2 November 2016 Asia Pacific/Australia Equity Research Investment Strategy Australian Investment Strategy Research Analysts STRATEGY Hasan Tevfik ,CFA 61 2 8205 4284 [email protected] Aussie darlings Peter Liu 61 2 8205 4071 ■ Aussies love their darlings: Australia currently has the most expensive [email protected] equity market "Darlings" in the world. Our darlings trade on a forward P/E Damien Boey of 38x. The other commodity-focused market, Canada, has the second 61 2 8205 4615 [email protected] most expensive darlings. Darlings in Australia have been more expensive only during the Nasdaq bubble when they touched 45x. ■ Darling derating: Buying Australian darlings at these valuations has been a poor strategy in the past. Also, the current high valuation for Australia's darlings suggest they are especially vulnerable to rising bond yields and the coming end of the Australian profits recession. A rising discount rate and a lower premium for growth suggest investors should focus on stocks that could be future darlings. ■ Hello Daaarling: Future market darlings have shared many similar characteristics over the last 20 years. They are generally well managed, have strong balance sheets and operate on high margins. Our "Hello Daaarling" strategy highlights potential future darlings and they currently trade on just 17x P/E and include Caltex, Eclipx, Mayne Pharma, Nufarm, Star Entertainment and South 32. We add Eclipx to our long Portfolio. Figure 1: Australia has the most expensive darlings in the world Median 12-month forward P/E of "market darlings" around the world* 40 35 30 25 20 15 10 Australia Canada Cont. Europe US Hong Kong Japan UK Korea (ASX 200) (TSX 240) (DJ Stoxx) (S&P 500) (HS Comp) (Nikkei 225) (FTSE 350) (KOSPI 200) * The current batch of Australian darlings includes Acconex, Cochlear, Treasury Wines, NextDC, Transurban, Domino's Pizza, Babcor, Sydney Airport, Technology One and Corp Travel. Source: Company data, I/B/E/S, Thomson Reuters Datastream, Credit Suisse DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. 2 November 2016 Aussies and their darlings Every market has its darlings and Aussies clearly love theirs. Our market darlings trade on a median 12-month forward P/E of 38x and are the most expensive in the world. They are also amongst the most expensive we have had in Australia over the last 20 years. In this report we highlight the lessons market darlings have provided over the last two decades. We look at how darlings have changed through time and the strategies investors should adopt for today's batch. High valuations, rising bond yields and the coming end of the profits recession suggest investors should refrain from a blanket buy of the current darlings. Rather we try and anticipate the up and coming darlings. Our analysis reveals darlings share many consistent features through time and in our "Hello Daaarling" strategy we highlight our best future darling ideas. They trade on 17x and include Caltex, Eclipx, Mayne Pharma, Nufarm, Star Entertainment and South 32. We add Eclipx to our long Portfolio and remove Macquarie Group. Aussies love their darlings Every equity market has its share of darlings. These stocks are most adored by investors. They have a history of solid performance and trade on some of the most expensive valuations of the time. Darlings tend to dominate much of the discussion we have with institutional investors and we find there is no middle-ground view. Growth managers love them, value investors avoid them. Darling definition We take a quantitative approach to define a market darling. We assume 5% of an equity index are darlings at any one time. So the ASX 200 always has 10 market darlings. The S&P 500 has 25. The Nikkei 225 has 11. Our darlings are ranked top on an equally weighted combination of; (1) the highest 12-month forward P/E over the last 18 months (we remove companies with a distorted P/E on the verge of loss making), (2) most number of months, in the last 18, where the stock has delivered positive total returns and (3) the highest risk adjusted total return over the last 18 months. Figure 2: Australia has the most expensive market darlings in the world Median 12-month forward P/E of "market darlings" around the world 40 35 30 25 20 15 10 Australia Canada Cont. Europe US Hong Kong Japan UK Korea (ASX 200) (TSX 240) (DJ Stoxx) (S&P 500) (HS Comp) (Nikkei 225) (FTSE 350) (KOSPI 200) Source: Company data, I/B/E/S, Thomson Reuters Datastream, Credit Suisse Australian Investment Strategy2 2 November 2016 Darlings around the world Currently the market darlings in Australia trade on a median P/E of 38x. While this is lower than the 40x we encountered at the end of September, it is clear Australia has the most expensive darlings in the world. By comparison, US market darlings trade on a mere 25x. Some of the cheapest darlings in the world are in Korea and trade on a puny 20x (Figure 2). In the US the current batch of darlings includes well known Technology companies like Amazon, Facebook, Netflix and Adobe. In the UK we find defensive companies like Rentokil (support services) and Reckitt Benckiser (consumer staple). Also there is Burberry Group and Rightmove (online property advertising). In Japan the darlings are also dominated by defensives like Terumo (medical devices), Shiseido (personal goods) and Meiji (consumer staples). In Hong Kong the darlings include defensives like China Resources Beer (beverages) and MTR (railway). But also include tech companies like BYD (electric cars), and Tencent (internet service portal). In Canada darlings include Agnico Eagle Mines (gold producer), Innergex Renewable (hydro, wind and solar energy) and Northland Power (renewable energy). Two decades of darling Not only do Australia's market darlings trade at a premium to their international peers, but they also trade at a premium to their predecessors. Since 1995 we calculate that market darlings traded on an average P/E of 22x forward earnings and P/E relative of 1.6x. Currently they are trading on 38x and 2.4x, respectively. Aussies are especially smitten with their darlings right now. Figure 3: Current Aussie darlings trade on 38x P/E Figure 4: Expensive in an already expensive market Median 12 month forward P/E of ASX 200 Darlings. Quarterly in millions, unless otherwise stated 50 3.0 45 2.8 2.6 40 2.4 35 2.2 30 2.0 25 1.8 Average = 22x Average = 1.6x 1.6 20 1.4 15 1.2 10 1.0 95 97 99 01 03 05 07 09 11 13 15 95 97 99 01 03 05 07 09 11 13 15 Source: Company data, IBES, Credit Suisse Source: Company data, IBES, Credit Suisse In 1995, when our time-series begins, there was certainly a domestic consumption tilt to the Aussie darlings. Back then Australia's most loved stocks included Harvey Norman, Westfield, Village Roadshow, Coca-Cola and Woolworths. By today's standards the darlings in 1995 were relatively cheap and traded on 17x forward earnings. This was just a 50% premium to the ASX 200 at the time. As we progressed through the late 1990s the Nasdaq bubble continued to brew and the Aussie darlings certainly had an aura of new-economy about them. In 1999 they included Computershare, Citect (software developer in automation), Aristocrat, ERG Group (smartcard readers) and Energy Developments (power generation from renewable and Australian Investment Strategy3 2 November 2016 waste fuels). This was also the time when darling euphoria was greatest. They traded on an incredible 45x forward earnings. During the aftermath of the Tech bubble the market darlings de-rated considerably and hit a P/E low of 15x in 2002. Given that interest rates were cut significantly, and the property market was booming, the darlings of the time included a number of real estate exposed stocks like Gandel and St George Bank. The combination of a sluggish macro backdrop and lower discount rates helped a number of consumer staples stocks to be darlings including Foodland, Coca-Cola and Woolworths. The next peak in market darling P/Es coincided again with a peak in the equity market, in late 2007. The Aussie market darlings were a mix of energy companies (Queensland Gas Company, Arrow Energy, Worley Parson), consumer stocks (Flight Centre, David Jones, Woolworths) and others like CSL and InvoCare (funeral operator). The Aussie darlings hit an absolute P/E high of 26x in 2007. Still this was not the relative high of the time. That happened about a year later when the market de-rated and the darlings included beneficiaries of rising energy prices like Origin, Santos, Felix Resources and Ausenco. Valuations for the market darlings floundered over the next few years and hit a cycle low of 16x P/E in 2011. But this was still 70% higher than the ASX 200 average of just under 10x. Since then the P/E for the darlings has more than doubled. We detail today's darlings in Figure 5. Instead of domestic consumption companies like we had 15 years ago they include stocks exposed to Chinese consumption.