30 September 2015
This is the second edition of Being BAEP, a publication that examines how we go about investing at Bennelong Australian Equity Partners (BAEP). This edition considers the struggle for earnings growth in the Australian market, and the importance of growth when investing in shares.
Politicians are denying it, Glenn Stevens is flagging it, and corporates are struggling with it: it’s the era of low growth. Many investors are however unperturbed by this reality, focusing instead on the high dividend pay-outs on offer and assuming some decent amount of growth as a given. Yield, however, accounts for only one element of the return an investor gets from equities, and to downplay the growth element is to ignore a fundamental reason equities have performed well over the long term. Now, with growth hard to come by, and only a gradual acceptance of this reality, we at BAEP believe that markets are overpaying for growth that often fails to materialise. This, however, does not deter us in looking for opportunities with genuine growth that adds to returns over the long term.
The lay of the land
Recent economic data presents a patchy but generally weak economy in Australia. The data is best summarised by the most recently reported GDP number, which saw growth of just 1.8% in the year to June. Measured on an annual basis, this is the lowest nominal growth since 1962, below even the recession years of the early 1980s and early 1990s, and below even Greece. For some time, it has been widely assumed that our economy grows at a trend rate of real GDP growth of 3.25%. GDP growth has been slower than trend now for all but three quarters of the last seven years. Reflecting a growing consensus, RBA Governor Glenn Stevens recently said, “perhaps the growth we have seen is in fact closer to trend growth than we thought”. Thus, while there are some pockets of strength in our economy – including select segments of the tourism, infrastructure, healthcare and financial services sectors, and more broadly in NSW and, to a lesser extent, Victoria – the economy and its outlook appear lacklustre.
Given this backdrop, most of our corporates are understandably also finding growth hard to come by. The ‘earnings season’ in August, during which most companies report their full year financial results to the market, gave a good sense of where our listed corporates are at. As always, we saw a mixed bag, but some general themes emerged.
Turning stocks into bonds
A lacklustre economic backdrop potentially offers little by way of attractive investment opportunities. Not helping is that many companies are applying pre-GFC investment criteria to current-day investment decisions, notwithstanding that companies now enjoy a much lower cost of capital. The Central Bank’s hopes that lower interest rates would stir up business investment have come to nothing. Not helping either is the propensity of corporates to appease yield-hungry shareholders and instead hand the cash back in the form of increasing dividends.
The table below shows the dividend yields for 46 significant global markets (the horizontal bars), as well as their ranking in terms of their three-year forecast earnings growth rates (the associated end number). As the table shows, the Australian market is one of the highest yielding markets in the world. Its forecast dividend yield of 5.1% is on a par with New Zealand and behind only the Czech Republic and Pakistan. Australian listed companies are now paying out 75% of their earnings, a higher dividend pay-out ratio than all but New Zealand and the Czech Republic, and well above the global average of 40%. In the absence of material earnings growth, Australian listed corporates are increasing dividends but only because they are paying out more of their earnings. Historically, investors perceived a company increasing its dividend as a sign of Board confidence in the future. Ironically, it is now a sign of limited growth opportunities. Meanwhile, Australia’s forecast earnings growth rate over the next three years ranks sixth last globally, and behind only the UK and Norway of the developed countries. It is set to grow annually just 4.6%, which as a forecast could well prove over-optimistic, but for the more valuable purpose of comparison, is well below the global average of 9%.
Dividend yields (%) and global ranking of earnings growth
Source: UBS, Factset, BAEP, as at 15 September 2015
The trends set up a potential self-fulfilling doom loop, in which the current weak growth and high pay-outs come with limited investment and therefore an even weaker outlook for growth further down the track. Taken to the extreme, companies will be all pay-out and no growth. Their stocks will then start to smell and feel like bonds, with nice but relatively fixed yields.
Is growth really that important?
Fundamentally, the value of a stock is the present day value of all the dividends to be received in the future. This value can be separated into two parts: the current dividend yield and the growth of that yield over time. It is the growth that distinguishes equities from bonds.
Equity investors have not been perturbed by a lack of earnings growth. Since the GFC and up until recently, investors have made decent money in the stock market, earned from nice dividends and some reasonable share price appreciation. The latter has not required earnings growth, as earnings multiples have expanded and dividend yields have compressed. Some may be forgiven for thinking that, despite its fundamental value, growth just doesn’t matter.
Interestingly, empirical studies provide some support for this thinking. These studies in fact reveal there is no correlation between GDP growth and a market’s return, and to the extent that there is a relationship, it is slightly negative. This may seem a somewhat surprising conclusion to most. After all, when was the last time you heard a market commentator say, “The economy is starting to improve now and so I am forecasting for stock markets to turn down.” Empirical studies also reveal the same at the stock level, with an apparent lack of correlation between a stock’s EPS growth and its stock returns. Looking further into these studies, however, points to their short-term nature, generally focussing on the simultaneous growth and returns over just one-year periods. However, at least in the short term, stock prices in general reflect the market’s expectations of the company’s near-term earnings. Thus, to complete the picture, empirical studies also show that returns are in fact highly correlated with changes in expectations and/or how the actual results correspond with those expectations.
Thus, a stock with high growth expected for the next year or two will be priced for that high growth, and it is only if the growth exceeds those expectations that the stock will typically be able to outperform. Take the example of Seek, which is best known for its employment classifieds website of the same name. Earlier in the year when the shares reached almost $19, market expectations were for Seek’s earnings to grow over 20% in each of the 2015 and 2016 financial years, to $217 million and $265 million respectively. These expectations fell significantly as the company guided the market lower over the course of the year, firstly in announcing its first half earnings result in February and then in issuing a downbeat trading update in June. As announced in August, the company ended up earning just $190 million for the 2015 financial year, still some 4% above the prior year, and the company gave lacklustre guidance, with the market now expecting just $191 million for the 2016 financial year. Following expectations down, the shares has fallen to now trade at under $12.
Thus, at least in the short term, stock returns for the market and any individual stock will depend on the growth achieved relative to expectations. Looking at it from a longer range perspective, near-term expectations will continuously be shaped around actual earnings results as they pass through over time, and so over the long-term stock prices will ultimately reflect the growth in actual earnings achieved.
One of the hurdles that stocks face is that the market is very often over-optimistic in its near -term expectations.
The graph below shows the average consensus forecasts in respect of the EPS for the ASX/S&P 300 Index. The forecasts are made in respect of the financial years 2008 to 2017, and start about two and half years prior to when the actual results are reported for the relevant year.
EPS forecasts for ASX/S&P 300 Index ($)
Source: BAEP, BAML
As can be seen above, the forecasts are downgraded as the point of reality draws near, with the end point – which coincides with when the actual number becomes known – generally some way below where it was first forecast to end up. Consensus earnings forecasts for 2016 were first made in August 2014 at levels over 10% higher than they are now, and are interestingly already below actual 2015 earnings. Over-optimism when it comes to forecasting earnings is apparently systemic, with studies from the likes of consulting firm McKinsey showing the same consistent bias in US and other offshore markets. While the reasons for this are interesting enough, the important point is thatthe market is very often set up for potential disappointment.
At BAEP, we deal with this risk by carrying out extensive research and analysis into companies’ near-term earnings strength. This involves a comprehensive program of company and industry contact, as well as other proprietary field research. Our investment philosophy and process is such that we place a great deal of importance on understanding a company’s ability to meet, and preferably beat, upcoming and medium-term earnings expectations.
Take Echo Entertainment, which owns the Star City casino in Sydney and other casinos in Queensland, and which is a company in which BAEP is a substantial shareholder. BAEP identified Echo as a company whose growth has been underestimated by the stock market. For years the company’s casinos had struggled, and anchored to that past, the market has been unwilling to consider a brighter future.
More recently, Echo’s casinos have started to benefit from:
Last month, the company reported NPAT of $219 million for the 2015 financial, which represented growth of 38% on the prior year and was almost 6% ahead of consensus expectations. Echo’s stock outperformed the market by approximately 9% over the following week, as the market came to terms with the result and pushed up expectations for future years. The stock’s outperformance resulted not from the strong earnings growth per se, but from growth that beat the market’s expectations. These expectations were shaped from the historical struggles of its casinos, particularly Star City, as seen in the graph on the next page, and are gradually becoming more optimistic.
10 years of Star City’s EBITDA ($m)
Source: BAEP, Echo Entertainment company reports
Long duration growth
The ideal situation is one in which the company has a very long runway of earnings outperformance. We believe these types of long duration growth plays are very often underappreciated and thus undervalued by the market. In contrast to the optimism with which it looks forward for other companies, the market appears unwilling or not long-term focused enough to pay up appropriately for high quality companies that can grow at very high rates for a long duration.
One of BAEP’s largest holdings for some time has been Ramsay Health Care. Ramsay is the leading private hospital operator in Australia, with a portfolio of some of the most popular and largest hospitals in their catchments. An ageing population brings with it increased demand for Ramsay’s hospital services, and the company is soaking up this growth by expanding its existing hospitals. These expansions entail investment of large sums of money at attractive returns on invested capital of around 20%. In the last nine years, that amount invested has been $1.5 billion, and this has contributed very materially to exceptionally strong and reliable earnings growth. Meanwhile, investors and brokers have been unable to envision, or unwilling to bank, the extent of this sizeable investment, or the high returns that feed through into the large uplift in earnings. Their expectations have also been tempered by management, who have consistently under-promised when it came to giving earnings guidance, an attribute we look very fondly upon at BAEP. Consequently, the consensus has consistently underestimated the company’s earnings growth, and in contrast to the over-optimism that broadly prevails throughout the market, Ramsay has been able to grow strongly and ahead of expectations over a long period of time. The following graph is in stark contrast to the earlier graph for the overall market.
EPS Forecasts for Ramsay Health Care ($)
Source: BAEP, BAML
Ramsay’s shares have benefited in a so-called ‘double play’. Since June 2010, when Ramsay’s share price was $14 and BAEP first bought into Ramsay, the company has been able to double earnings, and the market has come to understand the persistence of its strong earnings growth and accordingly doubled the multiple it is prepared to pay for those earnings. Doubling earnings and doubling the multiple has caused its shares to rise four-fold to now trade at about $60.
Putting a value on the unquantifiable
Another situation prone to systemic underestimation arises because the market is unable to fully price in that which it does not know or cannot quantify.
An example is provided by Transurban, which operates toll roads in the capital cities of the East Coast of Australia. In addition to the reasonably predictable cash flow growth arising from increased traffic and tolls, Transurban’s toll road networks have strategic platform value that derives from the potential to negotiate new value-accretive investment projects with governments that expand, widen or feed into its existing toll roads. While this platform value is unquantifiable, it adds to Transurban’s earnings and value over the long term, with the potential value rising in an environment where governments are looking to invest in the nation’s road infrastructure. While Transurban appears fully valued in respect of its existing toll road network, the share price arguably does not account for this platform value, which appears to manifest only on the announcement of new projects.
At BAEP, we work hard to find those opportunities in which we believe the company will outperform the market’s expectations for growth. These opportunities may arise for idiosyncratic reasons (as in the example of Echo) or they may be of a systemic nature (as in the case of Ramsay and Transurban). They may owe themselves to any means of growth, whether from innovating new products, putting up prices, growing market share, or undertaking investment or acquisitions. And they may be found in all types of companies, including defensive names such as Transurban and Ramsay, or cyclical ones like Mantra Group. And finally, they can arise in good markets and bad. The great attraction of the market is that it is never perfect, and that there are always opportunities for the enterprising investor.
Investment Director, BAEP
Director, Economics & Strategy, BAEP
This information is issued by Bennelong Funds Management Limited (ABN 39 111 214 085, AFSL 296806) (BFML) in relation to the Bennelong Australian Equities Fund, the Bennelong Concentrated Australian Equities Fund and the Bennelong ex-20 Australian Equities Fund. The information in this document is current as at 18 September 2015. The information provided is general information only. It does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units in any fund of which BFML is the Trustee or Responsible Entity (each a Bennelong Fund). This information has been prepared without taking account of your objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Product Disclosure Statement (PDS) which is available on the BFML website, bennfundsmanagement.com.au, or by phoning 1800 895 388. BFML may receive management and or performance fees from the Bennelong Funds, details of which are also set out in the current PDS. BFML and the Bennelong Funds, their affiliates and associates accept no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. All investments carry risks. There can be no assurance that any Bennelong Fund will achieve its targeted rate of return and no guarantee against loss resulting from an investment in any Bennelong Fund. Past fund performance is not indicative of future performance. Bennelong Australian Equity Partners (ABN 69 131 665 122) is a Corporate Authorised Representative of BFML.
 Issues In Economic Policy, G Stevens, 22 July 2015
 The most commonly cited study is The Global Investment Returns Yearbook, ABN AMRO & LBS, 2005 (Dimson, Marsh and Staunton)
 What Works on Wall Street: A Guide to the Best-performing Investment Strategies of All Time; Chapter 14 (J O’Shaughnessey)
 See for example pages 5-15 of the Credit Suisse Global Investment Returns Yearbook 2014
 Source: BAEP, Factset
 Indeed, the notion of the PE as the best measure of valuation across decades – and the relatively tight band which denotes over and undervaluation - indicates the strong linkage that the P has with the E over the long term.
http://www.mckinsey.com/insights/corporate_finance/equity_analysts_still_too_bullish. As noted in this article, there were a few short years in the mid-2000’s in which the market was not optimistic enough, but otherwise the bias dates back decades.
 A term coined from legendary US investor Shelby Davis. For more, see The Davis Dynasty: Fifty Years of Successful Investing on Wall Street, J Rothchild.
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