Interest Rates and PE Ratios
Over the last decade we have been living in a financial age that is unlike any experienced previously. Although the GFC was more than 10 years ago, financial markets in many ways are still feeling the impact of this event.
Quantitative Easing, Low and in some cases, Negative Interest Rates (it could be argued that after inflation and taxes Australia currently has negative saving rates in real terms) are still affecting markets to this day. The most simple explanation for this is that when fundamentally valuing an asset one of the key measures is the Risk Free Rate. The Risk Free Rate is typically a Government Bond (Governments are viewed as being almost certain not to default on this debt). Now when the interest rates of these bonds are worth less, generally growth assets like Property and Equities (also known as Shares or Stocks) tend to increase in value. The inverse is also true. When you are able to achieve a 5% return with no risk, you are not very likely to invest in an asset that will fluctuate in value but is expected to return 8%. However, if you are only able to achieve a return of 2% with no risk, that 8% becomes a lot more appealing.
Although interest rates are not anticipated to rise locally in the near future, it important to remember that in an interlocked global financial system any changes to market conditions can result in far reaching consequences across the planet.
At the moment these potential global catalysts for change include; the uncertainty regarding Brexit and the ongoing trade talks between the US and China. Domestically risks consists of the outcome of the Federal Election causing policy change, the continuing cooling of the property market and slowing credit growth.
In equity markets we historically see low interest rates and bond yields as being a good a catalyst to invest in growth assets. One of the primary reasons for this is that when borrowing costs for companies decrease they are able to improve cash flows, pay down debt faster, invest in new technology/products and hopefully return greater value to shareholders. What we have seen in recent years has been increased investment away from your traditional value based businesses (think Financials, Miners and Energy) and increased investment in high growth based businesses (Technology).
Following the GFC we have seen over $4,500,000,000,000 (four and a half Trillion dollars) flow into financial markets via Quantitative Easing with the goal of calming financial conditions and encouraging lending growth.
In this environment companies that have the potential to achieve high future growth and returns have performed very well. Investments in companies like Afterpay, A2M and Xero have performed outstandingly over time. Similarly to the Tech bubble we have seen high valuations and by many fundamental valuation metrics expenses prices.
For example, it is obvious to see that technology has changed and will continue to change the way we live our lives. However, along the public challenges that technology companies are facing such as user data privacy breaches, there is are more concerning issues for many technology based businesses. The historical Price to Earnings (PE) Ratio of Stocks on the All Ordinaries is about 15 times earnings from 1980. This number will vary across business cycles and companies but has ranged from a low of 7.80 to a high of 23.29 in this time period.
As you can see from the charts above, typically periods where the PE ratio becomes high are followed by a period where performance is negative and low PE Ratios are typically followed by a period of high returns. In 2008 PE ratios hit a low of 8.19 and in 2009 performance was 39.6%
However, currently many popular growth investments are trading at above 40 times earnings or some cases do not have a PE ratio at all.
This means that investors are expecting this company to growth quickly and continuously, A2M is the perfect example with a current PE of 41. In comparison Afterpay and Xero are running at loss and despite having a combined market value of over $10 Billion these companies don't have a PE. Often during times of uncertainty it is the more speculative and growth orientated businesses that see the biggest declines to their share prices.
If you have invested in these types of new and innovative companies it is important to understand that with rapid ascents comes the potential for substantial losses during market pull backs. While it may be noted many investments may be expensive there still exists many investment opportunities for the astute investor.
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