The surge in some ASX valuations reflect a "monkey see, monkey do" environment: Lazard's Hofflin

A quick squiz at two basic charts tells you that this year was a story for price appreciation. The trailing price-to-earnings ratio of the All Ordinaries index continues to climb - now at a smidge under 30x.

...and yet, both the aggregate earnings and dividend yield of this index is in the throws of a cyclical but meaningful decline. The earnings yield of the All Ordinaries is now at just 3.5% while the dividend yield has fallen by more than 1.5% from its March 2020 peak to where it is today. 

This "dramatic high-multiple inflation", as Dr Philipp Hofflin, Portfolio Manager/Analyst on the Australian Equity team at Lazard Asset Management describes it, is a reflection of a "monkey see, monkey do" sentiment in financial markets. Put another way, there has been a lot more following the herd than investing rationally this year.

But Hofflin also adds that the market's current setup is one that may bode well for deep value investors like them in the new year. 

"The good news for value investors like us is that the market is once more set up for great relative returns, as it was in early 2021 and early 2000, but these may well happen in a backdrop of negative absolute returns," says Hofflin.

In this edition of Livewire's famous Rapid Fire series, Dr Hofflin sits down with us to discuss where he sees stretched valuations in the market today, what is being overlooked by the market, and how the role of emotions in investing has changed over Hofflin's near-30 years in the business. Plus, we'll get the Doctor's favourite picks in four of his favourite sectors. 

What is one area of the market you think investors are overestimating the upside of? Are you avoiding any stocks or sectors as a result of this?

Hofflin: There are two areas of the market – together over 40% of the ASX – there this applies in spades, so the answer is “yes”. The first is the banks and the second are the high-multiple stocks, so let me talk about this second group.

If you rank all the ASX 200 stocks by their forward P/E multiples, you can group them into quintiles and if you do so, you find that something very unusual has happened over the last year odd. 

The group with the highest forward P/Es have had their multiples rise by close to 50% since last October, and the typical multiple for these 40 stocks is now at over 50x forward! 

Only at the dot.com bubble peak in March 2000 and at the peak of the COVID bubble in 2021 did we get to such extreme multiples for this group – and in each case there was a painful reckoning over the next two to three years.

Now this dramatic high-multiple inflation has been inspired by the US AI and Magnificent-7 boom, of course. But paying more and more for a dollar of earnings due to an unrelated boom in another country – we have no AI stocks or Magnificent 7's – is not a sustainable way of making money! It’s “more monkey see, monkey do” than rational finance theory.

Which opportunities do you think investors have overlooked in the current market and can you share some examples of how you have invested in these?

Hofflin: Given the strong gains in the general insurance sector, we now see the energy sector as the most undervalued opportunity. We see Woodside (ASX: WDS) as the best opportunity in this sector and it is one of our largest positions.

The share price is still about 30% below the pre-COVID levels and down 35% from a year ago odd ... and all that with the Asian gas price at US$15/mbtu! It trades on an about 15% FCF [free cash flow] yield, although it does have growth investment commitments, of course.

Since the GFC, WDS has traded on the same EV/EBITDA multiple as the S&P 500 Energy index – if that were the case today, WDS’s share price would be $42/share - or 70% higher. The sell-down of Louisiana LNG, expected sometime in the first half of 2025, may be the catalyst to reduce the deep discount Woodside is on.

There’s been a lot of talk about stretched bank valuations. 

Commonwealth Bank is one of the top five holdings in the Australian equity portfolio – but you are also underweight financials from a sector perspective. What are your thoughts on bank valuations and the financials sector and what would lead you to sell Commonwealth Bank?

Hofflin: We hold CBA only in those funds where we have to and in those we are at maximum underweight. In contrast, in our Select fund, we have zero CBA. 

We see CBA is being extremely expensively priced. We now have a quarter century of second year forward P/E data for CommBank and over that period CBA has traded at an average 13.5x
P/E. In fact, prior to 2015, CBA had never traded on even a 16x forward P/E. Four years ago during COVID, CBA first traded on 18x. At the 2021 bubble peak, it reached 20x for the first time ever. In April this year, it was 22x. In July, it was 24x. And in November, it went to over 26x. It’s been multiple inflation on steroids this year!

Now, is this massive multiple inflation due to great EPS growth over recent years that has convinced investors that they should pay more for CBA? No, it's quite the reverse. 

Prior to 2017, CBA’s EPS had risen by an average 6-7% pa for 20 years and so had its share price. This makes sense. But since September 2017, when CBA was at $75/share, CBA’s EPS has been basically flat while its P/E has risen by about 10.5% per annum. So, all the gains since then, from $75 to almost $160 have been multiple-oriented! 

CommBank used to grow its EPS, but over the last seven years the only thing that has grown is the multiple, at ever faster rates! Let me repeat, P/E inflation is not a sustainable way to make money.

CBA is literally the most expensive bank out of over 300 listed globally. Amazingly enough, it now trades at a P/E premium to CSL!

Over your investment journey, do you think emotional investing has increased, decreased or stayed the same? Has this required you to adjust your process or timeframes at all?

Hofflin: The last six years have been extraordinary in terms of style volatility! In 2018, we were nine years into a bull market and after the Fed cut, we started to get the first signs of froth in the US over 2019. Then, COVID hit and rates were cut to zero everywhere and Western money supply rose by 30-40% in a year and we got the “Everything Bubble”. 

That bubble started to deflate from late 2021 and by October last year the market had significantly normalised. But since then, the US has inspired an echo boom, which – amazingly enough – has got us right back to past peaks of excess in just 13 short months. So, investor sentiment and style returns have been on a rollercoaster. The best comparison may be with the late 1960 into early 1970s, which also saw a long bull market end in inflation-driven ups and downs. No signs over the last few years of markets becoming more rational!

The good news for value investors like us is that the market is once more set up for great relative returns, as it was in early 2021 and early 2000, but these may well happen in a backdrop of negative absolute returns.

You hold overweight exposures to Industrials, Consumer Discretionary, Energy and Consumer Staples. Can you discuss why?

Hofflin: For us its always about valuation – we don’t speculate. I already mentioned that energy is absolutely attractive. In Addition, we hold various industrials across various sectors, each with their own investment thesis. 

These range from reasonably priced staples stocks like Metcash (ASX: MTS) and Coles (ASX: COL) to some more exciting opportunities like Domino’s Pizza (ASX: DMP), which we bought into this year after this former darling had fallen over 75%. At its peak, it was $160 a share in 2021, it was on 50x forward earnings and had big earnings expectations. But at $33 today, it is now on a reasonable multiple on achievable expectations.

We are underweight resources, but do own small positions in two higher risk/higher return stocks in the commodities that have been hit hardest.

IGO (ASX: IGO) in lithium and Nickel Industries (ASX: NIC) in nickel. Both are differentiated from their peers, as IGO has the lowest costs by far in Australia and Nickel Industries operates in Indonesia and is thus part of the disrupters, not the local disrupted. We think that Nickel Industries has significant upside.

Finally - If you had to, what marketing slogan would you give your fund?

Hofflin: Imagine you are at a great party and the alcohol is flowing and it’s getting a bit wild. Everyone’s enjoying it, but all parties end, of course. We are the guys to whom you throw the car keys to get home safely!