One of the great things about “web 2.0” is interactivity. Each day on The Intelligent Investor’s website, our analysts field questions from our members. It’s one of the revolutionary impacts of the Internet and a wonderful opportunity to stay in touch with our customers.
In this article I’ll share with you a recent exchange that took place in one of our online forums. The question is one that many financial planners may be hearing at the moment. Peter F lodged the following post a couple of weeks ago:
“We hear from you and others, ‘the market always comes back’ etc … Didn’t we hear the same thing about the Nikkei after 1987? Is there a difference? What is it?”
My (lightly edited) response was:
“Hi Peter. I’d be disappointed if you’ve read such a trite cliché from our team. If that’s the case, though, I’d be grateful if you could point it out.
“One of the overarching philosophies of The Intelligent Investor is preparation, not prediction. We should certainly position our portfolios in such a way that a 10-year bear market wouldn’t completely ruin us (income securities, for example, might be just the ticket). For us, the key is to always focus on buying the right businesses at attractive prices, regardless of the market’s gyrations. Plenty of value investors have done well through periods when the broader market was flat (or even declining).
“With regard to Japanese stocks, I wasn’t paying particular attention to them 20 years ago (nor am I today, though many sharp investors view them as cheap) but my reading of the history books indicates that people had long given up on the traditional yardsticks of value at the height of the boom. James Grant (something of an expert on Japanese finance and one of the finest writers in the world on financial matters) penned an essay in February 1987 titled Nipponomania. A few selections may shed some light on exactly how outrageous the pre-crash Japanese market had become:
“ ‘But at last week’s price of 1400 yen, or forty-five times earnings, [Bank of Tokyo] stock is 61 per cent higher than it was late last year. (JP Morgan, by the way, changes hands at ten times earnings.)’
“ ‘The latest Salomon Brothers monthly Japanese Stock Review recommends a department store chain, Mitsukoshi, at a price of 230 times last year’s consolidated earnings.’ ”
“I felt we were getting into that kind of La La land last year when Leighton Holdings, for example, reached more than $55 per share. But that level of insanity didn’t prevail for as long as it did in Japan. So, overall, my judgment is that such ridiculous overvaluations weren’t as endemic in the Australian market as they were at the top in late 1980s Japan. There were certainly excesses…and optimistic valuations, though. And while many blue chips remain unattractive to us, it does seem that we’re currently working our way back to the old fundamental values and seeing tremendous opportunities in some cases.”
Our view that Australia’s blue chips aren’t particularly cheap is based not on how much they’ve fallen from their peak valuations, but on comparisons with similar high-quality stocks overseas. In Table 1, for example, you can see a not-particularly-scientific list of international (mainly American) companies. The businesses we’ve chosen have first-rate brands, produce high returns on equity and are leaders in their respective industries.
While the PER (price-earnings ratio) is a crude measure of valuation, these world-class stocks all look pretty cheap next to their historical earnings, with an average PER of 10.6 at the end of October.
In the red corner – or rather Table 2 – we have an ad hoc wish list of high-quality Australian blue chips we’d love to own at the right price. Again, the list is not particularly scientific or comprehensive but, with the exception of Woolworths and ASX, all of them have significant international operations. The average PER for this list at the end of October, as you can see, is much higher, at 16.3. Even if we remove the two “outliers”, Cochlear and CSL, the average PER is 15.2.
My conclusion may be disconcerting: Despite gut-wrenching falls in the Australian index, and with a few notable exceptions, our largest stocks do not look cheap.
