Strap or cane?
My boys’ high school was one of the last in the country to end corporal punishment. That wasn’t so long ago. Mid-1990s, I guess.
As the fear of ‘going to see the head’ receded, there was a noticeable change. Classes that had been silent became rowdy.
A thin line of confidence in absolute authority started to crumble.
Confidence in any system is built on sentiment. The way most people feel about something. Are they fearful of being on the outside? Being punished for the wrong action — or not taking action?
If you’ve been around markets long enough, you’ll know that’s how prices work. There’s fear and greed. But underpinning most prices is a thin line of confidence.
Stocks and shares
Publicly listed businesses can be valued more readily than many people realise. The most common consideration is P/E — price-to-earnings.
This mirrors how you might buy a smaller business from its owners.
The share price reflects a multiple that you’re paying to buy earnings.
Take a look at retailer Briscoes Group [NZX:BGP]. At time of writing, its P/E sits around 17.
What does this mean?
Given last reported earnings, it would take you 17 years of banking those profits to pay back your purchase price for Briscoes.
Now, if you went to a local business broker and bought a small shop, you may only pay 2x or 3x earnings. 17x seems expensive!
But at 17x, you’re dealing with a large business with many stores. A stake in the market that is more difficult to compete with. And the possibility of earnings growth and ongoing dividends.
With your little shop at 2 or 3x times earnings, you would likely have to work in the business. During hard times, it could fall over. Or be robbed at knifepoint.
Whereas a large, publicly listed company might have some moat protecting it from competition. And the ability to raise more capital when needed.
Confidence in future earnings
So the question comes down to the premium the market is prepared to pay. If there’s confidence in the market and belief that a business will grow further, the P/E could shoot higher.
See, if you pay 17x today but revenue doubles next year, your initial P/E starts to drop over time.
Now, this is simplified. As analysts, we use many other factors to drill down to the real value of a company. Considering assets through measurements like price-to-book, for example. Or future value using discounted cashflow.
My point is that it’s hard to argue with a stream of earnings. If your confident a business can keep up — even increase its earnings — you can consider pricing confidence.
Sometimes the market gets overconfident. Looking back on 1987, where many P/E multiples hit 50 or 60 with no promise of earnings growth, you can start to unravel why there was a market crash.
In our Quantum Wealth Report, we undertake more detailed study of certain companies that could present real value advantage. Visit us there if you’d like specific detail.
What about property prices?
In June last year, I was shocked to hear of some classified documents released by the Reserve Bank of Australia under a Freedom of Information demand.
As reported by the ABC, certain RBA internal analysis suggested there could be a house price slump of up to 15%.
But more concerning within these documents was the discussion by Bank economists. That ‘the [Australian] housing market is dysfunctional — and potentially they should try to shut down data sources letting investors know.’
The thin line of confidence…
You see, if house prices did fall 15% — in Australasia, America, or anywhere else — that has serious repercussions for the financial sector. LTV (loan-to-value) ratios could explode. And previous sound mortgage books could look shaky.
As with shares, there are a few ways to value properties. But earnings are not pre-eminent. On most conventional measures, here in Auckland, there are resemblances of a 1987 crash scenario.
- Price-to-income multiples are near the top of the developed world.
- Debt-to-income multiples are also very high, especially for first-home buyers.
- Net yields on residential property appear very weak.
- The standard valuation measure is to compare ‘similar sales’, which is biased toward value preservation.
Stick with what you can value
But this surface analysis ignores something. There is a shortage of homes. And demand for a necessity like shelter is inelastic.
People will continue to stretch themselves financially or crowd in and reduce their living standard to take a piece of the action.
To keep up the shortage and pricing confidence, we continue with high rates of net migration and burdensome building costs.
This is market failure. The government should act. But the promises all sides have been making to first-home buyers for years continue to fall flat. Because they must preserve pricing confidence to protect the market, the banking system. And the mainstay of established voters.
It is a merry-go-round. And not much fun unless you’re already on the ride with a house or two.
At some point. the ride may break. Braver leadership will remove the straps and canes.
The confidence will go.
But the wise will be safe. They’ll stick with what they can value.
Editor, Wealth Morning