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Valuation Does Count

This story was originally published on Wednesday, September 8, 2010. It has now been re-published to make it available to non-paying members at FNArena and readers elsewhere. By Rudi Filapek-Vandyck, Editor FNArena “You wouldn't be the first one to drown in a river which, according to statistics, ceased to exist long time ago.” The most important observation I made recently was on Monday, when I wrote this week's Weekly Insights and concluded that, on pure Price-Earnings (PE) metrics, the Australian share market was by a long shot not as “cheap” or “attractive” as many a stockbroker wants us to believe it is. Another way of describing Monday's message would be: all the obvious value propositions have been taken up already by others before you. What's left are the rejects, the misfits, the failures, the eternal promises, the laggards, the banks, and resources. Another way of putting it would be: what's left are the more risky value propositions, or at least what is being perceived as higher risk. I would still maintain that Australian banks' share prices are being kept low because of international developments, making the local plays a much less risky proposal, but hey, that's been my view since mid-2009. Two observations since have further strengthened my market analysis. On that same Monday, healthcare analysts at Morgan Stanley updated their sector views and outlook and one sentence from that report really says it all: “We see most valuations as full at best.” Those who have kept track of my market analyses will probably remember I have in essence been writing similar conclusions since the February results season this year. Moreover, and as highlighted in Monday's Weekly Insights, what goes for Australia's healthcare stocks (ok, most of them) also applies to most defensive stocks listed on the Australian Stock Market; sure, they might go up because of the intermediate flight to safety on a given day, but they're far from cheap. Which truly begs the question whether investors who make up their own mind (instead of trusting their nest eggs with a fund manager) should care about owning any of these stocks at all? Fund managers will switch from cyclicals and banks into healthcare and other defensives in a heartbeat, but they are playing the investment game on a completely different level. If a fund manager loses money, but still outperforms the index, that fund manager is a winner. Think about it before you try to mimic what is in essence something that should be left to the Big Boys. Those who have been reading my previous stories on healthcare, or who have read some of the conclusions drawn by Morgan Stanley's peers elsewhere, will find it no surprise the stockbroker likes ResMed ((RMD)), Ansell ((ANN)) and Sigma ((SIP)). Okay, the last one could be a surprise, but that is clearly a turnaround call or corporate target premise. Ramsay Healthcare ((RHC)) was still up there with the Happy Few in February, but the stock has now joined most others in what should be a rather benign outlook for the year ahead in investment returns. I have used this example before, but I think it never hurts to use an excellent reference: if you really want to convince yourself that “valuation” still counts in the share market, simply look at the CSL ((CSL)) share price over the past 18 months. Again: it is easy to tell yourself you did buy the shares for the longer run, but fact remains you missed out on the biggest opportunity for gains on the share market since August 2007 and CSL is not exactly a good dividend payer. (Unless you bought when the shares bottomed below $30, of course). A second observation, which equally doesn't come as a genuine surprise (not after my Monday analysis), is the fact that, while earnings downgrades have come to a halt post the August reporting season, recommendation downgrades are still ongoing. In fact, after stockbrokers issued more than two downgrades for every single upgrade, on average, during the August reporting season, they have continued issuing more recommendation downgrades in September. On Monday, the number of downgrades for the seven days prior stood at 22 against only 9 upgrades over the same period. That gap has remained intact two days later (today). I went through our archive and learned that the last time recommendation upgrades outnumbered downgrades was in the week ending July 12th – nearly two months ago and at a time when shares were tanking on bad economic news. Most downgrades are being issued on valuation concerns. For investors, how to approach the share market, while using the above insights to your benefit, depends on what type of risk seeker you are. If you are trying to ride the waves in search of short term gain, I assume you'd already figured out there was more opportunity in BHP Billiton ((BHP)) than there is in Coca-Cola Amatil ((CCL)), but even more opportunity in Perseus ((PRU)) or Fortescue ((FMG)). For longer term investors, however, the trick is not to fall in a valuation trap – see CSL above. Even if you have taken my earlier analyses on board, which in essence told you the best investments in a sideways market are those that pay a healthy and sustainable dividend, you still have to pay attention to valuation. Buy stocks that are trading on too high multiples and you could set yourself up for a “lost year” first. That's not the best way to play the share market. After all, the overall environment is already risky enough. As far as the immediate outlook is concerned: it would seem that a surprisingly good ISM manufacturing index in the US last week has put a floor under risk assets. I still think the coming months look challenging at best on the economic front and this does not take into account any bad surprises from government debts or rising tensions between the US and China. Can this market rally? Yes, it can. Can this market sell-off? Yes, it can do that too. While it is easy to get carried away on a day-to-day basis, it is good to remember that share markets have not made any progress for twelve months. It's a sideways market. Temporary madness cannot be excluded, but things will have to turn around pretty significantly before risk assets can sustainably break out of their trading range. While you are waiting, you might as well reap dividends in the meantime. (This doesn't take away the fact that total investment returns from the Australian share market since 1900 are made up of less than 50% from share price appreciation only, with dividend returns making up the rest). Banks are cheap. The cheapest of them all, National Australia Bank, is currently trading on an FY11 PE of 9.6, which is near the bottom of historical ranges. That's why the stock is also implying a 7.2% dividend yield, of course.