Update No. 58 – 04/05/12

I thought I would look this week at a comparison between a US listed stocks versus one on the Aussie exchange.  In my view, for reasons I can’t quite explain (I have some ideas, including the differences in interest rates & Australian pessimism due to Political issues), stocks in Australia appear to my judgement to be much cheaper than their US counterparts.  For example, the current P/E ratio for the S&P500 is 23.38x, this is up 7.84% from 21.68x on January 1, the S&P500, however, is up 12.3%, the difference between the 7.84% & the 12.3% is how much annual earnings have grown year to date.  The median for the S&P500 over the last 130 or so years is 15.82; this has the current measure at 47.8% above the median, so based on that, we could reasonably conclude the S&P500 is fully valued, to even a little expensive.  The current P/E ratio for the ASX200 is 12.81x, currently up 8.26% from 11.83x January 1, the ASX200 Total Return index, however is up 10.94% year to date, again, the difference is attributable to modest earnings growth.  The median P/E for the All Ordinaries index going back to 1875 is about 13.21, more modest I think because of the higher average dividend payout ratios in Australia (meaning US companies retain more earnings to compound their growth, thus commanding higher multiples).  In any case, the Australian index is priced a modest 3% below its (very) long-run average.  The market expectation implicit in these differing ratios suggests US corporations will grow their earnings at a significantly higher rate than their Australian counterparts for the foreseeable future.  It is not unreasonable that the US market trade at a higher multiple in my view, while the Fed keeps rates effectively at 0%, they leave investors little choice but equities, and as I stated earlier, US companies tend to payout lower yields leave more to reinvest.  The question is where the relative difference should lie, I can’t say, except that in my view when US P/E ratios are 82.5% (23.38/12.81) higher than their Aussie counterparts, there is probably more value in Australian equities at present.

Specifically though, I thought I would conduct a ‘death-match’ to establish relative value, to demonstrate to some extent the process I would go through if I were deciding between investments between alternative businesses.

I have mentioned previously that I am a fan of the Costco business model and that it might give Woolworths some trouble as it’s rolled out into Australia.  With that in mind, I thought I might compare valuations of the two grocer/retailers.  Costco, it must be noted has a substantially greater growth story than Woolworths, who must be considered a substantially more ‘mature’ business.  Though they are similarly sized in market capitalisation, the disparity in the growth story is to do with Costco’s more ‘unique’ business model, which they have lately been successfully rolling out internationally.  Woolworths has a more ‘traditional’ retail offering, which is unlikely to warrant international expansion, though it must be noted, they have brilliantly managed a country that is tricky logistically, due to sparse population & wide geographic spread.

10 years ago, Costco had $1.48 (EPS) and Woolworths $0.49.  Last financial year, Costco earned $3.30 and Woolworths $1.72.  So over the last 10 years, Costco averaged EPS growth of 8.35% per annum, Woolworths averaged 13.28%.  I am always extremely cautious about comparing 2 figures plucked out of a sequence and using that as a meaningful measure.  What I would ordinarily prefer to do is to average figures from a number of periods.  So, over the last 5 completed financial years, Costco earned $13.95 (EPS), Woolworths earned $7.26.  Over the 5 prior financial years, Costco earned $9.34, Woolworths earned $3.38. These comparisons show Woolworths grew EPS by 118% compared to 49.4% for Costco over these equivalent measurements. Using these values as the first & tenth year (for conservatism), we could say Costco has averaged about 4% EPS growth and Woolworths about 8%.  Any way you look at it, over the last 10 years, Woolworths has been the better performing business in terms of profit growth.  Part of this difference, it must be said can be attributed to Woolworths much ‘leaner’ balance sheet.  As a matter of habit, Costco own most of their stores, so they carry a lot of ‘property’ which impedes EPS growth in the short-term.  It does however prevent you from being beholden to a rapacious landlord.  You repeatedly hear ‘historic returns are no guarantee of future returns’, but I must admit, I usually give them a good bit of weight, because in my experience, they are usually a better guide than virtually any other.

Over the 10 year period examined, Costco’s shares on issue have shrunk by 4.63% whilst Woolworths have grown by 15.9%.  The key difference here are the much higher Australian dividend payout ratios, and Australians love of the dividend reinvestment plan (DRP).  Woolworths have paid out $7.34 in dividends, whilst Costco only returned $5.80 to shareholders. For Australian holders of Woolworths, it should be noted these dividends came with $3.15 in Franking Credits, which Australian Costco Holders did not receive, this Franking advantage should continue for the foreseeable future.

That is all in the past, we all understand that when you buy a share today, it is how the business is expected to perform into the future that matters.  Over the coming financial years, consensus analysts forecast EPS for Costco is $3.84 (FY12) & $4.34 (FY13) & $4.63 (FY14) and for Woolworths is $1.78 & $1.96 & $2.08 for the equivalent periods.

Using the same valuation method I use for my normal stock purchasing decisions, I derive a valuation for Costco of about $57 per share and for Woolworths about $26.50 per share.  I use a discounted cashflow method to derive this figure and because of Costco’s superior growth prospects I attribute a terminal PE value of 16x to Costco, compared with the very conservative 12x I use for Woolworths.

At the time of writing, Woolworths shares are almost exactly matching my valuation at $26.42.  Costco, however are priced at $86.64, which is about a 50% premium to my valuation.

So given the information above, what is our decision?  Well, this is where it gets tricky.  I believe Costco has a stronger franchise and will continue to grow earnings for many, many years to come at a rate which should materially exceed any growth Woolworths achieve.  Given that neither are below my valuation sufficiently to warrant a purchase, my first instinct is, buy neither.

The valuation quandary is this though, if I were buying with a 3 – 7 year horizon at current prices, given the substantial difference between how close they are to my assessed ‘intrinsic value’, I would have to choose Woolworths.  Given any sort of economic downside, or troublesome economies, there is substantially less downside risk in Woolworths valuation in my view.

That said, if I were told I had to buy one of these two stocks for my son for his 20^th birthday (which was this weekend 5^th May) and put it in the drawer so that he could open the drawer only on his 40^th birthday, I would probably select Costco for the superior franchise.  This is the quandary the stock-picker invariably finds themselves in, the truly outstanding franchises are rarely priced at a price which make them really compelling in the short term, which makes lesser businesses appear more attractive – Tony Hansen 04/05/12.

EGP Fund No. 1 Pty Ltd. Up by 6.64%, lagging the benchmark by 3.29% since January 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 2.65%, leading the benchmark by 7.42% all-time (April 1^st 2011).