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[1] 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).
1 Bloomberg
All data points at 30 June 2018 unless otherwise noted.