Traditionally, the world of investing can be broken down into value and growth stocks. Growth stocks tend to enjoy strong growth in at least revenues, but sometimes profits and other metrics as well. Value stocks are considered as such, because they tend to be cheaper; that doesn’t necessarily mean that each share is trading at a lower dollar price, but rather trading at low price relative to the company’s profits, assets, dividends, etc.
A simple look at value
One of the key value ratios is the price-to-earnings ratio (p/e). For large ASX-listed stocks the average price-to-earnings ratio currently sits at approximately 25. This means that if a large ASX stock is making $1 profit per share each year, you would expect the stock to cost approximately $25.
Some sectors tend to trade at higher p/e ratios than others and some tend to trade cheaper than others. For example, the Australian tech sector is trading at an average p/e of -77, this means that on average tech sector stocks make a loss each year, and that the average tech sector stock trades at a share price of $77 per $1 lost.
Historically one of the cheapest sectors on the market has been the banking sector, globally, banks tend to trade at low earnings multiples, because banking profitability can be very marginal at the best of times, and that banking often bears a large burden during periods of economic downturns. The average Australian banking stock is currently trading at around 24 times their earnings.
While the average bank p/e of 24 follows a year of earnings declines, with earnings expected to start bouncing back this year, Australian banking still looks fairly expensive of a forward price-to-earnings basis.
So where lies the value?
Almost the entirety of the ASX is trading at high multiples of earnings, if they have any earnings at all. This is a global phenomenon at the moment, and much of the world is trading at even higher earnings multiples than we are. While you may consider that this is due to a decline in earnings in 2020, even on a forward earnings basis prices are extremely high relative to historic norms.
When looking at value using this methodology, the best value stocks on the ASX are mining stocks.
The ASX-listed metals and mining sector has a p/e of 18.3, which means that the share price is trading at $18.30 for each dollar of profit the stock makes. This was even after a year of profit growth (companies with profit growth tend to trade at higher p/e ratios) and with profits expected to growth this year.
While strong gold, copper, and aluminium prices have helped the sector, the real strength in the mining sector has come from the iron ore miners. They have benefited from record high iron ore prices, along with strong volumes, and relative isolation to the coronavirus pandemic. This has pushed a stock like Fortescue (FMG.AX) to a p/e of 11.4, while their price trades at just 8 times forward earnings.
That the market has allowed these price-to-earnings ratios to get so low, while other P/Es are skyrocketing indicates that they don’t believe it will continue. In fact, many analysts forecast that iron ore prices will drop by fifty percent or more in the next two years.
While such a drop in iron ore prices would have a major impact on miners’ profitabilities, keep in mind that these analysts have been forecasting such a fall in iron ore prices for more than two years now; in that time, iron ore prices have more than doubled.
Sam Green is the Portfolio Manager at Emerald Financial, whilst also being an Equities and Derivatives expert for his clients at TradersCircle.
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