Making sense of current sharemarket mayhem

Friday, 17 August, 2007

IML investment director, Anton Tagliaferro, comments:

In today's Australian Financial Review (page 33), IML’s Anton Tagliaferro said the correction was long overdue.
 
"We have had four unprecedented years on the sharemarket and we have had price earnings ratios being massively re-rated in most sectors and this (correction) was inevitable" he said." It was just a matter of when."
 
"This liquidation, emotional, irrational phase will go on for a bit longer but in a month or two or three the panic will be over and things will settle down. We are moving to a new phase where people will be risk averse and things will get valued more appropriately".
 
To expand on this further:
 
Basically every serious sharemarket correction or crash, over the last 25 years follows quite a similar pattern:
 
When a bull market goes on for an extended good period, more and more sharemarket investors become increasingly risk-seeking as they convince themselves that the good times will never end. This unbeatable, victorious feeling often also shows up in fixed interest markets where credit spreads come in, reflecting the view that risk is almost non existent.  In addition, after many good years in the sharemarket more hot money is attracted to it because it is seen as a one way winning bet. From what I have observed a new generation of sharemarket punters re-emerges about every five or six years after the previous ones had been wiped out, given up and walked away after the rubbish they punted on in the previous bull market fell to zero or fractions of their previous prices in the last crash/correction.
 
At this bull stage of the sharemarket, valuations tend to get expensive as PE ratios go higher as the sharemarket continues to discount risk and values more and more years of earnings into a stock price, hence the higher PE's.  At this stage too, many brokers will tell you the sharemarket is still cheap, citing all sorts of statistics and charts as to why it is different this time. This phase is most readily recognisable in speculative sectors when stocks with no earnings at all but plenty of blue sky get valued at many billions of dollars and become more valuable than other well established but boring profitable companies. This phase is always the beginning of the end - the problem is that this phase may last a while and is often the phase when the sharemarket seems completely resilient and at its most euphoric. This has happened in Australia over the last 12 to 18 months with, until recently, companies like Fortescue and Paladin being valued at more than Amcor. You may dislike Amcor but it will be around paying dividends long after many of these sorts of stocks are trading at fractions of where these stocks are today.
 
The trigger for this correction has been the turmoil in credit markets, which while pretty serious, will settle down at some stage. As mentioned above, it is often the case that much of the positive psyche and nonsense in the sharemarket also shows up in credit markets with, as we showed in our Roadshows in February/March, credit spreads on very risky loans, such as on junk bonds and emerging markets debt, down to record lows.
 
So where are we now?

While we are not out of the woods yet, I make the following comments:
 
1.  I have learnt to never get seduced into low quality stocks or sectors, as when the correction comes it is without warning, completely savage and losses are huge. I am happy to say that every stock in IML's portfolios today - both large and small cap - makes money and, in our view, are led by sound management with a long term strategy which we assess will create long term value for shareholders
 
2.  In a sharp correction as we have had over the last month, everything falls .It doesn't matter if it is the bluest and cheapest of blue chips. In fact perversely and sadly enough,  it is often the better companies that fall more  than the rubbish stocks in a crisis  as there is more liquidity and buyers for the good stuff ! This happened, much to my amazement, in the week of the 1987 crash and I believe was responsible for the worst of the 300 point drop in our sharemarket yesterday. While we may have a little further to go, I believe we are more than half way through this phase and that  the liquidity panic phase may be over fairly soon. Hopefully good stocks will soon get good support while rubbish will continue to wilt and fall further. (Actually another problem for many new investors is that in very long bull markets many investors do not understand what a quality share is and what a rubbish share is - so many punters yesterday would have been buying Fortescue  or Paladin or "XYZ" Gold, thinking they are "good value" because they had so far fallen a third from their peak, this sounds silly but it's true).
 
3.  I would steer away from buying further resource shares at this stage - even the good blue chip names like RIO and BHP, for four reasons:
 
* the  impact of the sharemarket falls and credit crunch turmoil on the real economy are unknown at this phase, but very unlikely to be positive, to say the least, which will negatively impact future demand for their output;
 
* as investors become more risk averse they are less willing to own intrinsically volatile stocks like Resource shares in their portfolios;

* In addition, what is effectively happening at the moment is a PE derating of the sharemarket and riskier stocks will get derated by more than that of more stable companies and
 
* Many resource stocks do not pay good, reliable dividends and are on low yields. Dividends will become more valuable to many investors going forward.
 

In summary:

In a nutshell these are tough times for all sharemarket investors. However, things will settle down as they always do, while the sub prime fiasco won't go away soon, but like in the aftermath of September 11 2001, investors will just have to learn how to live with the higher risks that are around. Humans are amazingly adaptable at accepting the new environment quickly and moving on.
 
In the case of the share market, in our view, what this all means is that going forward the average sharemarket investor is going to have to get used to the extra risk around and will be much more risk averse than he or she has been in the recent past. This is not necessarily a bad thing and despite the current hiccup, our portfolios are well placed to do well and recover in value in the new era of prudence, where real companies will hopefully be better appreciated than holes in the ground.
 
In fact, this is an environment where the stronger companies in their sector can actually do better while the weaker ones will struggle e.g: Telstra with its strong earnings and balance sheet versus many telco hopefuls, that may struggle to raise new debt or equityfind new debt or equity to fund their plans; the major banks who now do not have to contend as much with many mortgage originators (like Rams) where margins on home loans have been under pressure for years; many other companies with good balance sheets now do not have to compete with private equity funds on price  for deals as much  of private equity funding has dried up (e.g. Ansell or PBL, which is completely debt free (with $ 3b) in cash  looking for new casinos).