Joseph Taylor: So, we're talking in early March with reporting season mostly in the rearview mirror now. What was your take on it as a whole?

Lochlan Halloway: Sure. Well, let's start with a little bit of context. So, the way we look at valuations at Morningstar is through our fair value estimate. Basically, this is a company level valuation, a long-term valuation. Our analysts, they look at a company, they look its industry, and they project out all its future cash flows. They discount them back to today, sum them together, and that is our long-term valuation or fair value estimate for a business.

When we look at that fair value estimate, it might not be the same as the market price. And we think generally, if you are buying businesses when they are trading for less than their intrinsic value, their fair value, you can probably do well as an investor. So, if we want to think, well, was this good or bad or an average earning season, what all you can do this is to say, well, how many companies do we upgrade and downgrade and leave fair value estimates for. In other words, do we think the ASX has more valuable business on it now than we did a month ago or not.

If I look at the numbers, fair value upgrades and downgrades, we upgraded about a third of companies we cover. We downgraded about 15% and about half we left unchanged. That's very similar to earning seasons over the past few years. The proportions are almost exactly the same. So, on that metric, you would say this was a fairly standard, fairly average reporting season.

Taylor: So the reporting season, in terms of company results and how our analysts see the companies performing as businesses (not necessarily as stocks) was quite vanilla?

Halloway: Absolutely. The fundamentals really didn't change that much. There were, obviously, outliers. We had some snow at the margins, some big downgrades, big upgrades, but overwhelmingly on average it was pretty standard and pretty in line with expectations.

Taylor: And then you contrast that to the market performance, and it was actually quite a weak February.

Halloway: Absolutely.

Taylor: What explains that?

Halloway: Yeah, sure. So, I mean, you're right to point out it was a weak February. On our sort of numbers, it was probably in the bottom 10% of reporting season monthly returns to the ASX in the last 20 years. So, that's quite sharp, quite unusual. And when we say, well, this was actually fairly vanilla by the fundamentals, you would have grounds to question why was that the case.

So, it's probably, at least in our opinion, to do with expectations, what the market had baked in, what it had priced in to stock prices coming into reporting season. We've seen a couple of years now very strong equity market returns, both here and in the U.S. Without, in our opinion, really material changes in the fundamental picture, the broader economic outlook. And so, we have to question more why is that the case. We spoke a few months ago and we said that the ASX in general was trading at a fairly steep premium to fair value in aggregate. It was something like 20% premium, a lot of that was to do with expensive large caps, I should point out who have an outsized influence in a market weighted index. There are still many opportunities we saw amongst the small caps, but the large caps did look expensive. Part of the reason was because they've run so hard over the past couple of years. And when you have that mismatch between what's priced in expectations and what is delivered, even if it's fairly average, if you've priced something to perfection, well, you're going to be disappointed. And that's what we saw across the market, broadly speaking, in February.

Taylor: Were there any sectors where this kind of played out?

Halloway: Yeah, sure. I mean, there was some interesting ones here. There were few consumer stocks that I'd call out that were particularly poorly treated by the market, so to speak. JB Hi-Fi comes to mind that was a stock that we thought had really performed quite well over the latter part of 2024 it had taken a lot of share, it had sales growth in Australia of 7%, which in a tough consumer environment, I think is quite impressive. We upgraded the stock in terms of our valuation for the business, but the market sold it off almost 10% on the day.

So, when you're trying to reconcile that, I mean, JB Hi-Fi had run really hard into earning season, it share price had probably just priced for too much. So, even to us, what was a fairly solid result was interpreted as bad news by the market. And probably Guzman y Gomez was another victim of that expectation, lofty expectations. Again, a double digit falls in the days after reporting, despite the fact it had 12% like for like sales growth, that's trading up to date, which again is pretty phenomenal in such a tough consumer environment.

So, they are the two kind of ex-emblematic examples of how much was probably baked in to share prices coming into reporting season and the fact that it failed to live up to those resulted in, in what we saw in terms of stock price volatility.

Taylor: Were there any sectors or industries where that dynamic was kind of flipped on its head and the opposite happened?

Halloway: Yeah, I mean, it's probably – it was kind of interesting to see when we look at share price performance or sector performance last year versus what's happened in the early parts of this year. It's not quite, but it's almost like a mirror image in terms of companies in the tech sector ran really hard, it was our strongest performing sector on the ASX last year.

We had a lot of banks, of course, which ran really, really hard. And those two sectors have been on kind of the laggards coming into this year, probably again, reflecting that what's baked in versus what actually materialized.

One of these ideas that a lot of the great value investors like Ben Graham or Howard Marks talk about is this concept that, you know, as stock prices run up, there's more risk baked into it at that point, things become riskier, more has to go right as share prices run up and you're more likely to be disappointed. Conversely, when stock prices come down, less has to go right. And we're thinking about risk in terms of outperforming or losing money, it actually becomes less likely you're going to do that as long as the fundamentals haven't changed dramatically.

So, I think it's worth keeping that in mind. Basic materials had a really rough year last year, mainly because the iron ore miners. We're now seeing the risks and rewards there as broadly balanced for big companies like BHP and Rio having corrected a little bit since last year. So that would be a sector we'd say held up reasonably well. And also, for those two miners the copper earnings were quite a supportive part of the story this year against falling iron ore prices.

But yeah, generally speaking, it was those big high-flying sectors of last year that suffered some of the sharper corrections in Feb.

Taylor: So, we've really been talking a lot about value and the importance of valuation. Where do we sit today?

Halloway: Yeah. So, look, after that 4% odd correction we saw in Feb on the ASX and some modest upgrades on our fair value estimates. We see the market, the ASX aggregated about a 15% premium, which is still what we call overvalued territory.

Once again, I'd reiterate though that this is not uniformly overvalued. And we look down the spectrum in terms of size across the ASX. There are many undervalued opportunities we see outside the ASX 20 more than usual as a proportion of our total coverage is trading in undervalued territory. So that's still a good thing for investors on the ASX, but the large caps still generally look expensive.

It's not unprecedented territory in terms of valuations. We saw stocks relative to our estimates at a steeper premium in sort of 2021 and late 2020 when we came out of COVID and we had all the loose monetary policy and fiscal stimulus, which pushed those sort of frothy highs we saw in that period. So, we have in that sense been here before, we'd still characterize in general as overvalued, but less so than before February.

Taylor: So, overstretched, but not really as frothy as we've seen before.

Halloway: I think that's probably fair.

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