Earlier this week FAnews Online attended Investec's quarterly Media presentation held in Sandton. Investec director, Jeremy Gardiner provided some valuable comment on conditions in the global investment environment before handing over to Sam Houlie, head
Instead of focusing only on the historic and forward price-to-earnings (PE) ratios, he included an analysis of earnings volatility for some of the JSE's largest listed companies.
In todays article we comment on this analysis and mull over whether banks are really a better bet than construction shares for the next year or two.
Bubbles in global markets
One of the great benefits for South African investors is that emerging markets continue to enjoy international support. Money has been pouring into these markets in each of the last five years. A quick look at a chart of Equity Market inflows confirms the extent of this phenomena starting with 14.4 billion of inflows in 2003 and culminating with 32.6 billion in 2007 to date. And international investors know where to put their loot!
Houlie believes that the current strength in emerging markets and commodities is warranted and based on sound economic principles. "Corrections happen and they typically effect whichever area in the market is the weakest link," said Houlie. Emerging markets are not weak, so a bubble (or crash) in these markets is highly unlikely.
One certainty is that emerging markets will not be able to carry the current earnings growth momentum into future periods. Investors will still achieve gains; but at a slower pace. The reason for this is that earnings growth at companies in these economies will not be able to keep pace with higher share ratings.
Don't view price earnings in isolation
Investors traditionally use the price-to-earnings ratio (PE) to determine whether a stock is cheap relative to its peers (specifically) and the market (in general). An investor considering the South African banking sector is faced with a number of choices. He can buy Standard Bank, ABSA, Nedbank, Investec or FirstRand among others. Apart from his assessment of the operational potential of each of these companies the investor also has reams of historic price data and future earnings estimates to base his investment decision on.
Most share trading websites publish both historic and forward PE ratios. The historic PE is based on the current share price and earnings in the current year. The 1-year forward PE is calculated using the current share price and analysts earnings expectations for the company in the next year. Consider Standard Bank as an example. The shares current PE ratio is 11.83 times. The 1-year forward ratio is 10.9, 2-year forward ratio 9.67 and 3-year forward ratio 7.94. What this tells us about Standard Bank is that analysts expect consistent earnings growth in the next three periods.
An investor can now compare Standard Bank to other shares in the banking sector, or shares in other sectors in the market. Nedbank's historic PE is 10.6 times while FirstRand is currently trading at 11.82 times. South Africa's big four banks are trading off remarkably similar PE ratios. A construction sector stock like Murray & Roberts has a much higher PE of 30.21 times. Would you be prepared to pay 30 times earnings for a share in the construction sector right now?
Houlie warned against viewing the PE ratio in isolation. There are many other factors an investor could consider. Top of this list is earnings expectations which prompted Houlie to examine earnings volatility in conjunction with PEs.
Earnings volatility reveals volumes about a share
Houlie's conclusion: "Low volatility earnings streams are under-priced in our market today." This means that stocks like Standard Bank and Imperial are extremely good value at the moment. They are cheap on a PE measure and offer lower risk on an earnings volatility basis. A low PE combined with low earnings volatility make a good addition to a long-term portfolio.
The argument makes perfect sense. The forward PE is based on earnings expectations. A stock with low earnings volatility will deliver similar (or moderately better or worse) earnings in each consecutive reporting period. This means that if the stock is cheap today (as measured by the historic PE) and it has low earnings volatility, it is likely to be cheap in a years time. There wont be income shocks to spoil the party.
Houlie demonstrated his analysis using a range of shares from the ALSI Top 40 index, ultimately focusing on the banking (where shares appear cheap at the moment) and construction (where shares have run hard over the last year or two) sectors. And he favours a safe-bet Standard Bank over a riskier bet Murray & Roberts at this moment in time.
Editor's thoughts:
Although Houlie's analysis is insightful it may be dangerous to compare the banking sector with the construction sector on the basis of earnings volatility. Banks enjoy consistent earnings from one year to the next, while construction firms are at the mercy of the inconsistent cash flows associated with long-term building contracts. Although construction earnings are volatile, we believe they will be volatile to the positive until 2010 and beyond. Would you rather be in construction or banks over the next three years? Send your comments to gareth@fanews.co.za
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