waiting for the shares to return to $34, however, it would seem they will have to wait another two, possibly three years. That too is a shared characteristic for assets that have experienced a bubble: it always takes longer than one would like for prices to return (if ever). Note that uranium is still below US$60/lb (from a peak of US$138), while crude oil is below US$85/bbl (from US$147). We won't even mention US house prices, or what happened in Spain or Ireland. Woolworths shareholders can praise themselves lucky. The bubble didn't inflate nearly as high as in those examples, but it'll still take 5-6 years for the share price to sustainably return to the former peak level. Now, if only we ever learnt from all this