Buyer beware: high valuations based on unrealistic growth hopes

There can be little doubt in any professional fund manager’s mind that prices for many companies listed on major developed exchanges around the world can only be justified by assuming rates of growth that few companies have ever sustained.

In many cases the anchor of conventional metrics has been cast aside by the mostly unrealistic expectations associated with the now almost cliched themes of an ageing population or a booming Chinese consumer, or the infinite margins associated with a globally-scalable technology platform.

In every boom, a dominant theme emerges that provides the scope for valuations to disengage with reality. This current boom is no different. And history has proven, time and time again, that only a few companies succeed in the way that investors appear to hope all their holdings will. Indeed, even globally, few companies achieve the sort of growth rates that are currently being implied by the prices of so many Australian companies.

Take a look at the market capitalisations of some of Australia’s listed businesses whose share prices have rallied on the back of hopes of global domination; A2 Milk, Afterpay Touch, Xero, Wisetech Global, Altium and Appen have an aggregate market capitalisation of $31 billion, combined revenue of less than $2 billion and combined net profits of just $240 million. Of that profit A2M is responsible for $185 million and Xero and Afterpay Touch are losing money. I should add that a quarter of consumer ‘factoring’ company Afterpay’s revenues come from late fees which jumped over 364 per cent in 2018.  

Even the large caps aren’t immune to a bout of optimism. An analyst from the UK-listed wealth manager Schroders recently revealed their consternation by breaking down the price of CSL – a company whose shares we also sold a long time ago, after concluding it was overpriced (it has since almost doubled).  The analyst noted that if the assumptions are made that 1) CSL’s current product portfolio is mature (of course it isn’t), 2) the product pricing is fair (it can probably rise), and 3) they’d be willing to accept an 8 per cent return and therefore pay 12.5 times for CSL’s business, then they’d be prepared to pay $37.5 billion for the company’s $3 billion of operating earnings.   

The market obviously disagrees with that valuation at the moment because every other owner is willing to pay $107.5 billion (even holding it at these prices an owner is implying they’re willing to buy it here).

In other words, the market is willing to pay $70 billion above a conservative valuation, for the next phase of growth. And even though the company already dominates its markets – China is the next frontier - investors are willing to effectively pay, today, the full price of two more CSLs to be created in the future. That really is the definition of hoping the company can grow into its price.

Investors should be cautious when such hope is built into prices because it is much harder for a company to execute on its business strategy, and it takes much longer to do so, than it is for hopes to be reflected in share prices.

If the Schroders analyst had applied the same metrics to miner Rio Tinto’s operating profits, the same 12.5x multiple they applied to CSL (remembering there was an implied $70 billion being paid for blue sky), the Rio Tinto valuation could allow for operating profits to halve.  Alternatively, a margin of safety of about $100 billion opens up between the current price and the valuation.  But investors would have to get pretty excited and treat RIO the way they are treating CSL for that margin of safety to close.

While you may not be compelled to buy RIO, the point we and others are making is that you should be very cautious about buying CSL at these prices. And the same goes for Appen, Wisetech, Afterpay and friends.    

We painted a pretty dim picture of the prospects for Kogan investors earlier in the year. At the time the shares were trading above $9.00. Today those same shares trade at around $5.35. While we do not believe Kogan is in the same universe as CSL, we do believe investors are justifying their investments on an equally irrational basis – paying a very high price for growth that is yet to materialise or a rate of growth that may be unprecedented.

While market highs continue to be broken and elevated valuations persist we are sounding likely the canary in the coal mine – annoyingly chirping away.  

Popularity wins in the short-run. But in the long run the market cannot help but reflect the actual, rather than hoped-for, performance of the business.