Thursday, November 1st, 2018
At times like now it’s easy to get caught up in the shock and emotion of suffering a sudden and significant decline in wealth from falling share prices. However it is normal for equity markets to experience two or even three corrections per year during a broader uptrend, and signing up for the wealth creation potential of equities also means signing up for their volatility.
All investors need strategies that go beyond merely tolerating volatility to explaining its role in wealth creation. Value investors welcome share price volatility, especially when generated by disparate global macro fears as at present, because it creates discounts to value large enough to justify initiating new stocks in the portfolio or adding to existing positions. This is especially welcome in the case of quality large companies, which typically trade at full multiples in rising markets like the ASX of the last two years. Market corrections are therefore not only a normal and frequent part of sharemarket life, they are a pivotal milestone in the wealth creation process.
Value investors tend to act aggressively during corrections after earlier periods of doing relatively little investing. Since the launch of the StocksInValue model portfolio in March 2015 we have invested several percentage points of cash at a time during the seven selloffs since: the Chinese economic slowdown panic of late 2015, the Brexit vote crash in European equities of June 2016, the anxious selloff on Wall Street ahead of the 2016 US presidential election, the second nervous selloff after Trump won, the anxiety about rising US inflation and interest rates in February this year, the trade war fears of March and now the current miasma of fears about Fed rate rises, slowing US corporate earnings, the trade conflict, falls in US tech stocks, Saudi Arabia’s alleged assassination of a journalist, Italy’s budget, falling/rising oil prices (the market can’t make up its mind which it fears more) and the US midterm elections.
It is important to respect the power of the sharemarket to create and destroy wealth but also to have no respect for the market’s mood swings, particularly the current one given its diffuse causes. These instead create opportunities to be exploited. We are seeing numerous quality companies of various sizes pull back several percentage points to levels which justify attention. Some of these are:
The selloff in this stock is inconsistent with the AGM commentary, which reassured the market on all matters: first quarter earnings, full-year guidance, recovery of higher raw materials costs, North American beverage volumes, emerging markets performance, cost reduction programs, free cashflow, the number of shares to be issued as consideration for the acquisition of Bemis and expected synergies with Bemis. There was no earnings downgrade as the market feared but the stock is now lower than before the AGM. We value AMC at $15 compared with a share price of $12.87.
As a proxy for world growth, BHP shares are reflecting the market’s fears of a slowdown in the world economy. The market is however missing the favourable supply and demand fundamentals for BHP’s major commodities: iron ore, coking coal, petroleum and copper. All these markets are either balanced or prone to structural deficits in coming years. Chinese infrastructure and real estate development stimulus should increase demand for iron ore and copper next year, cuts to Chinese coking coal mining create market share opportunities for BHP, and steady annual growth in demand for crude oil is set to exceed the petroleum industry’s ability to grow supply after the underinvestment in exploration and capacity of recent years. The upcoming return of over US$10 billion of surplus capital from selling US onshore shale assets should enhance earnings per share and attract investors seeking the franking credits to be returned in the off-market share buyback we expect. We value BHP at $39 compared with a $31 share price.
RWC has 80 per cent market share in its niche of push-to-connect plumbing fittings, which are taking market share from traditional soldered and crimped fittings and are up to 10 per cent penetrated in the US, UK and Europe. The stock has fallen on general market sentiment and negative news about the US housing market. However RWC’s growth is more structural than cyclical. Over the last nine years sales have compounded at 10 per cent per annum. RWC recently acquired the UK-based, global leader in plastic push-to-connect fittings. We value RWC at $5.70 compared with a share price of $4.66.
A consistent performer for many years, CCP has also sold down on market sentiment in addition to the proposed Senate inquiry into payday and other lenders. Consumer finance is approximately 20 per cent of CCP’s earnings and its products offer significantly better customer terms than payday lenders. So we do not expect losses of earnings from any inquiry. The business is ramping up its operations in the US, which have the potential to provide a material step up in group earnings in coming years. We value CCP at $22.40 compared with a share price of $18.29.
This digital lotteries retailer produced an excellent full year result. Its main attractions are growth certainty due to a structural shift of sales to online channels, and the duopoly in online lottery sales. Significant barriers to entry suggest competition is unlikely to disturb the existing market structure. The balance sheet is pristine and there is the potential for further special dividends. We value JIN at $8.50 compared with a share price of $6.74.