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Read between the lines…

Read between the lines…

As you can imagine, we are delighted when we read the newspapers or see interviews to find other fund managers speaking effusively about the individual companies we have owned shares in for some time. Recent examples include Veda and CoverMore.

But less encouraging are some of the justifications for holding the same stocks. And there is one justification that I have heard a number of times creep back into the “analysis” that I would like you to appreciate in order to dismiss.

For the purposes of our argument, the example I will use is the one I read on Friday about a fund manager who owns and is continuing to buy Challenger shares for his clients.

You can, if you like, read our recent thoughts about Montgomery’s holding in Challenger on behalf of our investors here.

The particular bugbear I have however relates to the following quote (the emphasis is my own): “he is continuing to buy Challenger at current prices and provides three key reasons for his thinking. 1) Challenger is currently trading on a PE multiple of about 10 times, which is inexpensive relative to the market and other businesses in the sector (such as banks)…”

You too may have heard the above remarks made about many other companies when their price-earnings ratio was lower than that of their peers. I wrote about the flaw in this approach in Value.able, which was published in 2010 (with an international version in the pipeline):

“In the sharemarket, analysts and investors often use ‘peer’ comparisons to determine whether a company’s shares are cheap. For example, an analyst may say that the shares of Company A are trading on a price-earnings multiple (more on those later) of just ten, while the price-earnings multiples of all its peers are much higher. The implication is that Company A’s shares are cheap and must catch up to the others. What if, however, all the companies being compared were in the business of manufacturing steam trains or vinyl records? One might argue that their long-term worth collectively is zero and so a low price multiple isn’t a bargain at all.

Saying that Company A’s shares should go up because its price currently reflects a lower multiple than its peers makes as much sense as expecting a VW Kombi van to eventually catch up to the Ferrari in a race. Even if they were to race each other every day, it just wouldn’t happen. It may be true that Company A’s shares are cheap, but it rarely if ever has anything to do with its comparative multiple.”

In the case of Challenger, we agree that the valuation the market is attributing to the business may be lower than its longer term intrinsic worth, and we may also currently agree that its prospects are bright. But according the securities a place in a Montgomery fund has absolutely nothing to do with its price-earnings ratio or the price-earnings ratios of any other stock.



Roger 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.

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  1. Michael Shapiro

    While PE ratio is not a useful valuation measure, it is a useful pricing guage. Especially when comparing PE ratios for the same company during bull and bear markets. Its serves as a measure of liquidity and therefore exhuberance or capital dislocation in the market.

  2. Good point Roger. I think such rationale is falsely used to justify making the investment, when in fact the real reason some people might be attracted to the stock is because of its price momentum or to back a winner. However, I do think many relatively mature companies’ P/E’s can be compared to their own historical average P/E with a view to mean reversion (e.g. the banks are due for a P/E de-rating over time with the bank sector trading at around 13.5x forward earnings, compared with its historical forward P/E of around 11.7x). Whilst I like Challenger and it’s outlook is improving, it’s no longer the unloved bargain it was, so returns are probably more dependent on upward earnings revisions now, rather than further P/E expansion. It’s that insight as to how the earnings outlook is developing that will be valuable.

  3. garry howlett

    What I find more disturbing is when fund managers, brokers, media etc make comparisons between the index’s. Noting that one should play catch up or fall because of the others level at a certain time. Comparing the ASX200 to the S&P 500 for example.
    I would have thought that at no time should there really be any reason why our markets move in sync, when we have completely different company’s, earning different profits, at different times of the cycle, under different interest rates, having different dilutions (capital raisings), with different growth profiles etc etc etc.

    • You are spot on Garry. In the long run there’s little to justify a relationship. Look at the S&P at all time highs and the ASX 200 only back to where it was in November 2006.

  4. Why then in your bi annual reports, where you detail your top holdings, do you state the company’s forward P/E if it is as irrelevant as you describe above?

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