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Send  Share  RSS  Twitter  04 Apr 2013

ASSET MANAGEMENT: An Investment Bubble on the JSE‘

 





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Andrew Dittberner, Senior Investment Manager at Cannon Asset Managers, notes that rising valuation dispersions on the JSE point to a massive investment bubble in certain areas of the JSE – one which investors can use to their advantage.

Using Cyclically Adjusted Price Earnings (CAPE) ratios, Cannon Asset Managers notes that some equities are massively overvalued, and an investment bubble has formed in Large Cap Industrials and cash retailers, while others sectors of the market have become very keenly priced. This bubble is larger than the construction bubble of the mid 2000s, and the resource bubble of 2007 to 2008.

The CAPE ratio uses a 7-year earnings number to get the “DNA” or through-the-cycle earnings of a share, sector or market, as opposed to last year’s earnings (which can be very volatile and driven by near-term economic conditions) when valuing a business. Using CAPE ratios is a far more sensible way of valuing an investment than any method based on just one year’s worth of earnings.

We have divided the domestic equity market into five quintiles according to their CAPE ratio, with Quintile 1 being the attractive stocks (low CAPE = Value stocks), and Quintile 5 the expensive stocks (high CAPE = Growth stocks). There are some outliers on the low and high side, hence binning the data into quintiles makes for more sensible analysis in understanding valuations.

Charts of the CAPE valuation dispersions on the ALSI shows the bubble-like run up of expensive stocks in the last 2 years. It should come as no surprise that it is mostly resource stocks that make up Quintile 1. The valuation dispersion between Quintile 1 and 5 is currently in excess of 18.4 times.

The rising valuation gap shows that growth stocks have become a staggering 40% more expensive relative to value stocks in the last four years. The lower quintiles look very attractive with CAPEs in the early double-digits, but with Quintile 5 starting at a CAPE ratio of almost 30 times, alarm bells should be ringing.

These expensive growth stocks represent clear investment risk, while the value stocks represent clear investment opportunity.

While many of the bubble-like stocks are indeed great businesses, they are incredibly expensive. And it’s always easy to find reasons to buy expensive stocks at any stage, but don’t be fooled by their growth prospects. Remember construction stocks in 2007, when stratospheric valuations were well “justified” by their growth prospects, to only be decimated when the bubble burst. At the height of that bubble, Aveng was on a CAPE of 44 times, Group 5 at 39 times, Murray and Roberts a whopping 58 times and WBHO 54 times.

Among the largest 40 stocks on the JSE, the valuation dispersion is even more immense, having nearly doubled to an off the chart 22.2 in the recent past. Large Cap Growth shares have essentially become a staggering 90% more expensive relative to Value shares.

We know that resources have been under enormous price pressure recently, and financials have performed reasonably but are fairly priced generally. Therefore, this chart points to the dangerously elevated multiples within large industrials. Despite the overwhelming value in the resources sector, investors still need to exercise caution in terms of the specific counters purchased and to what extent.

Across different time frames and in various markets around the world, history has demonstrated consistently that anything above a CAPE ratio of 16 times is expensive. The market as a whole currently is on a CAPE ratio of 16.2 times, “fairly” priced. However, this aggregate is comprised of highly expensive stocks, as well as stocks that are very attractively priced.

Consider that the fair CAPE ratio for equities is 16 times, and the more expensive counters within the Top 40 are more than double this.

The multiples on the expensive stocks are not sustainable, given that they will need to maintain very high levels of earnings growth to justify such valuations. As some of these companies’ earnings begin to disappoint investors, they will suffer the risk of investor selloffs. Large caps are expensive as an aggregate therefore you want to avoid the Quintile 5 stocks in general.

One interesting aside to the above is that whilst the price action of these stocks has pushed the JSE to new highs, they have also masked some of the tremendous value opportunities that are available in other areas of the market at the moment.

It should be noted that the CAPE ratio is just one valuation tool that Cannon Asset Managers uses. In looking for balanced evidence of value in a stock we assess ratios such as PE, price:book, DY, forward PE and price:sales, and not just the CAPE ratio.

However, using CAPE ratios it is evident that a considerable gap exists between expensive stocks and those more modestly priced. Investors can utilise this gap to their advantage.

 
 
 
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