When a keen young equity analyst met fund manager Peter Lynch at the Boston headquarters of Fidelity more than a decade ago the legendary fundie imparted three pieces of sage advice that apply in spades in 2017.
First, Lynch said that stocks always follow earnings and cash flow – focus on them and you will get the stocks right.
Second, the person who turns over the most rocks wins the game.
Third, if you are a good fund manager you will be right six times out of 10.
Chanticleer was reminded of this anecdote from Amit Lodha, a Fidelity fundie who handles a $700 million fund in London, after watching the Australian market plunge to a four-month low on Tuesday. There was consistent selling throughout the day on strong turnover of $5.4 billion. Banks were hit again but the healthcare and utilities sectors were the worst performers.
But the negative headline numbers obscured some telling facts about the market.
The S&P; Industrials index is now trading about 25 times forward earnings, according to Bloomberg. There has been a bearish mood in the market for weeks but investors remain happy to pay up for companies delivering consistent earnings growth. This is the Lynch earnings and cash flow mantra at work.
Investors have also been willing to pay a premium for exceptional management talent.
Amid yesterday's red ink a number of stocks were breaking records. Orica hit a 12-month high and Magellan Financial Group was at its highest level in 18 months. Other stocks to break records were WiseTech Global, Fisher and Paykel Health and Treasury Wine Estates.
Treasury Wine's chief executive Michael Clarke is regarded as an outstanding leader. The stock trades at 32 times forward earnings. The only way to explain that is that fundies are paying a premium for Clarke's skill.
It is a similar story with paint maker Dulux. It would appear investors are paying a 20 per cent to 30 per cent premium to have chief executive Patrick Houlihan running the company.
Dulux delivered a strong profit result for the half year to March. Following a two-week investor roadshow, the stock struck an all-time high.
Dulux is probably benefiting from the recent breakdown in the $US29.5 billion takeover talks between US paint giant PPG Industries and Akzo Noble. Analysts believe PPG will turn its attention elsewhere for acquisition opportunities and that might put Dulux in its sights.
Normally, a defensive stock such as Dulux would trade about 12 times earnings. It is currently trading at 20 times earnings, which worries most analysts.
But Andrew Johnston at CLSA, the only analyst with a "buy" rating on Dulux, says the stock deserves a premium rating and has an $8 price target.
Dulux is almost ready to be classified as a market darling. These are stocks that enjoy being chased by just about every active equity manager.
Hassan Tevfik, a strategist at Credit Suisse, has written at length about the fact these market darlings trade at a 100 per cent premium to the S&P; ASX200 Index. They used to trade at a long-term PE of 22 times earnings and a 60 per cent premium to the market. "There is clearly too much money chasing these stocks in Australia," he says. Tevfik's advice is to find the darlings of the future and he has his own list of them. In other words he is suggesting you follow Lynch's advice and turn over some more rocks.
The high PE ratings applied to industrials as well as a handful of market darlings is a cause for concern among some fund managers.
Geoff Wilson, the founder of Wilson Asset Management, says he is finding it hard to pick value in the market. He is now holding about 42 per cent of the WAM Capital fund in cash. Wilson may be cautious in the large cap space but that has not stopped his fund-raising machine stepping up a gear in the past few months.
He recently lifted the total capital being raised for a new listed investment company from $110 million to $154 million. It will focus on micro-cap stocks. That capital raising is one of the few getting over the line. This exposes another dichotomy in the Australian market. While an excess of money chases market darlings there is a general reluctance in Australia to support new floats. Initial public offerings have died in Australia.
They have been killed by a combination of factors. One of the most important of these is that small-cap managers have been bruised by poor performance and fund outflows over the past 12 to 18 months. Poor performances by small-cap managers is the flipside of excessive ratings for large-cap stocks.
In a recent note, strategists at Macquarie found that industrials have been trading at levels only seen five times in the past 25 years. Macquarie found the re-rating of industrials could be attributed to the movements in a handful of stocks, including AGL, Crown Resorts and Woolworths. Others in this elite group are CSL, Resmed, Cochlear and Computershare.
But there is hope for the IPO market aimed at small-cap managers. Despite the fact that the $500 million ZIP float was pulled by Quadrant Private Equity, and Wesfarmers pulled the $1.5 billion Officeworks float, Archer Capital is proceeding with the IPO of Craveable Brands, formerly known as QSRH Ltd.
This $500 million IPO will go ahead at the end of the month. It has the benefit of owning recognised food brands Red Rooster, Oporto and Chicken Treat, which are not vulnerable to Amazon's arrival.
