24 Jun 2016

Step Ladder on Everest

This time last year we wrote an article about Auckland International Airport, likening its $4 share price to reaching the top of Everest. In terms of dividends and earnings growth investors were likely to receive quite mediocre future returns from paying that price for the company.

Well, a year on and the price is $4.50. And amazingly the company has operationally performed very much in line with expectations. Investors are simply paying even more for the same dividends and earnings outlook. Auckland International Airport is now trading at over 30x its forecast 2015 earnings.

To give this some context, when a company is trading at over 12x its earnings, investors are starting to get bullish about its prospects. So at 30x earnings investors have become openly exuberant, particularly when you consider the moderate earnings growth that the airport is set to deliver. In valuation terms we appear to have had a situation where a step ladder has been erected at the summit of Everest and we have once more begun to climb higher, rung by rung.

Zero interest rates and the all-encompassing hunt for yield has led investors into climbing ever higher up this step ladder. But the danger is that the ladder topples and investor confidence collapses. It’s a heck of a long way down from these levels. And frankly it is more a question of when not if, as companies cannot trade at prices far above their intrinsic value indefinitely. At some point they will trade back because valuation always, always matters. But it’s not just Auckland International Airport that is climbing the step ladder on Everest, the majority of New Zealand share prices have also ascended to levels where the air is very thin.

 

The above chart maps the Price to Earnings ratio for the broader New Zealand equity market for over 22 years. At over 20x earnings, our local market is trading at levels far in excess of the norm. It is currently standing more than 2 standard deviations away from its average. That’s statistical jargon for “out on a limb”. Another aspect of this chart worth noting is that whenever the PE for the market goes north of 16x, the subsequent correction sees it retreat to around 12x, from current levels that would see the New Zealand share market fall by over 40%.

You may well wonder, as we do, how many more rungs does this step ladder have? The miracle of the market dictates that New Zealand shares could become even more expensive, they could climb up to 22x earnings, or even higher. The certainty though is that at some point the weak footing of the step ladder will buckle and give way. But when is impossible to say. What can be counted on, is that the higher we go the greater the vulnerability of the market.  Ultimately the trigger for the collapse of the step ladder could be a seemingly trivial and unpredictable event. But the subsequent sell off is unlikely to be trivial.