Brexit on ARB, page-8

@Warrigals ,

The other issue that one needs to think about when contemplating an investment in ARB, is the current dynamic that is not just affecting ARB's valuation, but the valuations of all long-duration, growth business.

And that dynamic has to do with what happens to the real earnings yield when the returns available from risk-free assets fall dramatically and, indeed, when they approach zero (as has been happening over the past few years).

By way of demonstration, a decade ago when ARB's P/E was 18x (i.e., an earnings yield [EY] of 5.6%), the rate on terms deposits was around 5.0%.

This meant that the spread of EY above the yield on cash (a measure of how much extra return, compared to a risk free rate of return, investors are demanding to compensate them for the risk of holding the stock) was around 60bp (5.6% less 5.0%).

But with the new normal interest rate environment (or at least that's increasing the way bond markets seem to be viewing it), that same 5.6% EY today would - with term deposits currently sitting at 2.5% - be implying a risk premium of over 300bp (5.6% less 2.5%).

That would be five times higher than it was historically.

So what does the market do? Well, it arbitrages this risk premium out to some degree by re-rating the earnings multiple upwards (thereby reducing the EY).

Today the EY on ARB stock is around 4% (corresponding to its 25x P/E multiple). At the current cash rate of 2.5%, that implies a risk premium of 150bp. Which is still a lot higher than it has been for ARB historically.

Which might lead some investors (who are a lot braver than I am) to argue that, in the new world order of secularly lower interest rates, that the stock is still cheap compared to history given the poor returns on offer from alternative and risk-free asset classes such as cash and bonds.

For context, applying the same EY spread above term deposits, that prevailed for most of the 2000s (i.e., less than 1%), this would result in a P/E multiple for ARB of almost 33 times!

Now I'm not ever a subscriber to the "this time its different" school of thought, so this kind of talk scares the heck out of me, because it assumes that interest rates will be where they are for many years to come, and so the stock's multiple will continue to rise.

But what I do observe is that, as the months turn to years in terms of this extremely low interest rate environment, so the market increasingly comes to view it as normalised.

I see this P/E re-rating incrementalism take place in many stocks over the past few years: stocks that traditionally traded at P/E multiples of 12x or 13x have crept up to now trade at 15x and stocks that typically traded at 15x in the past now trading at 18x. And then there are the premium-to-market stocks, like ARB, CSL, AMC, RHC, REH, who now trade at P/E multiples at or above 20x, when they used to rade in the mid- to high-teens in the past.

For a "value" investor, which I consider myself to be, this phenomenon presents a really vexed issue.

Because, when "fair value" for a medium-quality business used to be around 12x P/E, and today it is priced at 15x P/E, what does one do?

Does one remain defiantly true to label, and not invest because one believes that rates will at some stage mean revert, in which case the upwards re-rating that has occurred in recent years will promptly reverse.

But if one does adopt such a principled stand, what happens if the situation remains this way for the next 2, 3, 5 or even 10 years?

In that case, were one to be sitting un-invested, the opportunity cost would be very large.

I'm not too sure what the answer is, but it is something that I think about a great deal of the time.

Because one thing is for sure - this is a very real dynamic and my sense is that, if anything, it is gaining in strength.

Knowing human nature, the end game is almost sure to be another asset bubble in the making, but it might take 5 years for it to burst. And I'm not sure too many investors have the patience to tolerate 5 years of foregone gains.

So, to my way of thinking, the best way to insulate oneself in the event that the equity re-rating bubble does burst, is to be holding shares in companies that have good underlying and long-term structural growth attributes... such as ARB.

Because then at least the compounding growth effect will ultimately chew into whatever valuation multiple one pays for the stock today.