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Despite a rocky road, don't stray from the path

Adam Fleck, CFA  |  07 Feb 2018Text size  Decrease  Increase  |  
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"Be fearful when others are greedy and greedy when others are fearful." Many investors know this Warren Buffet quote, but market movements like the 5 per cent drop in the S&P/ASX 200 over the last two days can test our ability to follow the Oracle of Omaha's sage advice, originally offered in 2004.

But at Morningstar, we continue to focus on long-term opportunities, and recommend staying the course, rather than focussing on short-term volatility. It's tricky to predict the near-term direction of the stock market.

As Peter Warnes noted yesterday in his article, "From FOMO to FONGO," it's very possible we could see continued market challenges, both in the US and at home.

But our fair value estimates, combined with our uncertainty ratings, lead to recommendations that offer investment opportunities over a multi-year timeframe. We continue to believe investors should demand an average 9 per cent total annual return for a company of average risk.

We had not assumed historically low interest rates would continue. Rather, our fair value estimates are based on rates close to the long-term average. Higher rates should not surprise, and a correction may see market valuations at more reasonable levels.

Moreover, for a typical company, the current price of the overall stock market has little impact on day-to-day operations, meaning our fair value estimates aren't likely to change much just because the index has fallen.

Given that, our fairly and undervalued recommendations should become more numerous as the market falls, as the price/fair value estimate falls, bringing a greater choice of attractively valued companies for investors.

We also note the Australian stock market has looked overvalued for some time. Our positive (Buy and Accumulate) recommendations have drifted downward alongside the recent run-up in the S&P/ASX 200 to only about 12 per cent of our coverage versus 20 per cent at the end of 2016, while the average P/FVE ratio has spiked.

Despite the recent sell-off, we still see the overall Australian market as overvalued. Our average price/FVE ratio remains at 1.14, and our median ratio at 1.04, both up from 1.08 and 1.02, respectively, in October 2017. And the average price/FVE has increased sharply from the undervalued 0.96 ratio in February 2016.

Part of this overvaluation likely stems from our assumption that long-term interest rates will continue to march upward from their ultra-low levels. In our discounted cash flow models, we assume a 4.5 per cent risk free rate--a decent climb from the recent 2.8 per cent quote, but still lower than the 20-year average of 5.0 per cent--given we expect increasing inflation over time.

Our opinion the basic materials and industrials sectors (principally mining and mining services companies) still have too much long-term optimism priced in influences our view on the overall market valuation, as well. Excluding these sectors, where the median price/fair value estimates are 1.37 and 1.21, respectively, our median market ratio would fall to 1.02.

But there are several opportunities for long-term, patient investors, even in an overvalued market. As shown in the exhibit below, we see several opportunities in Healthcare and Communication Services, which have the greatest tilt toward Accumulate and Buy recommendations.

And within this cohort, we think companies with economic moats, or sustainable competitive advantages, are best positioned to withstand potentially rising costs such as increasing wage pressure and higher interest rates, given these companies' strong pricing power to pass through cost increases to consumers.

These include several stocks on our monthly Best Ideas list, such as Telstra (ASX: TLS) and Ramsay Health Care (ASX: RHC).

 

Price to fair-value estimate by sector


chart


Morningstar Equity Analysts

 

Any further share price declines would create additional long-term buying opportunities. Beyond our Best Ideas list, several other names are now starting to screen as cheap following the recent market declines.

We think each of the names below is worth keeping on your watch list, should further price declines lead to their recommendations moving to Accumulate from Hold.

Westpac (WBC)

Westpac (ASX: WBC) is our preferred major Australian bank, trading 13 per cent below valuation and in a strong position to continue delivering robust profits and dividends.

The company enjoys stronger-than-peer-group earnings growth forecasts, best-in-peer group operational efficiency, impressive returns on equity, stable senior management, a strong risk management track record, and an Exemplary stewardship rating.

We like its track record of discipline around cost control, risk management, net interest margins, and shareholder returns.

Ainsworth (AGI)

We expect this narrow-moat gaming machine manufacturer Ainsworth (ASX: AGI) to enjoy further growth from its offshore expansion. About 70 per cent of group revenue is generated overseas, where revenue growth is solid.

In North America alone, the company more than doubled its ship-share to around 6 per cent in fiscal 2016, and we expect this trend to continue.

Moreover, volume and revenue in the domestic Australian market appear to have finally bottomed and should improve, driven by new product launches and increased investment in game development.

Stockland Group (SGP)

We like Stockland's (ASX: SGP) high-quality investment portfolio and welcome the revised group strategy to expand the industrial and retail businesses but gradually exit the office segment.

Although rising interest rates will likely weigh heavily on the company's residential property values, we already forecast sales volumes trending down over the medium term.

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Adam Fleck is Morningstar's regional director of equity research, Australia and New Zealand. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is Morningstar's regional director of equity research for Australia and New Zealand.

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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