We are seemingly in an environment of heightened anxiety, with many investors jumping at every Presidential tweet or Royal Commission headline.
A consequence of this anxiety in the Australian market is the ‘big squeeze’ observed into Industrial companies and, in particular, into ‘offshore earners’. The concentration of the Australian benchmark has been well documented and with banks (25% of the ASX 200 by market cap) considered by many to be ‘toxic’, REITs ‘structurally troubled’ (8%), Resources ‘at the top of cycle’ (20%), it’s become clear that Industrials (40%) are increasingly perceived to be ‘safe havens’.
Unfortunately, by limiting/avoiding regulatory or earnings risk many investors are unwittingly loading up on valuation risk! Two key points:
Firstly, Industrials valuations are approaching all-time highs (refer first chart below):
- The sector trades on a 12-month forward P/E multiple of just over 20-times, or 30% above the 15-year median of approximately 15-times; and
- Certain sub-sectors appear stretched, including Health Care (P/E of 29-times is a 39% premium to its 15-year average) and Consumer Staples (P/E of 21-times is a 26% premium).
Secondly, margins for Industrials are already at all-time highs (refer second chart below):
- Cost reduction initiatives over recent years have driven EBIT margins above 20% – a record high and double the 20-year median of 10%; and
- Margins face pressure from the clear, albeit early, signs of returning inflation (e.g. wage levels, transport costs, interest rates etc).
With Industrials now at a 30% premium to long-term averages, this ‘safe haven’ euphoria (or complacency) might well prove misplaced since for some companies, profitability has likely peaked. Time will tell whether companies like CSL (33-times P/E), Cochlear (40-times) and Woolworths (21-times) prove to be riskier than an out-of-favour (but stable and well capitalised) banking sector (12-times).
Yarra is underweight Industrials with a skew towards the more out-of-favour sub-sectors such as Telecoms (owning TPG and Vocus) and ‘old fashioned’ retailers (JB Hi-Fi, Super Retail Group and Kathmandu).
All data points at 30 June 2018 unless otherwise noted.