Don’t follow the herd into the market abyss

The sharemarket has been on a wild ride for the past 19 months, from highs to lows and back again on the back of a medley of concerns from bulls and bears.

These day-to-day fears take in the possibility of uncontrollable inflation, imminent recession, breakdown of global trade, and of course,
let’s not forget the ongoing effects of the pandemic and the ever-present possibility of wars.

As an equity investor, the sharemarket can feel like a rollercoaster when every one of those fears is magnified through share prices. Despite being an investor for close to two decades, I still find myself wondering – has it always been like this?

The answer is yes. The sharemarket largely reflects company earnings and investor mood. Rationally, company earnings should determine the share price but sometimes investor mood can collectively overshadow any company’s performance. This leads to opportunities for astute investors who focus on the companies rather than their behavioural biases.

Take BHP as an example. Its share price has come off close to 40 per cent from the fear of the contagion effect of Evergrande on China’s economy, along with weak iron ore prices. On the surface, however, taking a look at BHP’s earnings split, iron ore contributes less than 40 per cent of BHP’s revenue in FY22. This tells you that iron ore prices will have some impact on earnings, but not as much as 40 per cent.

What is not talked about is that close to 10 per cent of BHP’s revenue is from its energy asset, which is due to be folded into the new Woodside. The global shortages of energy have sent energy prices skyrocketing and energy majors, such as Woodside, have outperformed substantially, by a margin of more than 50 per cent during the same period.

As a rational investor, we don’t believe such price discrepancy is likely to be sustained.

Star Entertainment is another company that has seen extreme share price movement recently, down close to 30 per cent at one point. Before the company even had a chance to respond to the media reports, a clear “shoot first and ask questions later” mentality took hold with investors.

Clearly, these are serious allegations, but a fall of 30 per cent would send the share price lower than its book value of over $3.80, which in our opinion was too much. Particularly at a time when its earnings are on the cusp of recovering sharply and its other reopening peers are all trading at pre-COVID-19 highs.

Another name we like to bring up here is one of our all-time favourites, a2 Milk. Its share price has been under significant pressure over the past 12 months, as border closures presented significant challenges for big parts of a2’s product distribution channel, the daigou.

At the same time, early pandemic panic pantry-stocking by Chinese mothers led to too much inventory sitting in people’s houses that needed to be cleared – a curse for a premium consumer goods company. A2 Milk’s share price fell more than 60 per cent since its full-year result in August 2020. For most investors, it was too hard to see past the current year’s earnings.

This is despite many of these disruptions being temporary and incrementally positive news on improving conditions over the past four months. As a premium branded business, over the past decade, a2 has captured the hearts and minds of Asian consumers. Its English-label and Chinese-label products are highly sought after hence why, when the pandemic first hit, Chinese mothers stocked up as much infant formula as they could find on the shelves.

A2 also has a very strong balance sheet, with a net cash position of $720 million.

These are just some examples of companies that have been mispriced when investors succumb to their behavioural biases. Be contrarian and don’t let another salesperson tell you that buying Wesfarmers is a reopening trade.

There are plenty of investment opportunities, investors just need to be discerning.

 

The article was originally published by The AFR.

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