Only if two very generous assumptions come to fruition can it do so. First, I assume that BHP’s earnings per share will recover smartly from the loss of $1.34 recorded in 1999 to a gain of $0.87 (a 15% premium on its average of $0.77 during the nine years up to the disaster in 1999) in 2001. I also assume that BHP’s earnings per share will grow at a compound rate of 15% per annum until 2005. This is extremely generous: even excluding the loss of $1.34 in 1999, BHP’s E.P.S. has grown at a compound rate of only 1% during the past ten years. These assumptions produce cumulative earnings (whether retained or distributed as dividends) of $5.90 and an earnings yield of 8.6% on our investment in five years’ time. The owner of the BHP share must wait three years before the share’s projected earnings yield matches that guaranteed today from the bond. Accordingly, as with Solution 6 so too with BHP: only if we assume (speculate?) that its operations will improve dramatically and produce historically-unprecedented results can we justify the purchase of its common stock at current prices.
Next, consider Telstra. I assumed that I had the choice of buying either one share of Telstra at $6.92 (its closing price on 1 June) or a hypothetical five-year $6.92 Commonwealth bond with a yield of 6.1% (the yield of five-year Commonwealth bonds on 1 June). Again, I assumed as well that I am a “long term” investor and that I will retain my choice for five years. If so, then by mid-2005, I will have earned $2.11 (i.e., a stream of $0.42 per year for five years) in coupons from the bond. If the TLS share is to be a better investment than the Commonwealth bond, then clearly it must return to me at least $2.11 during this five-year period.
Even when boosted by a very generous assumption can it (barely) manage to do so. I assumed that TLS’s earnings per share will increase 15% between now and 2001 and that this rate of growth will continue until 2005. This is very generous because TLS’s E.P.S. has grown by only half that amount, i.e., at a compound rate of 8%, since 1996. This assumption produces cumulative earnings (whether retained or distributed as dividends) of $2.10 and an earnings yield of 7.9% on our investment in five years’ time. Like the owner of the BHP share, the owner of the Telstra share must wait at least three years before its projected earnings yield matches that guaranteed today from ‘risk-free’ Commonwealth bond. Only if we are willing to speculate that TLS’s operations are going to improve even more considerably than our already-generous assumption can we justify the purchase of its common stock at current prices.
Finally, consider News Corp. I assumed that I had the choice of buying either one share of NCP at $19.49 (its closing price on 1 June) or a hypothetical five-year $19.49 Commonwealth bond with a yield of 6.1% (the yield of five-year Commonwealth bonds on 1 June). Again, I also assumed that I am a “long term” investor and that I will retain my choice for five years. If so, then by mid-2005, I will have earned $5.95 (i.e., a stream of $1.19 per year for five years) in coupons from the bond. If the NCP share is to be a better investment than the Commonwealth bond, then clearly it must return to me at least $5.95 during this five-year period.
Not even on the basis of very generous assumptions, beyond News Corp.’s actual operations during the past ten years, does it come remotely close to doing so. I assumed that NCP’s earnings per share will increase 15% between now and 2001 and that this rate of growth will continue until 2005. This is generous because NCP’s E.P.S. has grown at a compound rate of 10% since 1990. These assumptions produce cumulative earnings (almost all of which will be retained – NCP pays notoriously miserly dividends) of only $2.83 – less than half the ‘risk-free’ bond’s earnings. Further, not even in five years’ time does its projected earnings yield come close to matching the yield guaranteed today from the ‘risk-free’ Commonwealth bond. Only if we are willing to speculate that we can pass the parcel to somebody who is even more stupid can we justify the purchase of its common stock at current prices.
A Dissent from the Crowd
Because returns projected from their operations during the next five years – even when boosted by some very generous assumptions – cannot reasonably be expected to surpass by a wide margin (or, indeed, at all) the current return of a “risk free” Commonwealth bond, I do not believe that it makes sense to purchase the securities of these and other tech darlings and ‘blue-chips’ at anything approaching their current market prices. To do so is not to allocate investment capital on the basis of a justifiable assessment of these companies’ future operations; rather, it is to gamble that the market prices of their securities will continue to increase – and thereby to become even more detached from business fundamentals – and that it will be possible to flip them to other speculators at even more inflated prices. Because Leithner & Co.’s investment philosophy precludes speculation, it rules out the purchase of securities such as these.
It is important to note that very few people would agree with this assessment. Telstra provides a good example. A “leading telecommunications analyst,” quoted by The Courier-Mail on 6 May, described TLS “as a $10 stock pricing comfortably in the low $7 range.” The article containing that quote also stated that “in a weak market, Telstra’s share price is likely to fall further. Anticipating this, leading broking firms, including some close to the company, have been downgrading their recommendations from buy to hold, despite the fall in prices.” A second analyst was quoted in the AFR on 12 May: “Telstra is a long-term buy but that doesn’t mean that you should buy it today.” A third uttered similar comments in The Wall Street Journal Interactive Edition on 24 May. This, as the first quote suggests, is curious: given the fall in its price, if Telstra were really a ‘$10 stock’ and a ‘long-term buy’ then surely now is the time to increase one’s holdings?
Recommendations to this effect appeared in the AFR on 13-14 May. It stated that “market experts suggest that those who don’t own T2 [Telstra’s Instalment Receipts] may see this as a buying opportunity. and if the experts know their stuff it will only get better.” One “expert” was quoted in the article: “I’m telling people they should be buying Telstra with their ears pinned back.” Another stated that “this is a stock that’s going to show 10 percent growth in earnings before interest and tax for a number of years to come, and that’s not bad. Investors should feel very comfortable with it.” A third expert added that Telstra is “very cheap and presents a good buying opportunity. For those who have only a handful of T2, it’s even better value to buy more and top up.” Finally, according to the 3 June issue of The Courier-Mail, “[some] brokers are bullish on the Telstra price outlook.” One stated: “we think Telstra is very good value and we have a valuation on the stock of $7.90.”
Perhaps the strongest indicator of the conventional wisdom towards Telstra appeared in The Australian on 5 June. Its “100 Hot Stock Picks,” made by the paper’s six “experts,” were displayed in the form of a bullseye. On it were arranged 100 darts, each pinning to the board a post-it note containing a company name and a justification for its inclusion. “The closer the dart to the bullseye, the more favoured [the company].” Among the four closest to the bullseye were Telstra common shares (TLS) and Instalment Receipts (TLSCB). The justification? “Australia’s best tech stock. Growing markets and technological developments in the pipeline will boost earnings going forward; but held back by remnant government stake.”
BHP (“petroleum offers most earnings growth potential”) appeared halfway between the bullseye and the dartboard’s outer edge; News Corp. (“growth lies in levering into e-commerce”) and Solution 6 (“has had a rough time but underlying business delivers solid cash flows”) appeared on its outer edge. The comment about Solution 6 is interesting, given that its per-share cash flow figures for the past seven years are $0.17 (1993), $0.13 (1994), $0.12 (1995), $-0.07 (1996), $-0.09 (1997), $-0.16 (1998) and $-0.24 (1999). Clearly, with each passing year since 1993 its PSCF position has deteriorated.
Conclusion: Continued Unwarranted Optimism
All investment decisions must necessarily rest upon assumptions (whether explicit or implicit, cautious or exuberant) about the future. Sensible ones, it seems to me, stem from cautious assumptions and explicit analyses; conversely, what turn out to be mistakes can often be traced to overly-optimistic assumptions and the abandonment of explicit and careful analysis. Both shortcomings, it seems to me, continue to pervade experts’ assessments of many Australian blue chips and tech market darlings.
If so, then recent comments about financial markets in the United States may also apply to Australia. Gerry van Wyngen wrote in The Australian Financial Review on 31 May that “US markets and US investors seem to have forgotten [that] expectations are far too optimistic, US share prices are still overvalued and further stock market sell-offs are almost certain.” Similarly, Alan Abelson wrote in Barron’s Online on 22 May that “our feeling is that there’s still room, lots of room, on the downside for this failing market. One particularly ominous sign is that while investors might be nervous, they’re still very bullish. The old mantras – every drop is an opportunity, stocks came roaring back in 1998 and ’99 and will again, the big risk is being out of the market, not in it – are still sacred.” Finally, I also empathise with Stephen Roach, an economist at Morgan Stanley Dean Witter, who was quoted in The Weekend Australian on 27-28 May: “the excesses of optimism have only begun to be purged. To the extent that financial assets – especially equities – are still priced for open-ended growth of the new economy, investors could be in for a rude awakening.”
Although he uttered them during the 1920s and 1930s, Benjamin Graham’s views might just as well have been expressed yesterday. He stated that “the new era doctrine that blue chips were sound investments regardless of how high the price paid for them was, at bottom, only a means of rationalising the universal capitulation to the gambling fever.” This doctrine “involved the abandonment of the analytical approach and, while emphasis was seemingly placed on facts and figures, these were manipulated by a sort of pseudo-analysis to support the delusions of the period.”
The Road Ahead
Leithner & Co. has avoided and is steering clear of Australian blue chips and tech market darlings. Its cash weighting is also very high. At the same time, however, a small number of quality financial assets are available at sensible prices. A circular to shareholders, to be dated 15 August 2000 and released early in the new financial year, will justify this statement and outline the gist of the Company’s investment plan during the 2000-2001 financial year.
