Blowing bubbles on the NZX
Call it the bubble that Adrian Orr blew: New Zealand’s sharemarket has charged ahead more than 20 per cent so far this year. But not because many companies are making a lot more money than last year. And not because the economy is growing quickly and creating opportunities for businesses to do the same – growth is slowing here, as it is in major export markets.
The reasons are better found in the tale of the country’s two largest public companies: fast-growing but unreliable A2 Milk, and steady old electricity generator Meridian Energy (this was the case until yesterday when A2’s shares took a tumble). Each was worth about $12.5 billion by market capitalisation – the total value of all a company’s shares.
Surprisingly, each was trading at roughly 40 times their earnings, give or take a little. That means they would each take 40 years to earn back for their shareholders the current value of those shares. Forty years is a long time to wait, so broadly speaking it means those stocks are expensive.
In fact, stocks are so expensive these days the old price to earnings ratio, the calculation that says the price of something should relate to the actual value, seems almost quaint.
In these heady days of Beyond Meat – a loss-making company that bolted out of its United States share float in April and doubled in price within weeks – harping about the actual value of a business sounds like the hoary wisdom of grandmothers, up there with saving bits of string and darning socks. After all, lots of companies defy huge price earnings ratios. Cannabis companies, tech companies ... anyone with a big explosion of earnings likely in their future: companies that are conquering new markets and disrupting old ones. Names like Hubspot, and Square, trade at hundreds of times their earnings.
And that is fine if you are a gamechanging mobile payments firm or you are on the cutting edge of artificial intelligence and machine learning – you have got great potential but you are also risky because future earnings are still a long way from your pocket.
A2 Milk is not in quite the same league but its sales are expanding rapidly, it is pushing deeper into huge markets like China and the US, stealing business from established players, and growing its earnings in the strong double digits. Again, risky (as the share price tumble demonstrated) but it is a bet that there is more exciting growth to come.
Meridian on the other hand is stolid. It posts steady single-digit growth and yet it is now valued like a company with much more thrilling results. Sometimes it has got lots of water pumped into reservoirs high up, ready to power turbines when electricity demand is high. Sometimes it is a bit dry and generation isn’t so lucrative. But it is not nimbly charging into new markets shaking money trees. Its biggest customer is an aluminium smelter near Invercargill.
Once in a blue moon, the smelter expands or contracts and Meridian is affected. So Meridian is a good business. Demand for electricity is pretty reliable and it might get a boost if electric cars hit a critical number.
Its bailiwick, hydroelectric, is considered green, so much the better.
And it pays a decent 4 per cent dividend in the meantime.
That is the real reason Meridian’s valuation has hit 40 times its earnings.
A few years ago there was an even more boring game in town called the bond market. Money there was safer than it is in stocks and the fixed payout was similar.
In early 2015, the safe-haven New Zealand five-year bond paid 4 per cent and corporate bonds earned significantly more.
Shares, which are inherently riskier, were not nearly so popular and Meridian’s price was roughly half what it is today; so was its priceearnings ratio.
But bond yields have fallen off a cliff since then; that NZ five-year bond now pays less than 1 per cent thanks to the Reserve Bank of New Zealand lowering rates; the benchmark overnight rate now sits at a record low 1 per cent.
Shane Solly, portfolio manager at Harbour Asset Management, said Meridian’s share price rise has ‘‘very closely mirrored’’ this decline in bond yields.
In other words, investors have bailed out of bonds as they look for income and piled into dividend paying shares like Meridian, pushing up prices, and distorting them, as those prices become ever more distant from the underlying business.
It is tough to shout ‘‘bubble’’ when things keep going higher. But it is fair to say prices are now seriously disconnected from what old timers like to call fundamentals.