Ann: Fletcher Building Market Update, page-70

"@madamswer, I have no view on FBU but I have come to a similar conclusion regarding your last paragraph, but this is only part of the puzzle. The more challenging aspect which I have been grappling with is what this means from an equity allocation perspective or even an asset allocation perspective.
Perhaps it would be good to facilitate a discussion on this topic somewhere else on the forum?""

@Klutch,

Your question is relevant to a company like FBU, so I think here is as good as any place to flesh it out.

In short, when it comes to investment process, I don't think anything should change much at all if we are indeed entering a period of stagflation; certainly not change to an extent of undertaking wholesale asset allocation structural changes.

Instead, I reckon one simply sticks with the time-honoured approach of fundamental valuation, which has been proven to create wealth under all sorts of macro-economic scenarios.

In essence, trite as it sounds, it is little more than the two-step process of determining a price objective, P, based on:

1.) What a company's earnings are going to be ("E"), and
2.) Applying the appropriate capitalisation factor to that E value ("P/E")

Of course, in reality both of those parameters are difficult to determine at the best of times, becoming an even more difficult task if global, and Australian, economic growth continues to be anemic while the cost of money is elevated.

Which is why, after the FY2023 reporting season, I gave my portfolios a rigorous sanitary scrubbing, trying my best to position my family's capital away from crappy companies (unless there is truly compelling undervaluation on display, and where I can identify very clear catalysts to close the valuation gap).

Because under a stagflationary scenario, the disparities between companies in terms of business model quality and pricing power, become pronounced.

Earnings of superior businesses will continue to be relatively predictable (the very reason they are superior companies... examples here are CAR, COH, CSL, PME, REA, RMD, TNE).

But the earnings of inferior quality businesses, such as FBU and other cyclical, commodity product businesses [*], with their inability to defend Revenues (twin perils of absence of pricing power plus weakening demand) against rising input costs, become ever harder to predict than during period of strong economic activity.

[*] Invariably companies involved in agricultural products/chemicals, banking, building materials, construction, distribution, media, mining & energy, retailing, packaging, telecommunications, transport, wealth management ... in other words, 90% of the stocks listed on the ASX.

This has implications for the valuation multiple that the market will apply; whereas a business such as FBU might probably be afforded a P/E of 14x or 15x when things are rosy, when times get tough - like now - the market is unlikely to pay even 12x.

The reverse tends to happen to premium quality businesses, which get rated on higher multiples than normally would be the case, an outworking of the "flight to safety".

There are times when one can get away owning rubbish companies; now and the foreseeable future are not one of those times, in my view.

Governments running deficit budgets while also having to use taxpayer money to subsidise the living expenses of the citizenry is an alarming economic omen.

There are significant structural constraints in the Australian economy, which is going to make for a gnarly few years before they are addressed (that's if any government will be awarded a clear mandate to address them, because the solutions will not be popular).

The only exceptions to investing in sub-par companies is if their valuations are already factoring in a worst-case scenario, which would make them targets for industry consolidation and rationalisation.

Based on my analysis, I think this applies to FBU today.

But what it effectively boils down to is that the source of any investment return from FBU is contingent on M&A, rather than due to any company-specific catalyst, because it is very difficult to foresee any positive delta in financial performance from a high fixed-cost business with negligible pricing power, during a sluggish economic backdrop.

.