Buy Hold Sell: 3 stocks with ultra-low PEs (and 2 darlings to drop)

This article was published on Livewire Markets, 17 February 2023

Despite our good intentions, our behavioural biases can often get in the way of making smart investment decisions. As Benjamin Graham wrote, “The investor’s chief problem – and even his worst enemy – is likely to be himself.”

So how do you lessen the likelihood of a behavioural blunder? Just like everything in investing – there is no easy answer. But simple tools such as price-to-earnings ratios may help.

Traditionally, stocks with high PE ratios are considered overvalued – with investors paying up for promises of future growth. But are lower PE stocks always better value?

To find out, Livewire’s Ally Selby was joined by Merlon Capital Partners’ Neil Margolis and Totus Capital’s Ben McGarry for their analysis of three of the lowest PE names on the ASX.

Plus, for a little dash of drama, we asked them to name one darling that could drop from here.

Note: This episode was filmed on Wednesday 8 February 2023. You can watch the video, listen to a podcast, or read the edited transcript below.

Edited Transcript

Ally Selby: Hey, how’re you doing? And welcome to Livewire’s Buy Hold Sell. I’m Ally Selby, and today we have an absolute cracker of an episode for you. We’re going to be taking a look at three stocks with some of the lowest price-to-earnings ratios out there, and we’ll also be asking our fundies to name one darling that’s likely to drop from here. To do that, we’re joined by Neil Margolis from Merlon Capital Partners, and Ben McGarry from Totus Capital.

Okay. First up, we have the flying kangaroo, it’s Qantas Airways. It’s on a forward PE of around 7.3 times. Ben, I might start with you. Is it a buy, hold, or sell?

Qantas Airways (ASX: QAN)

Ben McGarry (SELL): Qantas is a sell. They cancelled my flight back from the US last week, but there’s actually more to it than that. We think they’re over-earning at the moment. Capacity is going to slowly come back into the market, which will reduce prices, and I think they’ve cut too deep on the cost out with contractors. The flight cancellations and the bag delays are eating into the brand. They’re also facing a big CAPEX refresh cycle over the next few years, which the new CEO will have to deal with. So Qantas is a sell for us.

Ally Selby: They’ve had to ground quite a few flights recently, but the share price has definitely taken off. It’s up 19% over the past year. Neil, over to you. Is it a buy, hold, or sell?

Neil Margolis (BUY): We do own it, so it’s a buy. But with airlines, you always have to be close to the exit. Excuse the pun. When there are government-owned competitors, they’ve got high-upfront costs and low-marginal costs, so it is an industry that you’ve got to be wary of. I think the difference with Qantas is their market position has actually strengthened through COVID-19. Their market share has gone from 60% to 70% in domestic. We ascribe about 80% of the value to the domestic segment, which includes loyalty. The international segment is a small part of the value. In domestic, you’ve got Virgin, owned by Bain, who just want to maximise their short-term profits by trying to float it, so you know that Virgin is not going to compete aggressively in the next couple of years. Qantas might be able to benefit from the pent-up demand, and the high margins for some time. The low multiple does reflect the fact that it is over-earning though.

New Hope Corporation (ASX: NHC)

Ally Selby: Okay. Next up, we have New Hope Corporation. It’s a coal company. It’s on a forward PE of 2.8 times. Is that one a buy, hold, or sell?

Neil Margolis (SELL): It’s a sell. This was our best stock during 2022, but we have exited it, so I have to call it a sell. I think with these stocks, coal prices are three times what they have been historically. The market’s pricing in one to two years of these prices remaining this high. If you think they’re going to stay high for longer it’s a buy, if you think they’re going to stay high for shorter it’s a sell, the risk-return is not there. History has shown us the best time to buy these industries is when there’s blood on the streets, but it’s never been more profitable.

Ally Selby: Okay. Its share price is up 146% over the past 12 months. Ben, is that one a buy, hold, or sell for you?

Ben McGarry (BUY): It’s a buy for us. We’re in the stronger for longer camp on coal. I think what’s different in this coal cycle is just the lack of supply, the hurdles to get a new project up and running are just so much higher than they were back in the 2010-2011 boom. So, difficult to see where the new supply comes from. Resource security is a big issue these days. New Hope is the highest-quality thermal coal producer on the ASX, and it’s the only one with an organic growth, expansion option in New Acland. We think it’s cheap, and if you can hang on for 12-18 months, you’ll get richly rewarded for holding onto that one.

Magellan Financial Group (ASX: MFG)

Ally Selby: Okay. Last up for today. We have Magellan Financial Group. It’s trading on a forward PE of around 9.3 times. Ben, is that one a buy, hold, or sell?

Ben McGarry (SELL): It’s a sell for us. Even though about 40% of the market cap is supported by the value of the equity investments, funds management businesses – and particularly active funds management businesses – are quite fragile, and very vulnerable to outflows.

Ally Selby: Don’t you run an active funds management business?

Ben McGarry: Yes, and if anyone wants to offer me a five or 10 times multiple for Totus, talk to Ally. She’ll get us in contact. Look, it’s very difficult to turn around these ships’ inflows, and the new fund managers that have taken over from Hamish Douglass have yet to prove their mettle. Until those outflows turn to inflows, it’s a sell.

Ally Selby: Its share price is down a whopping 40% over the last 12 months. Neil, is that one a buy, hold or sell?

Neil Margolis (SELL): Its actual market value has gone from $12 billion at the peak down to under $2 billion. It has fallen a lot, but it’s still a sell for us. We quite like fund managers that are in inflow. They should trade on high PEs. We don’t mind them trading on 20 times, because they are very high return on capital and they don’t carry much debt. In the case of Magellan, they’ve also got fully franked earnings. It was one of our best stocks in 2012, for example. But right now, they’re in a world of pain with outflows. Their fees are still high. We think the current share price is pricing in another 25% drop in funds under management (FUM). There’s definitely some bad news priced in, but we think all the institutional FUM outside of the infrastructure business could get lost, and the retail book could halve. On that basis, you’d probably want to be buying it for around $7, but we could be getting a bit greedy there.

Crowded darlings that could drop

Ally Selby: Okay. Speaking of darlings that have dropped, we asked our fund managers to bring along one crowded trade that they think could suffer from here. Neil, what have you brought along for us?

Goodman Group (ASX: GMG)

Neil Margolis (SELL): The darling we’re going to nominate is a very popular stock called Goodman Group. Industrial was always seen as the poor cousin of real estate because the cost of the building is low relative to the cost of land – compared to shopping malls and office buildings. It always traded at a much higher cap rate than office and retail property. People are somehow being convinced it’s now called logistics, not industrial anymore, so it sounds much more interesting. Their last reported cap rate is 4%, which is below what it costs major banks to borrow five-year money. There’s a lot of debt, obviously, within the business, but also within their funds. So if people do realise that industrial properties have got downside, then that’s one that’s going to struggle.

NEXTDC (ASX: NXT)

Ally Selby: Okay. Over to you, Ben. What’s your dialling that could drop from here?

Ben McGarry (SELL): NEXTDC. Data centres are a space that has attracted a tonne of capital in the listed and unlisted space in recent years. Everybody has bought the migration to the cloud thematic. We think that a lot of the things that were working in their favour have started to work in reverse. If you look at Amazon, Microsoft, and Google Cloud – their growth is slowing. These are long-duration, very high PE assets that are sensitive to rises in interest rates. If you look at their return on capital since they listed, it’s about zero, and the shares on issue have tripled since 2013. NEXTDC looks expensive and facing some headwinds, so that’s a sell for us.

Ally Selby: Okay. I hope you enjoyed that episode of Buy Hold Sell as much as I did. If you did, why not give it a like? Remember to subscribe to our YouTube channel. We’re adding so much great content every week.