(June-2002) Following the herd into the wilderness

Herding is a form of behaviour usually reserved for migrating animals, keeping them together for their own survival. However, in the human world and particularly in investment markets, this behaviour is considered somewhat irrational and usually provides momentum to stock market movement, which this year appears to have been partly responsible for a number of domestic and international stock overvaluations.

Investors, believing the global economy was once again on the precipice of a period of exponential growth and profit return, pushed the ASX All Ordinaries (All Ords) into building up an unwarranted head of steam in February and March, and are now paying the price for their overconfidence.

Companies swept along in a frenzy of market expectation, on the grounds they would be able to provide strong profit growth, have been downgraded one by one in recent weeks after failing to meet the market’s overzealous expectations.

Such irrational exuberance is all the more stark, given that the reverberations from the implosion of the greatest stock-bubble in history are still being heard around fund management offices.

The All Ords, after climbing almost 600 points (or 20 per cent) post-September 11, to peak at 3,440 in early March, has subsequently taken a reality check, and was languishing well below that mark at the time of going to press.

Investors reacting to companies’ failures to meet anticipated profit targets (added to the already lingering uncertainties regarding company balance-sheet integrity), have forced the All Ords to forfeit all of its gains for the year.

According to managing director of Investors Mutual, Anton Tagliaferro, the downturn comes as no surprise given the number of companies operating on unsustainable price earnings (PE) ratios.

“The share market is in transition. Until recently, people were convinced there was a strong recovery coming ... What we’re now seeing is a continuous re-rating of the high PE stocks, such as Macquarie Bank, CSL, Mayne, Resmed and Cochlea.

“These stock PEs are a hangover from the tech boom ... In my experience in funds management how can you buy into a stock at a PE of 50, 60 or 70 and expect to make money?”

Tagliaferro believes trustees have been ‘conned’ into holding a number of these stocks for style purposes without there being any rational explanation based on fundamentals.

“There’s going to be a lot of fallout from this. There are a lot of fund managers who have convinced trustees that holding all of these stocks makes sense from a style point of view, and unfortunately for super funds they’re going to lose a fair bit of money,” he says.

Over at ABN AMRO Asset Management, investment director Andrew King believes investor reaction to the profit warnings has been excessive and warns that the Australian share market is in danger of becoming more ruthless, like its US counterpart.

“The US market has always been brutal, but the Australian market now appears to be following suit ... Resmed’s profits dropped seven per cent and the stock fell from $6.60 to $4.70 in two days,” he says.

King hypothesises that the increasing presence of hedge funds in Australia may be partly responsible for some stock ‘punishment’, rather than a simple case of overvaluation.

Head of Australian equities at Tyndall Investment Management Bob Van Munster says King’s hypothesis may have some legs, as extensive shorting of a stock will influence its volatility over time. However, Van Munster avoids attributing all investor brutality to hedge fund shorting strategies. Instead, he points out that many of the retreating stocks had simply become too expensive.

“Stocks like Resmed, ComputerShare and Mayne Nickless were trading on high valuations, so it’s only natural when there’s disappointment that they’ll be hit hard,” he says.

Regardless of the reasons, Van Munster says one thing such volatility teaches investors and trustees, is the need for a fully diversified portfolio.

Tyndall, which manages $1.4 billion in Australian equities, is the top performing fund manager for the year ending March 31, with a return of 33.1 per cent, according to InTech figures. But, going forward, Van Munster believes trustees must face the reality of lower equity returns.

“We’re now in a hiatus period, which is a natural part of the economic cycle ... [and] generally a period when equity returns aren’t that great.

“Trying to buy stocks for 60 cents that are worth a dollar is our bread and butter ... [However,] it’s becoming harder to find stocks that are undervalued,” he says.

Head of research at Colonial First State Hans Kunnen agrees that super funds are unlikely to reap great returns from equities for the foreseeable future, despite the fact there are bound to be some individual companies performing strongly.

Kunnen also has a strong view on inflation. “Low inflation is going to be entrenched in Australia for the next 20 years,” he says.

According to Kunnen, in the existing economic environment where there is both low inflation and high oil prices, growth is always going to be stymied. Therefore, he predicts only modest interest rate rises over the next six months — reversing those cuts made in response to September 11.

From a sector versus country perspective, head of research at van Eyk Research Rob Prugue says his group’s position is split in that it believes sector strategies tend to work best with large cap stocks, whereas country strategies tend to benefit when dealing with small to mid cap stocks.

The research house is also split on its preference of manager style and according to Prugue, it has been advising clients to move to a more style neutral positioning.

“We would advise caution over any moves preferring value over growth at this time because the ‘freebie’ which was previously given to investors when value was significantly undervalued compared to growth stocks is no longer there.

“Looking forward, we believe there will be normal market volatility, so it is important to focus on the quality of the manager as well as manager style ... Our preference is to allocate an equal split between quality growth managers and quality value managers,” Prugue says.

However, to Investors Mutual’s Tagliaferro, manager style is an anathema. Investors Mutual is classed as a GARP (growth at a reasonable price) style of manager by industry commentators, but Tagliaferro believes such pigeonholing is ridiculous as stocks cannot be selected in a vacuum.

“People try and pigeonhole managers and, I suppose yes, there are elements of style that are more applicable to some managers than others, but the reality is that you have to consider all aspects when buying a stock.

“I think [the argument of growth versus value has] been one of the biggest marketing cons to trustees by the funds management industry,” he says.