Risk, return and the share price triple threat

<p><strong>Glenn Freeman</strong>: I'm Glenn Freeman for Morningstar, and I'm talking today to Morningstar Investment Management's Peter Bull and we are speaking about investment styles within equity portfolios.</p> <p>Peter, thank you for your time today.</p> <p><strong>Peter Bull</strong>: Sure.</p> <p><strong>Freeman</strong>: When we were speaking earlier, you were explaining how much markets have fallen since probably late September or the start of October particularly and how well process that's been followed or the investment style by Morningstar Investment Management has served you in protecting on that downside. So, that's probably an interesting lead into what you are talking around fundamental risk. What is fundamental risk? Are we talking there about things like interest rate movements or market corrections or more specific? So, if you can just explain that firstly for us.</p> <p><strong>Bull</strong>: Sure. You could look at it in those terms. Really fundamental risk is that when you look at an investment, it's what can interrupt the earning power of the company you are investing in. And you can think of that in terms of extremes like banks going into the Global Financial Crisis. Or Australian banks, if residential property falls over, that's a big fundamental risk. So, that's something we always ask ourselves. So, it's essentially asking what are you buying before you actually go in and buy it.</p> <p>In the GFC, if you look at the prices of high-quality companies like Microsoft or Walmart, sure, the prices went down along with the rest of the market, but they soon recovered. And that's because when you look at the sales and the profits and the actual fundamental performance of these companies, the Global Financial Crisis basically didn't happen. So, it's that discipline that we always start with when we look at companies to invest in.</p> <p><strong>Freeman</strong>: And following on from there, how do investors look at required return versus expected return and how does that influence some of the investor behavior when they are tracking the company earnings multiples, for instance?</p> <p><strong>Bull</strong>: So, the fundamental risk leads directly into this question of required return. So, if you have a company, very low-risk, like maybe a bank account (indiscernible) or if you have deposit insurance and your savings rate is 3 per cent, that's great. What if you don't have that deposit insurance and you are buying, I don't know, a short-term paper fund, there's no guarantee of what's the good return above 3 per cent? 4 per cent, 5 per cent? It's the same thing in equities. So, when you have gauged that fundamental risk, that leads you to be able to answer what is your required return for this company.</p> <p>People can get excited by, oh, it is a high expected return on this company, but it's that context. If it's a very safe company like Microsoft or relatively safe, 6 per cent, 7 per cent, 8 per cent on earnings yield basis might be okay. And when you look at the multiple in the market and the multiples that the market puts on companies, really a lot of that is driven by the earnings quality. And if a company re-rates from a low multiple to a high multiple, it's because the attitude is changing. It's a higher-quality company, earnings are more visible and more stable going forward.</p> <p><strong>Freeman</strong>: If I understand what you are saying it's that the P/E ratios for companies in some sectors may be / naturally tend to be &ndash; even in a good condition they will be much higher in a good market environment than they might be in another sector. Is that part of what you are saying there?</p> <p><strong>Bull</strong>: Absolutely. Some of the higher-quality &ndash; if you are just looking at P/E multiple, you may never buy into sort of the higher-quality segments of the market. We call it the equity valuation triple threat. So, there are three things really that can drive up a stock price. That's sales growth &ndash; and they can compound sales growth and then there's profit margin. So, it's basically keeping a higher percentage of sales as a profit. And then, P/E multiple which is the third thing, the price that the market is willing to pay for those earnings. So, any of those three things that can increase the value of a stock investment, but they also can compound each other. And so, we pay attention. You don't have to have all three, sort of, firing off. That's the Holy Grail to get these huge outperformers. If you've got a company at a high P/E multiple, maybe it's got a high profit margin, high and stable profit margin.</p> <p><strong>Freeman</strong>: And how does the interplay between your Australian equities versus your international equities change, or has it changed in more recent times? Is there more quality to be found in Australia or in some of the maybe the offshore markets, maybe developed or emerging?</p> <p><strong>Bull</strong>: Yeah. It's a very interesting question. Australian equities are &ndash; they are sort of unique as a group. If you look globally and you look at &ndash; if you segment the equity market into stable industrial sectors, globally that's the majority of the market. And the more cyclical lower-quality sectors, financials, resources, energy, they may be safely, maybe at most 30 per cent. When you come into Australia, obviously, that's flipped. So, financials, resources, energy are more than 60 per cent. So, it becomes a very different exercise in Australia if again you are looking for that &ndash; your first sort of protocol are the stable industrial sectors where you get the growth return but with also the downside protection.</p> <p>So, in Australia, you've got that sort of &ndash; you've got that &ndash; if you want to build a quality-focused portfolio, you don't have much to choose from. And secondly, that part of the Australian equity market tends to be overvalued. So, you are either paying sort of overvalued for high-quality companies in Australia or you are stuck with the cyclical risky two-thirds of the market. So, it's not quite as much fun.</p> <p>And thirdly, the Australian dollar is very procyclical. I think it's the only developed market currency that actually is correlated with equity markets. That's not something that you find in other developed markets. So, you have this natural incentive for Australian investors to diversify out of their own currency in that respect for more stable investment returns. So, it's a great opportunity. Put it this way, Australian investors should not be underinvested in global equities for those reasons.</p>