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"At what price would you buy more CSL @madamswer?"

With this sort of question, the answer - as frustrating as it is - is "It depends."

In summary:

1. CSL is currently cheap - somewhat, but not very - compared to risk-free assets, including cash.

2. CSL is expensive compared to other stocks, especially small cap stocks.


Supporting explanation follows in the remainder of this post, but if the detail is unimportant, you can stop reading now.


"It Depends"

Investing is a capital allocation decision so the overarching thing on which it depends is on what alternatives exist at any given point in time.

And on that score there are two very fundamental changes that have occurred over the past several years which, in my mind, have meaningfully impacted the way CSL is viewed as an investment:

1. Dramatic fall ("collapse" would not exaggerate it) in the cost of capital, globally

2. Structural change in the composition of the Australian equity market


Stepping through the thinking around these changes, and starting with the first one, the reduction in the cost of capital:

Consider the vanilla P/E multiple precedent.

The secular upward re-rating of CSL's P/E multiple is well-known and widely-discussed.

For most of CSL's listed life, the stock was a high-teen to 20x P/E stock.

Then, about 5 or 6 years ago, the market started to happily pay more than 20x; and, in more recent tears, more than 30x, culminating in the unprecedented of 50x around 4 months ago, coinciding with the Covid-induced market collapse in March (the red column):



The current P/E multiple is ~40x (the blue column), give or take a few points either way.

One might look at that chart and conclude that, even after its fall in recent months, the stock still looks heavily overvalued compared to its history.

The trouble with that simplification is that it overlooks the seminal collapse in bond yields (people make reference to it from time to time, but I don't believe people really fully appreciate just how severe that fall has been and what implications it has had for the way all asset classes are valued today):




The implications of this bond yield collapse on valuations of growth assets such as CSL have been two-fold:

1. It has lowered the rate at which future cash flows get discounted into present value terms (and the faster the growth rate, the larger future cash flows are; therefore the present values of growth companies get increased disproportionately by lowering of discount rates)
[But this is an entire subject of its own, so let's leave it there for the sake of brevity.]

2. It makes other asset classes relatively more attractive to bonds (as proxies for risk-free assets). In CSL's case, as CSL's P/E multiple has risen sharply, its Earnings Yield (inverse of the P/E) has declined with commensurate sharpness.


But that fall in CSL's Earnings Yield has not been as dramatic as the fall in bond yields, which means that when comparing the difference between CSL's Earnings Yield and the yield currently on offer from bonds, the stock suddenly doesn't look at all expensive any more, in the context of history:



The light blue shaded area, i.e., a range in which CSL's EY is around 100 (+/- 25) basis points appears to be the fair value range based on history, in that, had one bought the stock above that level in the past (i.e., an EY spread over Bond Yield > 125bp), the investment returns from investing in CSL exceeded the returns you would have made investing in bonds. And vice versa, for the Yield Spread below, say 75bp.

So, with CSL's EY currently around 160bp higher than the yield on the benchmark bond, compared to risk-free assets, CSL looks to be cheap.


Put another way, if I was to choose between holding my capital in cash (or a cash proxy such as a government bond) or in CSL, I'd certainly use my cash to buy CSL.


However, no one is holding a gun to our heads, saying:

Risk-free Assets or CSL.
Either choose one of those two, or die.


We have a host of other investment alternatives - property, art, vintage cars, wine, stamps, coins, precious metals, and yes, other stocks - a fulsome 2,300-odd of them right here on the good old ASX.

If we compare CSL's valuation appeal relative to the broader market index, then - despite the stock's significant ~40% under-performance against the broader market (of which CSL itself is a large component, so the relative under-performance is even more pronounced) - it's valuation multiple relative to the rest of the market is still elevated compared to history.

Sure, it is not longer at the eye-popping levels it was four months ago, but it is still above average levels.




This segues into the second structural change to which I alluded, namely the structural change in the composition of the Australian equity market.

About 5 or 6 years ago, it started to dawn on me that the nature of the Australian equity market - in which I had spent over two decades investing – was undergoing a sort of seminal change.

For most of that two decade period, the market was dominated by large fund managers investing in large companies (The large miners, the banks, insurers, a few health care stocks, Amcor, Brambles, Leighton, Westfield, and a handful of infrastructure stocks.)

But at some point along the way - I can’t tell exactly when, probably around 2014/15 when the decay in bond yields started really accelerating - the valuation arbitrages among large cap stocks evaporated and they became expensive on most historical measures (I suspect that’s what ultimately happens when you get too many eyes looking at too few opportunities).

So that’s when I started to turn my attention to small caps.
And over the past 2 or so years, to micro-caps.

One needs to appreciate that a decade ago and earlier, “small caps” was a bit of a pejorative term, given that space was historically associated overwhelmingly with junior resource and exploration stocks, along with some dubious quality mining services companies, but with very few high-quality industrial, finance or technology stocks.

That seemed to change about 2 or 3 years ago, when suddenly, almost out of nowhere, an array of really interesting little businesses – well-managed, high-quality, scale-able businesses with unique and differentiated product/service offerings - started popping up in numbers on the boards of the ASX.
(Why this happened the way it did, and when it did, is a matter for another discussion, but my sense is that technological enabling was the overarching driver of it.)

So, while "large cap" stocks had become a really crowded trade, and very fully-valued as a result of the trillions of dollars of cheap capital slopping around the globe looking for a home, the small - and especially the micro-cap - end of the market, which was experiencing spectacular growth, has remained overwhelmingly un-researched and undervalued.

So that's where I spend 95% of my research time these days; looking for the undiscovered little gems which are valued at 10c and 20c in the dollar. You don't find those situations in $10bn-plus companies.

Sure, selected large cap stocks might deliver acceptable returns, but the real outsized wealth creation opportunities are to be found in the part of the market that does not get any attention from the masses.

The valuation dispersion between large cap versus small cap companies today is enormous; the biggest I can ever recall.

So, if I was to choose between investing in CSL today, or some of the small companies that I have come across in recent times, with little doubt CSL would serve as my funding source.

I checked: the last CSL share I bought was on 12 September 2016, just under 4 years ago.

Given the structural changes that have occurred since then, as described above, unless CSL's share price falls dramatically for some extraneous reason unrelated to the fundamentals of the company itself, I can quite easily conceive a scenario of not ever buying CSL shares again.

.