Price Falls Prompt Caution Over Valuations of Popular Stocks

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Are investors paying too much for ‘safe’ stocks? Recent price drops in household-name stocks like Commonwealth Bank and CSL have triggered a debate about the hidden dangers of following the crowd regarding defensive businesses.

Recent price declines in stocks such as Commonwealth Bank of Australia (CBA) and CSL Limited have raised concerns about overpaying for seemingly defensive businesses. As market watchers grapple with the volatility, experts have weighed in on the role of herd mentality, the distinction between defensive businesses and stocks, and the impact of crowded trades on the Australian Securities Exchange (ASX).

Dougal Maple-Brown, a prominent portfolio manager at Maple-Brown Abbott, has cautioned that pursuing defensive businesses can lead to suboptimal returns if investors pay too much. He highlighted how the valuations of several blue-chip favourites, including CBA, CSL, Goodman Group, ResMed, and Woolworths, have surged to such heights that investors may now face potential future losses.

“The macro at the moment is hard to call,” Maple-Brown stated, acknowledging the current economic uncertainty. “No one has a great read on whether we get the soft or hard [economic] landing. Hence people are forced into things that look safe.”

However, he emphasised the risk of conflating defensive businesses with defensive stocks. While the perceived safety of these businesses might make sense in the context of uncertain interest rate trajectories, the danger lies in overlooking the possibility of overpaying for these stocks.

“Crowded Trades” Unwinding on ASX

As the earnings season gains momentum, there is a noticeable trend of “crowded trades” unwinding on the ASX. Analysts and investors are grappling with how the market responds to high valuations and optimistic earnings forecasts. CSL, Macquarie, and ResMed have been notable examples, with their stocks experiencing price drops due to earnings forecasts that were deemed overly optimistic.

“Unrealistic expectations are nothing to do with a company,” Maple-Brown explained, shedding light on the mechanism behind these price drops. “So to justify a buy, sell-side analysts increase their earnings forecasts, and it happens slowly by stealth. That’s the story of these overinflated expectations, which become almost impossible to meet.”

Sell-Side Analysts and Rising Interest Rates

Sell-side analysts are not immune to the pressures of positive research, particularly when their firms have business relationships with the companies they cover. Rising interest rates have prompted investors to seek shelter in defensive sectors, such as healthcare and consumer staples, while being cautious about cyclical businesses that may be more vulnerable to rate hikes.

However, Aaron Binsted, a portfolio manager at Lazard Asset Management, emphasised a different approach. “We focus on the fundamentals, and we’re happy to be outside big popular names if we think it makes sense on a fundamental view,” he explained, pointing to the success of the Lazard Select and Lazard Defensive funds in the previous financial year.

Valuation Considerations Amid Economic Uncertainty

In light of the ongoing market fluctuations and the uncertainty surrounding economic outcomes, valuation has become increasingly crucial. As Goldman Sachs’ recent research aligns with Maple-Brown’s perspective, it is evident that defensive and growth sectors are trading at profit multiple premiums higher than their historical averages.

These valuations reflect the market’s response to rising interest rates and the associated strategies of buying defensive businesses while selling cyclical ones. Despite this, Binsted remained steadfast in his belief that the better-valued segment of the market would remain the preferred investment choice amid the uncertainty.

Earnings Season and Beyond

As the earnings season progresses, the cautionary tale of CSL, ResMed, and Macquarie serves as a reminder of the delicate balance between perceived safety and realistic valuations. While short-term price fluctuations are influenced by analysts’ forecasts and the herd’s expectations, the long-term performance of a business should not be overlooked.

The future trajectory of these stocks and others will inevitably be shaped by evolving market dynamics, interest rate shifts, and the broader economic landscape. Investors, analysts, and portfolio managers must navigate this landscape keenly aware of the fine line between attractive opportunities and the risks of overinflated expectations.

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