I wrote recently about the market rally I believe is on the way. I didn't (and can't) predict its timing, but I am very sure that patient investors will benefit when it comes.
My premise is that the market is currently undervaluing Australia's listed companies, based on a near-sighted extrapolation of the recent past and an under-appreciation of the longer term.
I believe the future for many Australian companies will be brighter than the market is suggesting. In addition, price earnings multiples have become infected with a 'pessimism discount' – the market is paying a lower price for the same dollar of earnings than it has been prepared to in the past – largely due to the level of uncertainty that investors are currently feeling.
Two chances to win
If the theory holds – and my money (metaphorically and literally) says it will – then the logical conclusion is that the market is undervaluing the earnings power of some of Australia's best businesses, and is currently offering that earnings power to us at a bargain price.
The upside of this situation is that investors buying wisely at today's prices potentially stand to benefit twice.
Firstly, as corporate profits improve, share prices will improve with them. It stands to reason that a company earning $100 in profits this year will be worth more if it earns $120 next year.
Secondly, investors will benefit as the market slowly removes the 'pessimism discount' that is currently depressing share prices. As the market starts to move out of its current funk and feels more certain about the future, other investors will be prepared to pay more for the same level of earnings compared to the multiple they were comfortable paying when they felt more concerned.
Look past tomorrow
The recipe for taking advantage of such a situation would be to find a company whose current or immediate future earnings are lower than they are likely to be further down the road, and whose share price (expressed as a multiple of those earnings) is unusually low.
In that situation, as profit returns to more normal levels and the market recovers its nerve, today's enterprising investor will reap the returns.
There are no guarantees in life – it's possible that the downturn ends up being longer in duration, or that the company is weaker (financially or competitively) that was first thought. Quality always wins and it pays to be picky.
There are some quality businesses on the ASX trading at pessimistically low prices – and multiples – and for whom the market is implying a less than rosy future.
Fallen angels waiting to fly
One such business – depending on your world view – is David Jones (ASX: DJS). The upmarket department store retailer was sold off heavily among investor concerns that consumer spending has fallen and was migrating online. As a result, DJs is down almost 40% from its previous highs, and is trading on a trailing price earnings ratio of less than 10 times earnings. Even if the multiple doesn't grow, DJs would have to do pretty badly to be a bad investment from here.
Salmat (ASX: SLM), the junk-mail and call-centre king, delivered a disappointing profit result in the most recent financial year, amid a lost call-centre contract and reductions in retailer advertising budgets. Investors punished the company, with the share price halving from its 12-month high before recovering slightly. Trading at only 12 times historical earnings, and probably less than 10 times the current year's expected profit, there's plenty of pessimism already reflected in the share price.
Australia's self-described 'third force' in groceries is Metcash (ASX: MTS). While Woolworths (ASX: WOW) and Wesfarmers' (ASX: WES) Coles grab all the headlines, Metcash has done a great job of consolidating and growing the rest of the retail grocery sector. The company is also strong in alcohol wholesaling, and has recently bought a majority stake in hardware retailer Mitre 10. While consumer confidence might be fragile, we all still need groceries. Despite a growing bottom line, Metcash's share price is off its 52-week highs, and is trading at a trailing P/E of under 13 times.
Foolish take-away
If you've ever tried to buy an umbrella when it's raining outside, you'll know they're scarce and expensive. When the sun is shining, umbrellas are often going cheap.
Likewise, an investor who waits for certainty is likely to pay a high price for that confidence – and experience suggests that by that point, the next downturn is probably closer than most people think. Just ask those who bought tech shares in 1999 or Americans who refinanced their houses in 2007.
The best time to buy quality, well managed companies with sustainable competitive advantages is when no-one else is – that's when the shares are on sale. When confidence returns and the rally comes, those are the businesses you'll be glad you bought on the cheap.
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Scott Phillips is The Motley Fool's feature columnist. Scott owns shares in David Jones and Woolworths. The Motley Fool has a disclosure policy. This article authorised by Bruce Jackson.
