Why are opportunities so thin on the ground?

Why are opportunities so thin on the ground?

For the last several weeks we have been looking hard to find new value opportunities, but have found very few. The reporting season just around the corner may reveal a few surprises, but for the moment we are sitting on our hands. This can be unsatisfying, but sometimes being a good musician means knowing when to stay silent.

To make the silence a bit more comfortable, we have done some analysis to confirm where the overall market sits in terms of valuation. We do this by running large numbers of good quality companies through our valuation models and comparing the aggregate valuation statistics with the ones we have seen at earlier points in time.

The results of this work support our bottom-up view: current valuations – at least for the sort of companies we like – are at levels comparable to those seen in September 2007, when the equity market was at its peak.

This may seem odd, given that the overall level of the market (as measured by the S&P/ASX200 index) remains well below the levels it reached in 2007, but there are several points that need to be taken into account when making comparisons.

Firstly, we have excluded resources companies from our analysis, given the somewhat cloudy outlook for this part of the economy. The high level of uncertainty around earnings prospects for these businesses means including them in our analysis would affect the reliability of the results. A subdued level for the ASX200 in part reflects recent declines in the resources sector, while prices for the companies that we are most interested in have been more robust.

Secondly, a high level of equity issuance during the GFC is likely to suppress the index. When companies issue large numbers of shares at cheap prices (as happened a lot in the GFC), any additional value that the market subsequently ascribes to the company needs to be apportioned across a much larger share base. Even if the market value of the business is fully restored, the share price won’t recover to the previous level.

Thirdly – and this one is a bit more encouraging – our valuations today reflect somewhat subdued economic performance by the companies we are analyzing. In September 2007, the median historical ROE of our sample group of companies was 19.7 per cent. Today it is significantly lower at 16.8 per cent.

Based on this, there appears to be reasonable scope for company performance to improve as economic conditions improve, and an ability to sustain higher ROEs would justify a favourable reassessment of valuations.

There is no guarantee that company performance will return to prior levels any time soon, and certainly from our perspective the improvements are not yet in evidence. However, we will be watching closely as full year results come in. At least in some parts of the economy, we might find we are surprised on the upside.

MORE BY TimINVEST WITH MONTGOMERY

Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.

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