In short, companies with strong balance sheets, minimal leverage and attractive four-year earnings that are, for some reason, unloved by the market, will beat the index – at some future point. “We don’t forecast the market; there is no value in that. Market forecasts depend on sentiment at the time rather than the earnings. We can determine earnings growth, more or less. But price to earnings numbers are sentimentdriven.” There are three reasons why big recuperative gains might not be made from this bear market, van Munster says.
First, the differences between price to earnings ratios of high and low value companies are not as great; there will be fewer takeovers because debt is more costly; and the effects of this crisis on the broader economy are likely to endure longer than those of the last one. There are also value traps in listed property trusts (LPTs), which look cheap in terms of headline asset backing, but, due to high levels of gearing, are very sensitive to movements in the valuations of underlying assets. “They look cheap but we don’t know how far earnings are going to fall. It’s a short-term value trap.
The market has a short-term focus on the impacts on earnings,” van Munster says. Amid such opaque LPTs and financial stocks lie refinancing risks, Kightley says. “There were real earnings and cash flow in stocks doing well, like financials, listed property trusts and Allco. There were earnings, but a lot were manufactured and based on leverage.” Both managers say the effectiveness of their positions will be clearer when the financial crisis ultimately affects the real economy.
As pervasive as its impact may be, businesses and consumers will still use broadband internet connections and mobile phones, eat and drink alcohol and so on, Kightley says. Echoing their actions during the Asian crisis, van Munster says investors are gravitating toward companies with strong balance sheets, sustainable earnings and minimal leverage, such as big food retailers, health care companies and brewer Lion Nathan. But the impact on corporate earnings from the depreciation of the Australian dollar had still not been factored in.
While the market appears cheap, at a multiple of 11.3 times earnings compared to the long-run figure of approximately 15, companies that are financially strong should be sought, according to a quantitative research report published in October by Citi. This means profitable businesses with market share that can fund their operations and expansion, can meet future debt obligations and are operationally efficient. Since November 2007, signals for the quantitative factors of growth, quality, momentum and value have produced anomalous results, Citi finds.
