Lower real returns cautions against overpaying for stocks: Alphen

Neels van Schaik of Alphen Asset Management discusses why investors have to be careful of the prices they pay for a company.

We have regularly cautioned investors in recent months not to get over-optimistic on future equity market returns. The surge in stock prices since March 2009 has rerated companies to the point where expectations, and therefore potential for disappointment are high.

We would not be suggesting at this point that long term investors that own high quality businesses sell them. Our caution relates specifically to investors that have missed the market rally and want to purchase stocks after the 64% gains we have seen.

We have attached a table of two companies that indicates the lowest rating, the highest rating and the average rating these companies have traded at since 2000. We also show the current ratings as well as the ratings 12 months forward, based on the consensus forecasts.

What is clear is that both companies’ ratings in the above table sit well above the lows of the past ten years. In the case of Standard Bank the low point was reached in March 2009, whereas Mr Price traded on a Price-to-Earnings ratio (PE) of 6.3 in 2001.

The rally in the share prices of Standard Bank and Mr Price puts them both at a premium of roughly 45% to the average rating they achieved over the last nine years. Looking specifically at Mr Price, the last time investors had the opportunity to buy Mr Price on a 16.2 PE was in March 2006, and the subsequent real capital returns over two and three years was negative. This was despite profits subsequently increasing by 48% and 66% in nominal terms over two years and three years respectively.

Conversely, if you bought Mr Price in March 2001, when the PE rating was at 6.3, and held on to them, even at the nadir of the stock’s most recent collapse in July 2008, when the PE was back at 6.9, your real capital return over the period (March 2001 to July 2007) would still have been 19.9% per annum, and up to today it would have been 27% annum.

Looking at the PE’s 12 months forward, both companies’ ratings come down as a result of relatively strong earnings growth, but remain at between a 15% and 20% premium to the average since 2000. Consensus forecasts have a tendency to change fairly often though, so investors should take forecasts with a pinch of salt.

The same arguments can be applied to Standard Bank. Standard Bank currently trades at the highest rating since December 2000, mainly as a result of the rally off the lows in 2009, while earnings dropped by 27% since the highs of 2008. The recovery in profits in coming years is therefore very much reflected in Standard Bank’s share price. The last time the PE was close to the current levels was in 2007, after which real capital returns were negative over both a two and three year period. If you bought Standard Bank at the PE rating of 6.9 in 2003 though and held on to it, your real capital return up to the low in March 2009, would still have been 10% per annum and up to today it would have been 16% per annum.

Both these businesses are of very high quality and are well managed, but we would caution new investors not to expect significant long term real capital returns off current levels as expectations of existing investors are very optimistic, as reflected in the high ratings.

Investors primarily invest in equities versus other asset classes for the real return they believe they can achieve over time. Inflation in the next few years will, therefore, play an increasingly important role in investors’ minds. When we have a situation like 2002 to 2007 where profits increase by 20% to 30% per annum and inflation eats away only 5% or 6% of your capital per annum, investors almost don’t even notice the impact of inflation on their investments.

This situation of course changes dramatically when profit growth is only 10% or 15% per annum, while the average inflation rate is still 6% per annum. Add to this a decline in the market rating to more realistic levels, and you have a recipe for very low real returns, which is why investors really need to guard against overpaying for stocks.

Bear in mind that we are not forecasting a spiralling inflation rate and escalating costs pressures, but are rather referring to more normalized lower nominal profit growth and moderate inflation. Companies with strong brands and well managed cost basis will do better under these circumstances and we would be in favour of owning such businesses.

But even high quality companies can sometimes be overvalued and we would, therefore, recommend to new investor to rather keep some powder dry, with higher portions of their investments in cash, until valuations get more attractive. Although cash also lost its purchasing power over time, this loss can be made back relatively easily when buying stocks at cheap valuations. Overpaying for stocks though permanently destroys capital.