Are small and mid-cap stocks good value?
Let me start by making something clear. The best returns will not come from the large-cap blue chips that so many baby boomers are invested in. They are likely to come from the stocks that have been beaten up the most in recent months.
The reason I suggest the most beaten-up stocks will provide the best returns is because those stocks are the very same that we regard as some of the highest quality and those with the best long-term growth prospects.
Let’s start with the large-cap blue chips.
Have you ever wondered why Telstra’s share price today is lower than it was 17 years ago? Are you surprised that the National Australia Bank’s share price is the same as in 1999? Are you surprised that BHP Billiton’s share price is no higher than it was in January 2007 – 10 years ago? These are the so-called blue chips. How can this be?
Business economics explains the reason.
Take Telstra as an example. Since 2005, the company has been paying most of its earnings out as a dividend, retaining very little for growth. Unsurprisingly, earnings have not grown.
When we look at the data for Telstra over the past 10 years or more, it has delivered nearly flat earnings per share (EPS), averaging around 30 cents per share. FY14 was a bit better than average, with EPS hitting 37 cents, but this is only slightly more than the result achieved in 2004. On a 13-year view, Telstra’s EPS growth has effectively been nil.
A hundred thousand dollars invested in Telstra in 2005 has grown to just $105,000 at the time of writing (mid-December) and the $5,970 of dividend income in 2005 has grown to just $6,500. Neither has kept up with inflation, meaning your purchasing power has been reduced by this supposed “safe” blue chip.
A company that pays most of its earnings out as a dividend might show an attractive dividend yield today, but unless the dividend income grows, owners of this asset are setting themselves up for reduced purchasing power and therefore a decline in their quality of life.
For the large-cap blue chips, this is an important point. It means that unless the future looks very different from the past, high-dividend-paying companies are unlikely to deliver material growth in intrinsic (true) company value.
And as the Reserve Bank of Australia reported a year ago, the most expensive stocks listed on the ASX have been those paying most of their earnings (greater than 85 per cent) out as a dividend. The most expensive group of stocks has been those offering the lowest growth. Those two conditions cannot co-exist for very long. Eventually, either growth needs to return (but it cannot if dividend payout ratios remain high), or prices need to decline. And if interest rates on bonds keep rising, the decline in prices for low- or no-growth companies could be harsh.
As Ben Graham once observed, in the short run the market is a voting machine, but in the long run it is a weighing machine. In other words, the share price in the short run is just a popularity contest. In the long run, however, prices will follow the performance of the underlying business. If the underlying business performs with mediocrity, over the long run so will the share price.
What about property?
The next asset class I believe will offer mediocre returns, if not capital losses, is property, particularly apartments.
Australia’s east-coast capitals are facing a tidal wave of apartment supply and developers will not be able to sell all their inventory at current prices. Indeed, they are already trying to offer carrots to lure potential buyers. These carrots, such as millions of frequent-flyer points, holidays to Asia or ten-year rental guarantees are forms of discounts designed to try to preserve the ticket price.
As the supply of apartments increases, however, the discounting will become more aggressive simply because the developers owe their lenders money and need to pay back the loans – many of which have also capitalised interest (something to think about when owning bank shares, too).
Investors who borrowed to buy an investment apartment are at particular risk. Look at Brisbane where in the first nine months of 2016 just 5,200 apartments were completed in the inner 5-kilometre ring from the CBD.
Investors who bought outside that inner ring – five to 15 kilometres from the CBD – have seen aggregate vacancy rates climb from 2.3% to 4.7%. And that number can only keep rising when another 13,000 apartments are due to be completed in the next 18 months. A unit without a tenant has a yield of zero per cent and a unit earning zero, with a mortgage attached, could put its owner in financial stress.
With record levels of mortgage and credit-card debt in Australia, we expect there will be some financial stress ahead. Want to buy some bank shares?
Finding better opportunities
Finally, we turn to a group of listed companies that appears to provide the best opportunity for positive returns over the next year or two. But first a little background.
Over the last year or two, a lack of expected growth from the banks and resource companies meant large institutional fund managers migrated down the market-capitalisation spectrum, looking to boost their returns. High-quality, mid- and small-capitalised company shares, those with bright prospects and economics, benefited.
More recently, however, that perception of prospects for the banks and resource companies improved and those institutions found themselves underweight these sectors. Needing to “catch up” they were forced to sell down their holdings in smaller, high-quality growth companies to fund their purchases of the banks, BHP, RIO et al.
The result has been a bloodbath in the share prices of smaller high-quality, high-growth companies. ISentia has declined more than 30 per cent in the last month, as have APN Outdoor and Vita Group. Healthscope has fallen 32 per cent from a high of $3.14 to a low of $2.15, REA Group and Carsales are down 27 per cent and 28 per cent respectively from their highs.
Many investors ask me how high-quality companies could ever be cheap if everyone knows they are high quality? Well, occasionally, scenarios such as the one just described occur and the market treats that which is temporary as permanent. And value emerges.
Our inability to identify good value earlier in 2016 meant Montgomery Funds had built cash levels placing them in the enviable position of being able to take advantage of lower prices, and in some cases, the first opportunity to acquire value in a long time.
Perhaps most interestingly, the companies that score the highest on our quality matrix have been the very worst performers. This can be seen in the illustration of returns for quality deciles of the S&P/ASX300.
Being somewhat obsessed with quality, we maintain a database covering the entire ASX300, scoring every business in terms of its pricing power, barriers to entry, industry structure, switching costs, and many other factors. This allows us to calculate an aggregate quality score for every business we may be interested in and, using that, we can sort the market in order from best to worst.
Our objective is to rank businesses by the sustainability of their propensity to create shareholder value by investing incremental capital at rates of return above the cost of capital. The underlying rationale for this is reasonably self-evident. Over long periods, a business that has the ability to create genuine value for its shareholders should be able to generate good investment returns by the accumulation of that value.
Importantly, however, this is a long-term dynamic. Value creation only reveals itself over a number of years and as the business reports growing shareholder equity while sustaining a high return on that growing equity.
Over shorter periods, the share prices for good businesses can decline and the prices for inferior businesses can surge, and we believe we are currently witnessing just such a period.
Source: Montgomery
As shown in the above chart, the businesses with our very highest-quality scores (at the left of the chart) have delivered the worst returns since August 1, 2016. Meanwhile, the strongest returns have been found towards the low end of the quality scale (the right-hand side of the chart). The index at far right returned minus 0.6%.
Once again, this combination of circumstances does not coexist forever. In the long run, quality (as defined by Montgomery as the sustained ability to generate high rates of return on incremental equity) always wins.
Conclusion
Investing in the future will look very little like the recent past. Because we are so inadequately armed to pick turning points, most investors will continue to believe property and conventional blue-chip shares will be where the best returns will continue to come from.
Our own view is founded on the basic investing tenet that the lower the price you pay, the higher your return. Combine this investing truism with quality and the recent sell off in high-quality mid-cap company shares starts to look very attractive. Rather than appearing like a risky place to invest, a market that has just suffered a bout of volatility starts to look like the safest place to be.
An observation, famously ascribed to Jesus of Nazareth, notes: “…many who are first will be last, and many who are last will be first.”
This may just be true for investors in 2017 and beyond.
This article first appeared in the ASX investment and finance January update.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Alf
:
“With record levels of mortgage and credit-card debt in Australia, we expect there will be some financial stress ahead. Want to buy some bank shares?” Then why are WBC and CBA two of the top 10 holdings of The Montgomery Fund?
Roger Montgomery
:
We purchaed our bank holidngs in January of 2016, at that time there appeared to be very good value being presented. That value gap has now reduced and the holdings are on constant watch.
Max Zan
:
Hi Roger
For the 12 months to 31 December 2016 TMF showed a loss of 2.73%. That’s no big deal and to be expexted as different investment strategies at times can and do work against you. What’s important is how TMF portfolio is positioned for the future. You appear to be confident that over time your investment style and strategy will be successful, but keep warning us to expect lower returns than the immediate past. Are you able to provide some guidance on what Investors can expect from TMF over say the next five year period? Is the portfolio structured to achieve a minimum regular income stream or will it be more focused on the growth returns?
Roger Montgomery
:
Hi Max, Returns are a function of the price paid. Given so many high quality growth companies have fallen significantly, I would expect future returns to be higher.
jay
:
Hi Roger, what do you think about Telstra pumping billions into 5G? As far as I’m aware no other business in Australia is even close to investing in wireless like Telstra and 5G may even leapfrog the NBN.
Roger Montgomery
:
A friend at Ericsson demonstrated 5G to Telstra and it does trounce NBN speeds.
jay
:
One could say Telstra might be worth a closer look than the article suggests.
peter latham
:
Roger, I know you have spoken about ISentia on numerous occasions and at the moment, as a shareholder, I am feeling a degree of pain. Assuming management is doing their job, wouldn’t you think that with the change in the US political system at the very highest level, that the services of ISentia would be reaching peak demand ?
LindsayByrnes
:
Thanks roger, I appreciate for HSO there are some “protective moats” for single regional hospitals. But by competitive pressure I mean the competitive pressures applied by Medibank and BUPA. For instance given the Vic’s nurses EBA late last year, as HSO has signed long term contracts, those increased costs would only be partially recoverable. But whether they can charge what they like down the track as I think you might imply is surely a moot point. There is also the added risk of adverse case mix outcomes with excess capacity leading to surgeons electing to go elsewhere because of lower costs. They may not be particularly concerned where their patients reside.
Best wishes
Roger Montgomery
:
I do not believe they can charge whatever they like but the regional monopoly status does ensure a steady stream of customers.
Ante
:
I’ve had developments in older areas where Telstra could have supplied my phone line via an overhead cable. 1 man x 1 hour. Yet they legislated some wacky rule that the service must run underground. I estimate they spent over 5k getting the job done, at no extra charge to yours truly. If that’s the way they want to operate their business than avoid them at all costs.
Greg Cole
:
Some of those “smaller high quality, high growth” stocks that you refer to Roger have had quite high PE ratios and still do, so it is not a surprise to me that the prices have dropped. Also, I can’t see where the growth is coming from in some cases eg Vita appears to be dictated to by Telstra so it’s a ‘price taker’ rather than a ‘price maker’ which is not necessarily essential but nice to have. Others that have come down in price include Blackmores and Sirtex Medical but I have concerns about those as well.
jack
:
Hi Roger, would your portfolio consider Slater Gordon(sgh), one of the worst performers in the past year due to impairment, write downs and tangled in potential capital restructure, but have a market leading position? Or would that be considered too risky? I personally invest in SGH, and can see value in the business vs it’s current share price. Just wondering from a risk appetite perspective, is this stock too risky to the Montgomery Fund?
Lindsay Byrnes
:
Hi Roger,
Thanks for your insightful summary.
A few points on some aspects: Let’s take the banks and an unloved ANZ by way of example:
If I discount current actual results by reducing EPS, Dividend and Return on Investment by 25% respectively to ($1.68, $1.20, 8.5%) but add in the franking credit benefit of 48cents the intrinsic value equates to a return of 7.7%. Of course leaving it out reduces the return to only 6%. But if I sold covered calls and get to the added benefit maybe one could get 10%, or more even if the stock EPS declines around 25% over the next few years.
I like Vita and bought it after it crashed but I am awaiting the February update before buying some more. But another one you are keen on which has me scratching my head over is Health scope- HSO. I bought in on the float but sold out at a profit because I thought it was going to experience some headwinds – no particular wisdom on my part but a bit of experience in the sector and noting the high degree of competitive pressure that prevails, notwithstanding the aging sector advantage of a growing market. However, if I add 25% to the current projected EPS of 15cents the intrinsic value equates to a return of still only 7.3%. What am I missing here?
Best wishes
Roger Montgomery
:
Each hospital is a regional monopoly so not sure I agree with the “high degree of competitive pressure” comment.
Phillip Stewart
:
Roger I too think your analysis of Telstra is a little self-serving. The price of Telstra in the 2005 calendar year was in the range $3.82 to $4.98. So depending on the price at the time of purchase your notional $100,000 could have purchased as little as 20,000 shares or as many as 26,000 shares. This 30% swing would significantly impact on the investment outcome. Perhaps in the interests of clarity you could provide a summary of your analysis of Telstra showing buy price, franking credits etc. Perhaps this is a bridge to far but your analysis could show outcomes if your notional $100,000 was spent at both the lowest and highest price points.
I confess to being one of the cohort of baby boomers to which you refer – I am a “blue chip” sort of a guy and deeply mired in the evils of confirmation basis. It will therefore come as no surprise when I declare that I purchased a quantity of Telstra shares in late December 05. With hindsight I could have done better, but I could also have done far worse.
Roger Montgomery
:
The differences are marginal compared to the outcomes of many, many other opportunities available at the time. And that is the point.
Bruce
:
I enjoy your stuff Roger
However I have tried diversifying away from the banks and Telstra on the basis of advice like yours above.
Your advice is very true – that better returns can be found elsewhere and often in smaller cap stocks. But I spend nearly $5k a year on subscription investment advice and very few small cap stock tips have been successful. For example I have diversified into the following with very poor results: GBT, MTR, ANG, BAP, IFM, VOC – all on the recommendation of various highly respected advisers.
It is all very well to look at small stocks with hindsight – and by cherry picking prove correct your claim. But without the benefit of hindsight my experience has been that Telstra and the banks, despite their lack of headline results, provide a safe and reliable income to help me through my self-funded retirement.
I share the comments of others about ignoring the dividends. A proper comparative analysis would combine both div and capital gain and calculate a Net Present Value over a particular time frame.
Many thanks for your good work
Roger Montgomery
:
We have never owned TLS but have owned MTU and CSL. Both examples of companies with the right economics that saw their share prices and dividend income increase by multiples over the same ten years (despite each falling by as much as 50% during the GFC too).
Rick
:
Roger I enjoy your articles and have followed you for some time. I understand where you are coming from when you mention the current opportunity for top up purchase of these high quality, high growth, companies at a much reduced price based on their recent falls , however the old adage that you mention regularly of buy low and sell high would not have been the case for your more recent investors who entered your funds just prior to these massive falls. Its seems to me that they have invested high and now will have to wait for new highs to maintain there original capital. Who knows how long that will be? If large institutional fund managers sold these good quality companies to migrate to the big caps for the reasons you have given, why are there not warnings to investors that these situations can occur at random. These companies you invest in are generally low dividend high growth companies, so fat chance of receiving much of your capital back to compensate for a very quick capital loss, be that a paper loss. I heard you on Sky news with Switzer say its great when these quality companies drop so you can add to them. Again not good for recent investors into the funds. Thanks
Roger Montgomery
:
Hi Rick, Lets chat again in a year or so and see.
Chris magri
:
Another excellent paper thank you.
You have previously lauded the company OFX. Do you think the reasons that contributed to yesterdays profit downgrade materially changes the long-term prospects of that company? The reason that I ask is (to me) OFX appears to belong in the list of under-valued small to mid cap companies you refer to in your paper and, as a result of yesterdays over-reaction by the market currently offers good investor prospects. Your thoughts would be appreciated.
I have been a scaffold client since its inception – it is an awesome tool – well done.
Roger Montgomery
:
I have talked about OFX in the context of being a disruptor but we’ve not ever bought it.
Justin
:
Let’s hope you’re right Roger! Will be costly if you’re not!
Roger Montgomery
:
Hi Justin, we will inevtiably get many things wrong.
Shaishav Patel
:
Simple conclusion will be – Dividend + Growth is what you will be looking at in stock with good business model and management, for retiree looking for a safer bet which DDR was at 1.80???
John Pendlebury
:
Why did you fail to include the dividend income that Telstra shareholders would’ve received if they had held $100,000 in TLS stock since 2005? I’ve done the maths for you. Since 2005, TLS shareholders would’ve received $105,000 in dividend income, rather tax efficient dividend income too. And those gains would be even larger if the shareholder had chosen to re-invest the dividends back into TLS stock. Seems a little disingenuous to say that the TLS portfolio would’ve only gone up $5000 over that time without mentioning the large dividend income it provided (quite an important element for the self funded retiree).
Roger Montgomery
:
Thanks for performing the calc John. Over ten years investing in Telstra has seen no growth in dividend income ensuring erosion of purchasing power. Contrast that with, say, M2 Telecommunications. $100,000 in M2 produced an annual dividend of $3910 in 2005, but grew to almost $100,000 p.a. by 2015. Note we didn’t include dividend income of the other companies either.
lakun agrawal
:
I think the point John is making is Dividends and Capital Appreciation are both components of total investor return, so you can’t leave one out. Both end up as money in investors hands!
If John’s calculations are correct, then TLS delivered $105k dividends, and $5k capital growth – so $110k total on $110k investment – a little over double your money in 11 years. Not super stellar, but its not a mere 5% return in 11 years as implied in the article.
It might still be correct that Telstra has underperformed other blue-chip stocks (and maybe the market) when you include capital growth AND dividends. Wonder how these 3 (TLS, NAB, BHP) fare on that basis?
Roger Montgomery
:
You might be suprised that doubling your money over 11 years equates to a compounded annual return of 6.5%. Far less than the returns offered by other examples.