There’s an exclusive club of companies on the JSE that trade at earnings multiples of more than 20. These are high-quality businesses that represent the best of the best, with local asset managers piling into their shares as about the closest thing that you’ll get to an equity “safe haven” — with the word “safe” working particularly hard here. Remember Transaction Capital? I certainly do.
This phenomenon isn’t just found on the JSE, either. A similar story has played out in the US market, which is why you see Costco trading at a p:e of close to 60. Despite all the market drama we’ve seen this year, the share price is actually up 9% year to date! Why is this happening?
If we look only at the JSE, it’s easy to make the argument that this is linked to structural market barriers like regulation 28 and foreign investment allowance limits that force pension funds and large individual investors to pay more attention to local stocks than might otherwise be the case. When investors have a limitation on what they can own, it’s a natural outcome that the best options within that opportunity set will trade at a premium to what they are actually worth.
Fair enough — but this doesn’t explain why we see a similar story in the US. Does it have to do with currency debasement? Could it be worries about inflation and what this means for government bonds? Is the government really a “risk-free” investment in the US? Macroeconomists and geopolitical analysts will argue these topics ad nauseam.
Regardless of the textbook answer, the market is sending a strong message about what investors think. It seems that there are only two reasons for Costco (and many other blue chips) to be trading at a yield below US 10-year bonds. The first is that the market is expecting incredible growth. The second is that the market feels safer sitting in blue-chip equities, due to inflation and other concerns. The shine has come off growth expectations this year, yet Costco remains at a ridiculous valuation. So we have to assume that the second reason is the correct one.
Unless earnings at top companies really take a significant hit, it’s likely that the market will continue to hide in high-quality stocks as well
It therefore seems valid that though these multiples of more than 20 (and sometimes 30) are clearly very high in the context of the yield you’ll get on South African government bonds, it’s unlikely that they will unwind in the way textbooks suggest they should. In other words, the share price doesn’t respond to growth by simply saying “Oh, yeah, we saw that coming” — instead, it says: “Absolutely, now give us more!”
This is a technical point that is well worth unpacking. If a company trades on, say, a p:e of 30, it means that the market is expecting a lot of growth. If you buy on 30 and there’s no growth, then your return would be the earnings yield of just 3.33% (the inverse of the earnings multiple). In practice, it’s actually worse than that, as very few companies have a dividend payout ratio of 100%. Due to the need to reinvest a portion of earnings in the business, the cash yield would probably be more like 2%.
That’s a lot less than you’ll get from your local bank’s money market account, let alone the “risk-free” government bonds, so clearly the market is expecting plenty of growth to elevate that return to acceptable levels of a listed company — in other words, into a double-digit return.
Now, what should happen is that as the company delivers growth, the multiple should gently come down over time to reflect that the growth is going to be harder to achieve each year, not easier. Markets become saturated and incremental growth becomes riskier to deliver, particularly in a country with such little economic growth. Instead, what ends up happening is that companies like Clicks (and several others on the JSE) deliver growth in the mid-teens (or similar values) and the share price increases by much the same percentage.
It doesn’t happen instantly; it usually happens over the course of a year. This means that the trailing multiple “stays expensive” and hurts anyone who put on a short position to express a view on an “overpriced” valuation.
Record high gold prices tell us that the market is worried and is looking for safe places to hide. Unless earnings at top companies really take a significant hit, it’s therefore likely that the market will continue to hide in high-quality stocks as well. The “risk-off” trade doesn’t mean that the multiples of the best companies unwind. It does typically mean that small- and mid-caps take a knock, though, so keep that in mind.
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