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Finding value in a fairly-valued world

Adam Fleck, CFA  |  06 Apr 2018Text size  Decrease  Increase  |  
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We've had a wild ride in Australian equities over the past couple of months, and after a 5% fall in the S&P/ASX-200 since the start of the year, the market is starting to offer better value for long-term investors. While the average price to fair value estimate ratio in our coverage of nearly 200 listed companies in Australia is 1.07, the median stock is now fairly valued, a sharp correction from a median ratio of 1.05 at the start of the year, and 1.03 in mid-2017.

What's changed in our thinking? Not much. The main cause of improved price to valuation ratios is that the Australian market simply hasn't performed very well. This explains most of the difference between the start of the year and our current bottom-up market view. Looking back a bit further, the change since mid-2017 was also a function of rising fair value estimates, but this highlights an important facet of our process. Our fair value estimates typically rise over time--after all, stocks should generate returns for investors to compensate for their risk. All else equal, our valuations should move up annually at roughly the cost of equity, or the required rate of return we should demand as investors, less any dividend yield paid out. We assume this required rate of return is 9% per year, including dividends, for a stock of average risk.

Compared to the mid-point of last year, our fair value estimates, before dividend payments, should be roughly 7% higher (9 months of a full year of 9% required rate of return). It should come as no surprise, then, that the 4% return in the S&P/ASX 200 Acummulation Index since 30th June 2017, on top of the 3% overvaluation we saw at the time, has led to stocks being fairly valued at the median.

Another way of putting this: a price/fair value estimate ratio of 1.0 doesn't mean that we expect the market to stay flat. Rather it means that we see the market as fairly pricing in risk and future expectations; it's truly trading at a fair value. We expect investors will experience a total return over the next three years of about 9% annually at this valuation.

So, at 1.0 median price/fair value estimate, is it time to back up the truck? Not quite. While we see roughly the same number of undervalued and overvalued stocks, the substantially higher average (rather than median) price/fair value estimate suggests that the stocks we view as overvalued look really overvalued--some stocks are trading at more than two times our valuations, for instance. We think it's better to look for undervalued opportunities with sizeable margins of safety, of which there are several.

Our monthly best ideas list (on page 4 of this week's issue) highlights our top picks for long-term investment. Beyond our monthly best ideas list, there are always a handful of names trading below fair value that didn't quite make the cut but are worth keeping on your watch list should the market present an even more-compelling opportunity.

Death and Taxes

One such undervalued name is Invocare, a wide-moat stock trading in 4-star territory. The funeral services industry is fundamentally attractive, with resilient long-term demand, while InvoCare's strong brand and market position give it pricing power that should generate strong returns on invested capital over the long run.

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Adam Fleck 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.

 


Your feedback on this week’s Overview is always welcome. Send your comments to YMW@morningstar.com. We’d love to hear from you.

 


© 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 content 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.

© 2020 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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