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Whether or not the country is avoiding or will avert recession, short-term interest rates continue to decrease, consumer confidence recovers, the sun shines and pretty girls smile, the prices of most Australian equities – including the ‘blue chips’ which comprise a heavy percentage of the All Ordinaries and other indices – are from the perspective of a value investor prohibitively dear. Most Australian market participants are accepting meagre margins of safety in exchange for the ownership of what Part II characterised as ‘risky’ assets. This is not to predict that the market prices of these assets will fall: it is simply to caution that to the extent that it entails trading the shares of Australia’s largest listed companies, the achievement of results which even remotely approximate those presently expected by most market participants must rely upon emotional and speculative – and not cognitive and investment – operations.
Soft and Comforting Words Versus Hard and Bracing Numbers
To make sense of this minority and disconcerting position, note first the current coupon of ‘risk free’ Commonwealth bonds, i.e., the dollar amount the government pledges to pay each year to a particular bond’s owner. In the case of a hypothetical 5-year bond with a face value of $1,000 and an initial yield of, say, 5.61% (the average yield prevailing during the second half of May for bonds maturing in February 2006), the issuer pledges to pay the bondholder $56.10 per year for 5 years; moreover, at the end of the 5 years the government pledges to return $1,000 to the bondholder. In the meantime, and no matter how many times or at what price the bond changes hands, the annual payment of $56.10 remains fixed and, for all practical purposes, assured.
As a second step, recall that a corporation’s ‘coupon’ is its earnings per share (E.P.S.) and that its earnings yield is E.P.S. divided by its shares’ current market price. A hypothetical company, All Ordinaries Ltd, provides a useful example. The weighted price-earnings ratio on 30 May of the companies comprising the All Ordinaries Index was 17.30. On that date, although its present level (to say nothing of any increase) of earnings cannot be assured, market participants were in effect willing to pay an average of $17.30 for each dollar of the earnings of All Ordinaries Ltd. Let us say that AO’s current E.P.S. is $1.00. Hypothetical purchasers were thus prepared to pay $17.30 for a share of All Ordinaries Ltd. At that price its earnings yield was therefore [(1 ÷ 17.30) · 100] or 5.8%.
Also on 30 May the weighted average dividend yield of the companies comprising the All Ords was approximately 3.43%. In effect, from each dollar of the earnings of the hypothetical All Ords Ltd during the past year, a dividend of $0.59 per share (i.e., 17.30 · 0.0343) was declared. Finally, on 30 May the weighted average multiple of market price to book value of the companies comprising the All Ordinaries Index was approximately 1.4. It follows that the per-share book value of All Ordinaries Ltd was thus $12.36 and that its return on equity was 8.1% (i.e., {[1 ÷ 12.36]· 100}).
The characteristics of All Ordinaries Ltd clearly differ greatly from its hypothetical overseas counterparts such as S&P 500 Inc. and FTSE 100 plc. For a dollar of earnings, one pays a substantially lower price, buys (as a percentage of purchase price) much more book value and receives a considerably higher dividend yield in Australia than elsewhere. Further, although AO Ltd’s return on equity is very low by American standards, so too is its gearing; as a result, the return on assets of companies on the two continents, whilst still higher in North America, is nonetheless roughly comparable.
Assume now you have the choice of buying (i) one share of All Ords Ltd with the aforementioned characteristics or (ii) a hypothetical five-year Commonwealth Government bond with a purchase price and face value of $17.30, a yield of 5.61% and thus a fixed annual coupon of $0.97. Further, assume that whether you choose the bond or the share you are a long term investor, i.e., you will hold your investment for five years, sell and then evaluate the results of your buying and selling. By 2006 you will earn $4.85 in coupons from the bond, collect total proceeds of $22.15 (i.e., $4.85 interest plus $17.30 principal’) ‘and earn an annualised compound return of 5.1%.
If the share of All Ordinaries Ltd is to be a better investment than the Commonwealth Government bond, then in five years’ time it must return to you significantly more than $22.15 and thereby earn an annualised compound return significantly greater than 5.1%. How much more depends upon the margin of safety which you require from the share. At first glance, judging from both recent increases in its market price and ebullient statements by analysts and market commentators, this seems to be a very easy hurdle to surmount. But upon closer examination it becomes considerably less easy.
A Simple Assessment of ‘All Ordinaries Ltd’ (2002-2006)
| |
Assumption No. 1:
ROE of 8.1% |
Assumption No. 2:
ROE of 10.1% |
Assumption No. 3:
ROE of 12.2% |
Cumulative Earnings |
$5.56 |
$7.26 |
$9.04 |
Return (Earnings + Principal) |
$23.80 |
$25.76 |
$27.77 |
Closing Earnings Yield |
6.8% |
9.2% |
11.7% |
Annualised Compound Return |
6.8% |
8.5% |
9.6% |
The table shows, under three sets of assumptions, the annualised compound returns which today’s purchaser of the hypothetical All Ordinaries Ltd can reasonably expect to earn in five years’ time. Each scenario assumes that the multiple of All Ords Ltd’s market price per share to earnings per share remains at 17.30 and that the multiple of per share market price to per share book value remains at 1.4. Each thus assumes, using Mr Munger’s analogy, that no (further) ‘Rembrandtisation’ of Australian equities occurs. Each scenario also assumes that all retained earnings are used to generate earnings; none, in other words, are squandered or destroyed.
Scenario No. 1 represents the status quo: return on equity will remain at 8.1% and the dividend payout ratio stays at 60%. Scenario No. 2 is more ambitious: beginning in 2002 the payout ratio falls to 50% and remains at this level, and ROE increases by 25% above its current level (i.e., to 10.1%) and stays there for the four years thereafter. Scenario No. 3 is even more ambitious: beginning in 2002, the payout ratio falls to 50% and ROE increases by 50%, i.e., to 12.2%, and remains at this level for the four subsequent years. It is important to recognise that under Scenarios 2 and 3 the profitability of All Ords Ltd - which, it should be remembered, is a proxy for the Australian equities market more generally – increases at an annual rate which is several times faster than any plausible estimate of economic activity in Australia. To call these scenarios ‘ambitious’ is thus a drastic understatement.
The table shows under Scenario No. 1 that at the end of five years cumulative earnings of $5.56 – 15% more than the bond’s cumulative earnings – will accrue as dividends, retained earnings or some combination to the owner of All Ords Ltd. By 2006 the asset’s earnings yield increases to 6.8% and its annualised compound return over the five years is also 6.8%. Under Scenario No. 2 cumulative earnings of $7.26 – 50% more than the bond’s cumulative earnings – accrue to the shareholder and by 2006 the earnings yield increases to 9.2%. Interestingly, however, even under these very ambitious assumptions the annualised compound return increases to ‘only’ 8.5%. Finally, in Scenario No. 3 cumulative earnings of $9.04 accrue to the shareholder and by 2006 the earnings yield increases to almost 12%. Again, however, even under these very ambitious assumptions the annualised compound return does not exceed 10%.
...continued in Part IV
 
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