Finding value in a fairly-valued world

We've had a wild ride in Australian equities over the past couple of months, and after a 5% fall in the S&P/ASX-200 since the start of the year, the market is starting to offer better value for long-term investors. While the average price to fair value estimate ratio in our coverage of nearly 200 listed companies in Australia is 1.07, the median stock is now fairly valued, a sharp correction from a median ratio of 1.05 at the start of the year, and 1.03 in mid-2017.

What's changed in our thinking? Not much. The main cause of improved price to valuation ratios is that the Australian market simply hasn't performed very well. This explains most of the difference between the start of the year and our current bottom-up market view. Looking back a bit further, the change since mid-2017 was also a function of rising fair value estimates, but this highlights an important facet of our process. Our fair value estimates typically rise over time--after all, stocks should generate returns for investors to compensate for their risk. All else equal, our valuations should move up annually at roughly the cost of equity, or the required rate of return we should demand as investors, less any dividend yield paid out. We assume this required rate of return is 9% per year, including dividends, for a stock of average risk.

Compared to the mid-point of last year, our fair value estimates, before dividend payments, should be roughly 7% higher (9 months of a full year of 9% required rate of return). It should come as no surprise, then, that the 4% return in the S&P/ASX 200 Acummulation Index since 30th June 2017, on top of the 3% overvaluation we saw at the time, has led to stocks being fairly valued at the median.

Another way of putting this: a price/fair value estimate ratio of 1.0 doesn't mean that we expect the market to stay flat. Rather it means that we see the market as fairly pricing in risk and future expectations; it's truly trading at a fair value. We expect investors will experience a total return over the next three years of about 9% annually at this valuation.

So, at 1.0 median price/fair value estimate, is it time to back up the truck? Not quite. While we see roughly the same number of undervalued and overvalued stocks, the substantially higher average (rather than median) price/fair value estimate suggests that the stocks we view as overvalued look really overvalued--some stocks are trading at more than two times our valuations, for instance. We think it's better to look for undervalued opportunities with sizeable margins of safety, of which there are several.

Our monthly best ideas list (on page 4 of this week's issue) highlights our top picks for long-term investment. Beyond our monthly best ideas list, there are always a handful of names trading below fair value that didn't quite make the cut but are worth keeping on your watch list should the market present an even more-compelling opportunity.

Death and Taxes

One such undervalued name is Invocare, a wide-moat stock trading in 4-star territory. The funeral services industry is fundamentally attractive, with resilient long-term demand, while InvoCare's strong brand and market position give it pricing power that should generate strong returns on invested capital over the long run.

Adam Fleck is Morningstar's regional director of equity research for Australia and New Zealand. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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