90% of stocks are fairly priced.
At least, that’s what some buy-side analysts think.
Retired hedge fund manager Brett Caughran — who now runs Fundamental Edge — frequently points out 90% of stocks are ‘somewhat fairly priced’.
But he didn’t take this as bad news.
Because, at ‘nearly all times, at least 10% of stocks are meaningfully mispriced’.
The smart money chases those exceptions.
That’s where the alpha lies…
But how much of this is true?
Are markets really that efficient?
What if we take five stocks at random from the ASX 200 and value them? Will the valuations be similar to the market’s?
That’s what I sought to find out today.
But first, a detour about the efficient market hypothesis.
Is the efficient market hypothesis true?
Many corners of the market deride the efficient market hypothesis.
Any irrational exuberance is snidely brought forward as refuting evidence.
Tulips, housing, the internet — bubbles are mentioned as clear rebuttals to market efficiency.
But the theory isn’t so strong — or silly — as to actually claim all stock prices are ‘correct’.
No. The theory only posits that stocks mostly reflect all available information.
The market is a sponge that quickly absorbs news, updates, releases, financial statements and their implications.
Further, the theory argues that stock prices reflect all available information up to a point.
As an RBA research paper explained:
‘For one thing, this is a strong version of the hypothesis that could only be literally true if “all available information” was costless to obtain. If information was instead costly, there must be a financial incentive to obtain it. But there would not be a financial incentive if the information was already “fully reflected” in asset prices. A weaker, but economically more realistic, version of the hypothesis is therefore that prices reflect information up to the point where the marginal benefits of acting on the information (the expected profits to be made) do not exceed the marginal costs of collecting it.’
Even Eugene Fama — who won a Nobel Prize for his advancement of the efficient market hypothesis — said this many years ago about security analysis:
‘If there are many analysts who are pretty good at this sort of thing…they help narrow discrepancies between actual prices and intrinsic values and cause actual prices, on the average, to adjust “instantaneously” to changes in intrinsic values…
‘Although the returns to these sophisticated analysts may be quite high, they establish a market in which fundamental analysis is a fairly useless procedure both for the average analyst and the average investor.’
Clearly, Fama’s final message in the preceding quote riles many investors up.
We can’t all be exceptional. Chances are, we are part of the average. Does that mean our attempts at security analysis are ‘fairly useless’?
Should we really just lay down the laptops, close the spreadsheets, and buy index funds?
Let’s run an experiment to find out.
Are ASX stocks mostly fairly priced?
Let’s pick five stocks from the ASX 200 at random and see if they are fairly priced.
I asked Number Generator to spit out five numbers between 1 and 200. It outputted 38, 126, 10, 162, and 120.
Using Monday’s close, those numbers correspond with the following ASX 200 stocks by descending market capitalisation:
- Reece [ASX:REH]
- Stanmore Resources [ASX:SMR]
- Wesfarmers [ASX:WES]
- Contact Energy [ASX:CEN]
- A2 Milk [ASX:A2M]
Reece
Let’s value Reece first.
Reece is a $12 billion plumbing and bathroom supplies business, established in 1920.
It’s an ASX stalwart.
Does its long presence on the ASX mean it trades at a fair value?
Using an 8% discount rate (which I will use for all stocks) and FY24 consensus estimates, I get an intrinsic value estimate of about $7.50 a share.
Reece last traded at $18.70 a share.
That’s…a massive mispricing right off the bat.
Consensus estimates pin Reece’s FY24 ROE at 9.3%. But at its current price, it’s trading at an implied ROE of about 16%.
According to Market Index, Reece hasn’t hit a ROE that high since 2017.
What if we use the dividend discount model? Will we get the same valuation?
Pretty close, at $8.52 a share.
Both methods suggest Reece is grossly overvalued.
Stanmore Resources
Stanmore is a coal producer with a market cap of about $3 billion.
Is it fairly priced?
Not according to the valuation model. But that’s because the model relies on steady ROE and dividend payout figures.
Stanmore Resources is highly cyclical and has oscillated between losses with no dividends to windfalls and juicy payouts.
It is hard to value a company like that. Its ROE forecasts and dividend payouts are unsteady.
For instance, despite a massive 1H23 profit of US$340 million and operating cash flows of nearly US$400 million, Stanmore decided not to pay an interim dividend.
That’s because the company is highly geared at the moment and wants to use the cash to ‘support significant deleveraging’ at a time of ‘softening commodity markets’.
These windfall profits and suspended dividends inflate Stanmore’s ROE.
In that case, you could argue the market’s current estimate is pretty reasonable.
Wesfarmers
Wesfarmers is a $61 billion retail conglomerate, operating in supermarkets, department stores, home improvement, outdoor living and even building materials.
Wesfarmers’ businesses include Bunnings, K-Mart, and Officeworks.
Will it give us more valuation trouble?
Using FY24 consensus estimates and an 8% discount rate, we get a value estimate of $38 a share.
Wesfarmers last closed at $53.23 a share.
Hm.
Maybe the market isn’t so efficient after all.
At its current price, the market is inferring a FY24 ROE of about 37% on a discount rate of 8%.
Yes, Wesfarmers is a great business with high profitability. But its payout ratio is 85%. Most of its profits are not reinvested into the business for compounding growth.
Is its P/E ratio of 25 a bit too steep given the low reinvestment?
However, if you assume a discount rate of 6%, you pretty much get the exact current valuation.
Given Wesfarmers’ strength and predictability, is the lower discount rate an efficient appraisal by the market?
Contact Energy
Contact Energy is a $2 billion New Zealand energy firm owning a range of power generation assets.
Is it fairly priced?
Not really.
The 8% discount rate and FY24 consensus estimates yield a valuation of NZ$6 a share.
Contact Energy last closed at NZ$8.20 a share.
Finally, will A2 Milk offer some efficiency?
A2 Milk
A2M is an infant formula producer that was once a retail favourite but has hit hard times of late.
Is the market now valuing it fairly?
Since A2 Milk is forecasted to pay dividends from FY25, let’s use consensus estimates for that year.
Using a discount rate of 8%, our valuation model appraises A2 Milk at NZ$5.08 a share.
The firm last traded at NZ$4.80 a share.
Finally! Some market efficiency in action!
Clearly, there are discrepancies between valuations and current prices.
Note, however, that none of the stocks were undervalued by the model.
Bargains are hard to find.
And that’s the gist of the efficient market hypothesis, isn’t it?
There are no easy pickings.
Until next time!
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Kiryll Prakapenka,
Editor, Money Morning
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