Welcome to the Fear and Greed business interview. I'm Sean Aylmer. With the ASX recently entering correction territory, albeit briefly. There were plenty of calls to buy the dip. After all, it was Warren Buffett who's said to be fearful when others are greedy, and greedy when others are fearful. But it might not be as simple as that, particularly when plenty of companies are still potentially overvalued. I wanted to look today at buying in a market pullback to citing fair value and whether it's time to make a move. Of course, this information is general in nature and doesn't take into account your own circumstances. You should always do your own research and see professional advice before making investment decisions. Lochlan Halloway is the equity market strategist at Morningstar. Lachlan, welcome back to Fear and Greed.

Welcome to the Fear and Greed business interview. I'm Sean Aylmer. With the ASX recently entering correction territory, albeit briefly. There were plenty of calls to buy the dip. After all, it was Warren Buffett who's said to be fearful when others are greedy, and greedy when others are fearful. But it might not be as simple as that, particularly when plenty of companies are still potentially overvalued. I wanted to look today at buying in a market pullback to citing fair value and whether it's time to make a move. Of course, this information is general in nature and doesn't take into account your own circumstances. You should always do your own research and see professional advice before making investment decisions. Lochlan Halloway is the equity market strategist at Morningstar. Lachlan, welcome back to Fear and Greed.

Good to be back.

Good to be back.

Buying the dips. Not quite as easy as it sounds, is it?

Buying the dips. Not quite as easy as it sounds, is it?

Yeah, that's right. I mean when we think about just looking at what the price has done, I think we need to go a bit further. So if you're just going to buy something because price has fallen X percent in a trading session. You kind of have to make two assumptions if you care about valuations. Firstly, that the fundamental picture didn't change and that that dip was not reflecting something genuine about the business and its outlook. And secondly, if you're looking for value, you have to assume that the new price of which it is trading offers some value, that it is now undervalued and now in that sense worth buying. If something is thirteen percent overvalued and it corrects ten percent, you're still buying something expensive, less expensive, but expensive all the same. So I think when we hear about when you talk about buying the dip, I think we have to keep those two points in mind.

Yeah, that's right. I mean when we think about just looking at what the price has done, I think we need to go a bit further. So if you're just going to buy something because price has fallen X percent in a trading session. You kind of have to make two assumptions if you care about valuations. Firstly, that the fundamental picture didn't change and that that dip was not reflecting something genuine about the business and its outlook. And secondly, if you're looking for value, you have to assume that the new price of which it is trading offers some value, that it is now undervalued and now in that sense worth buying. If something is thirteen percent overvalued and it corrects ten percent, you're still buying something expensive, less expensive, but expensive all the same. So I think when we hear about when you talk about buying the dip, I think we have to keep those two points in mind.

Okay, so how do you work out then whether it's expensive or not.

Okay, so how do you work out then whether it's expensive or not.

Yeah, that's a good question, and it comes to the core of the way we look at markets, our valuation methodology. So we look at individual companies globally, but in this in this office in Australia and New Zealand, and we look at them on a discounted cash flow basis. So how much cash effective do you think this business will generate from now into perpetuity. It's a fairly standard approach to valuations. We consider things like the company's industry, the company itself, it's idiosyncratic competitive advantages, or its economic moats, and we project those out. Obviously different approaches to different companies, but that's broadly speaking the way we look at it. That gives us a company level valuation or fair value estimate. But we can also roll that up. You know, we cover two hundred ASX and NZX listed stocks, and we can build that up to a market level picture to get a sense of, well, okay, overall, where do valuations sit across those two exchanges?

Yeah, that's a good question, and it comes to the core of the way we look at markets, our valuation methodology. So we look at individual companies globally, but in this in this office in Australia and New Zealand, and we look at them on a discounted cash flow basis. So how much cash effective do you think this business will generate from now into perpetuity. It's a fairly standard approach to valuations. We consider things like the company's industry, the company itself, it's idiosyncratic competitive advantages, or its economic moats, and we project those out. Obviously different approaches to different companies, but that's broadly speaking the way we look at it. That gives us a company level valuation or fair value estimate. But we can also roll that up. You know, we cover two hundred ASX and NZX listed stocks, and we can build that up to a market level picture to get a sense of, well, okay, overall, where do valuations sit across those two exchanges?

Okay, now, I am going to... I might be Lachlan asking the impossible - without too much maths, explain the market cap weight method of valuing a company.

Okay, now, I am going to... I might be Lachlan asking the impossible - without too much maths, explain the market cap weight method of valuing a company.

Sure. So again going back to that view of rolling up these fair value estimates, these companies to evaluations. There's a couple of ways we can do that, and you point out one, which is to weight them by their market capitalization. I understand this is going to give more more emphasis on larger companies. If we did a very, very simple example, we'll take two, you know, fairly well known ASX companies, retailer Wesfarmers. The congolmerate Wesfarmers and oil and gas producer Santos. Wesfarmers, it's about an eighty billion dollar company, Santos about a twenty billion dollar company. If we just said that was the entire market, Wesfarmers would be eighty percent of that market and Santos the remaining twenty percent. Now, we can put valuations on those two businesses, and at the moment, we see Wesfarmers at a fairly steep premium to what we think it should be trading at about sixty percent. And on the other side of things, we see Santos is undervalued. It's almost a forty percent discount to its fair value estimate in our opinion. Now, if we wanted to find a valuation for that market as a whole, we would take West Farmers fair value estimate, we'd multiply it by its eighty percent waiting, and we'd take Santos's fair value estimate the discount, multiply it by it's twenty percent, and we'd roll it up into a headline number for the market as a whole. And at the moment it would still be on those two basic companies, it would still be of overvalued about forty percent of value because that Wesfarmers premium dominates in a market cap index. So if we look at the market like that, and if I generalize this to our our true comprehensive cover to the ASX, we still see the market as overvalued, even after the ten percent correction over the last couple of weeks. So it was about twenty percent overvalued before the correction. It's now about ten percent overvalued. So it's pulled back, it's not as expensive as it was, but it is still in general overvalued, and that's primarily because of the influence of those larger companies.

Sure. So again going back to that view of rolling up these fair value estimates, these companies to evaluations. There's a couple of ways we can do that, and you point out one, which is to weight them by their market capitalization. I understand this is going to give more more emphasis on larger companies. If we did a very, very simple example, we'll take two, you know, fairly well known ASX companies, retailer Wesfarmers. The congolmerate Wesfarmers and oil and gas producer Santos. Wesfarmers, it's about an eighty billion dollar company, Santos about a twenty billion dollar company. If we just said that was the entire market, Wesfarmers would be eighty percent of that market and Santos the remaining twenty percent. Now, we can put valuations on those two businesses, and at the moment, we see Wesfarmers at a fairly steep premium to what we think it should be trading at about sixty percent. And on the other side of things, we see Santos is undervalued. It's almost a forty percent discount to its fair value estimate in our opinion. Now, if we wanted to find a valuation for that market as a whole, we would take West Farmers fair value estimate, we'd multiply it by its eighty percent waiting, and we'd take Santos's fair value estimate the discount, multiply it by it's twenty percent, and we'd roll it up into a headline number for the market as a whole. And at the moment it would still be on those two basic companies, it would still be of overvalued about forty percent of value because that Wesfarmers premium dominates in a market cap index. So if we look at the market like that, and if I generalize this to our our true comprehensive cover to the ASX, we still see the market as overvalued, even after the ten percent correction over the last couple of weeks. So it was about twenty percent overvalued before the correction. It's now about ten percent overvalued. So it's pulled back, it's not as expensive as it was, but it is still in general overvalued, and that's primarily because of the influence of those larger companies.

Yeah, so the market cap weight method, is it things like banks and that which have such a huge weighting in the local market that gives the premium to the local market.

Yeah, so the market cap weight method, is it things like banks and that which have such a huge weighting in the local market that gives the premium to the local market.

That's absolutely right, to look at it that way. So obviously you're putting more emphasis on the big companies when you wait things by their market cap. The ASX two hundred bench mark index is a market weighted index, so it's going to have a high allocation to bigger companies. Banks, you know, the four majors make up about twenty percent of the index by market cap. CBA alone is about ten percent. So if you have that particular sector of the market looking expensive and in general we think it does. You wouldn't be surprised to find that the market overall looks overvalued.

That's absolutely right, to look at it that way. So obviously you're putting more emphasis on the big companies when you wait things by their market cap. The ASX two hundred bench mark index is a market weighted index, so it's going to have a high allocation to bigger companies. Banks, you know, the four majors make up about twenty percent of the index by market cap. CBA alone is about ten percent. So if you have that particular sector of the market looking expensive and in general we think it does. You wouldn't be surprised to find that the market overall looks overvalued.

Okay, So another option is to talk about an equal weight methodology. So we've been talking about market weight equal weight. Presumably in your example, Wesfarmers and Santos get fifty percent waiting.

Okay, So another option is to talk about an equal weight methodology. So we've been talking about market weight equal weight. Presumably in your example, Wesfarmers and Santos get fifty percent waiting.

That's right, Yeah, and that very simple example, they would. Again if we use the numbers from earlier, that Wesfarmers is quite overvalued and Santos is quite undervalued. If I did the fifty to fifty weighting to each, then the market would come out as slightly overvalued because in this example, you know, Wesfarmers is more expensive than Santos is cheap, but it would be a significantly lower premium to fair value under that approach, because we're weighting the two companies equally, rather than having the valuation dominated by the very large company of the two, Wesfarmers. Now, what that does is it allows us to take a little bit more of a look, more of a comprehensive look across valuations over the entire market. It is not just skewed by very large companies. So if you are a big institutional investor, you're probably going to be holding things you know, close enough to market cap weight, that may be looking at on a market cap basis the right way to assess value. But if you're an individual investor or, you're unconstrained, you can hold small caps, you can hold the market in an equal way to proportion. You have a lot more flexibility and diversity there. So looking at it on an equal weighted basis might give you a bit more of a sense. So well, actually how much opportunity lies across the entire ASX and not just focusing on the large companies.

That's right, Yeah, and that very simple example, they would. Again if we use the numbers from earlier, that Wesfarmers is quite overvalued and Santos is quite undervalued. If I did the fifty to fifty weighting to each, then the market would come out as slightly overvalued because in this example, you know, Wesfarmers is more expensive than Santos is cheap, but it would be a significantly lower premium to fair value under that approach, because we're weighting the two companies equally, rather than having the valuation dominated by the very large company of the two, Wesfarmers. Now, what that does is it allows us to take a little bit more of a look, more of a comprehensive look across valuations over the entire market. It is not just skewed by very large companies. So if you are a big institutional investor, you're probably going to be holding things you know, close enough to market cap weight, that may be looking at on a market cap basis the right way to assess value. But if you're an individual investor or, you're unconstrained, you can hold small caps, you can hold the market in an equal way to proportion. You have a lot more flexibility and diversity there. So looking at it on an equal weighted basis might give you a bit more of a sense. So well, actually how much opportunity lies across the entire ASX and not just focusing on the large companies.

Okay, I want to talk about how investors can now use these methods to inform their strategies and get a couple of stocks to keep an eye on. We'll be back in a minute.

Okay, I want to talk about how investors can now use these methods to inform their strategies and get a couple of stocks to keep an eye on. We'll be back in a minute.

My guest this morning is Lochlan Halloway, equity market strategist at Morningstar. So we left talking about the benefit of equal weight methodology, particularly for individual investors. Would you recommend one over the other at any certain time?

My guest this morning is Lochlan Halloway, equity market strategist at Morningstar. So we left talking about the benefit of equal weight methodology, particularly for individual investors. Would you recommend one over the other at any certain time?

Look, it's going to depend on how the investor likes to look at the market. There's not really a preference. I mean, they are two different ways of looking at the market, of assessing valuations. Not to say that you will always follow one investment strategy or the other, but it gives you two different benchmarks to assess; is the Australian equity market overvalued or undervalued or fairly value at any given time. Now, obviously there are certain products that you know are available for investors that are market cap weighted products like just simple ASX two hundred benchmark tracking ETFs for example.

Look, it's going to depend on how the investor likes to look at the market. There's not really a preference. I mean, they are two different ways of looking at the market, of assessing valuations. Not to say that you will always follow one investment strategy or the other, but it gives you two different benchmarks to assess; is the Australian equity market overvalued or undervalued or fairly value at any given time. Now, obviously there are certain products that you know are available for investors that are market cap weighted products like just simple ASX two hundred benchmark tracking ETFs for example.

Yes.

Yes.

There are also equal weighted Australian and global products and ETF. So, you can invest like that if you want, and if you look through into the underlying constituents at a very very simple level, if we have large companies that you see is very expensive, like we do in Australia at the moment, then perhaps you'd say, well, let's try and diversify away from those companies, reduce the concentration risk and have something like more closer to an equal weight allocation across asset classes. Obviously that's not you know, this is your general approach, but that might be more attractive when you see large cap companies looking expensive.

There are also equal weighted Australian and global products and ETF. So, you can invest like that if you want, and if you look through into the underlying constituents at a very very simple level, if we have large companies that you see is very expensive, like we do in Australia at the moment, then perhaps you'd say, well, let's try and diversify away from those companies, reduce the concentration risk and have something like more closer to an equal weight allocation across asset classes. Obviously that's not you know, this is your general approach, but that might be more attractive when you see large cap companies looking expensive.

Okay, let's remind listeners this is not investment advice. Of course, go and speak to a financial planner if you want to investment advice. Let's bring small caps into it, because what you're sort of inferring here is that we are at a time now where small caps are trading at a discount to large caps and have done for quite some time, then one methodology in this instance the equal weight might actually be a better option than the market cap weight.

Okay, let's remind listeners this is not investment advice. Of course, go and speak to a financial planner if you want to investment advice. Let's bring small caps into it, because what you're sort of inferring here is that we are at a time now where small caps are trading at a discount to large caps and have done for quite some time, then one methodology in this instance the equal weight might actually be a better option than the market cap weight.

Yeah, like, I think that's fair. It will give you a relatively higher exposure to smaller companies if you're investing, choose to invest like that. I think you have to be careful when you do invest in small caps. I mean, often there's a reason why they're small. They might be at the start of their journey and they haven't established a mode, or they might be on their way to establishing a mode or a competitive advantage, or they might have been a former large cap that has fallen out of favor for reasons that might be justified or not. So there is a bit more risk there, and I think particularly in the Australian context, our small cap, our Small Ords Index has a fairly poor track record or performance because of the way the listing rules about companies here and the fact that we have a lot of smaller exploratory miners in that part of the index that don't have a great track record of performance. So I don't think the sort of shotgun spray approach there makes a lot of sense, because you you probably should be applying in our opinion, the way we look at it, I should say is that you should look at things based on, you know, their intrinsic valuations, their qualities as a company, and just sort of indiscriminently going into a certain part of market may not be the best approach.

Yeah, like, I think that's fair. It will give you a relatively higher exposure to smaller companies if you're investing, choose to invest like that. I think you have to be careful when you do invest in small caps. I mean, often there's a reason why they're small. They might be at the start of their journey and they haven't established a mode, or they might be on their way to establishing a mode or a competitive advantage, or they might have been a former large cap that has fallen out of favor for reasons that might be justified or not. So there is a bit more risk there, and I think particularly in the Australian context, our small cap, our Small Ords Index has a fairly poor track record or performance because of the way the listing rules about companies here and the fact that we have a lot of smaller exploratory miners in that part of the index that don't have a great track record of performance. So I don't think the sort of shotgun spray approach there makes a lot of sense, because you you probably should be applying in our opinion, the way we look at it, I should say is that you should look at things based on, you know, their intrinsic valuations, their qualities as a company, and just sort of indiscriminently going into a certain part of market may not be the best approach.

Okay. So let's talk about a few small caps that I know you've mentioned recently in a note. Domino's Pizza, which might have been a mid sized cap at one point. It's probably now a small cap that isn't at the start of its journey. But why do you like it?

Okay. So let's talk about a few small caps that I know you've mentioned recently in a note. Domino's Pizza, which might have been a mid sized cap at one point. It's probably now a small cap that isn't at the start of its journey. But why do you like it?

Yeah. Look, that's probably in the bucket of stocks that I alluded to earlier, which is companies that were formerly, in Domino's case, a market darling that has fallen at least now, as the market, on hard times. We think that the selldown is unwarranted. Domino's, it's a moated brand in our opinion, it's a globally successful brand, strong store concept, it has a strong track record before this recent period of cost inflation and sales slowdown of you know of store growth outstripping you know, cost growth, which is what you look for in a strong brand. Yes, coming out of COVID, they overexpanded. This is Domino's in Australia. That is the Domino's Pizza which is a master franchise in Australia but also has as operations over in Europe and Japan. But we think that represents more sort of short term cyclical issues that we're seeing across the consumer environment more broadly. This is a tough time to be a retailer. Things look like they're getting better, but it is still difficult. And we think Domino's brand is still there and its growth outlook is still intact, and the market takes a different view. So that's why we see Domino's Pizza as undervalued.

Yeah. Look, that's probably in the bucket of stocks that I alluded to earlier, which is companies that were formerly, in Domino's case, a market darling that has fallen at least now, as the market, on hard times. We think that the selldown is unwarranted. Domino's, it's a moated brand in our opinion, it's a globally successful brand, strong store concept, it has a strong track record before this recent period of cost inflation and sales slowdown of you know of store growth outstripping you know, cost growth, which is what you look for in a strong brand. Yes, coming out of COVID, they overexpanded. This is Domino's in Australia. That is the Domino's Pizza which is a master franchise in Australia but also has as operations over in Europe and Japan. But we think that represents more sort of short term cyclical issues that we're seeing across the consumer environment more broadly. This is a tough time to be a retailer. Things look like they're getting better, but it is still difficult. And we think Domino's brand is still there and its growth outlook is still intact, and the market takes a different view. So that's why we see Domino's Pizza as undervalued.

Another one Bapcorp, which many people that well they may not know that the head company, but you know Burson's, Autobarn, Midas that organisation. You quite like that one too?

Another one Bapcorp, which many people that well they may not know that the head company, but you know Burson's, Autobarn, Midas that organisation. You quite like that one too?

Yeah, that's right. Again, probably to some agree in a similar bucket to Domino's. There are concerns there around what the rise of electric vehicles might mean for autoparts retailers. That's fair. We think, again, these are sort of overblown concerns. It's had a slowdown recently. We think it has a cost advantage over many of the smaller competitors in that environment. We think that, again, protects it and should allow it to earn economic profit in the long run. So, again, I put that in a similar bucket to Domino's in that it looks like an oversold company that has, you know, it's fundamentals broadly speaking, are intact.

Yeah, that's right. Again, probably to some agree in a similar bucket to Domino's. There are concerns there around what the rise of electric vehicles might mean for autoparts retailers. That's fair. We think, again, these are sort of overblown concerns. It's had a slowdown recently. We think it has a cost advantage over many of the smaller competitors in that environment. We think that, again, protects it and should allow it to earn economic profit in the long run. So, again, I put that in a similar bucket to Domino's in that it looks like an oversold company that has, you know, it's fundamentals broadly speaking, are intact.

And finally, Siteminder.

And finally, Siteminder.

Yeah, that's right. So Siteminder. They're an interesting one and they're probably a little bit different the other two that I mentioned, because this is really looks like an up and comer as opposed to something that's been unfairly treated. Siteminder they're an ecommerce software provider for the hotel industry, particularly sort of at that smaller and mid sized hotel is end of the market. The SaaS business model looks like it will really work quite well there because you don't have to develop something in house. It's something that they can roll out quickly, you know, with incremental profits on not a lot of additional investment, which is a great business model in general. They're metrics on how much it costs them to acquire a customer versus the lifetime value of that customer base on the subscription that they'll received look really, really strong and much higher than the sort of benchmark across the software as a service industry. So we think they're at the start of a really positive growth journey and that's another one of the small cap picks that we see at the moment.

Yeah, that's right. So Siteminder. They're an interesting one and they're probably a little bit different the other two that I mentioned, because this is really looks like an up and comer as opposed to something that's been unfairly treated. Siteminder they're an ecommerce software provider for the hotel industry, particularly sort of at that smaller and mid sized hotel is end of the market. The SaaS business model looks like it will really work quite well there because you don't have to develop something in house. It's something that they can roll out quickly, you know, with incremental profits on not a lot of additional investment, which is a great business model in general. They're metrics on how much it costs them to acquire a customer versus the lifetime value of that customer base on the subscription that they'll received look really, really strong and much higher than the sort of benchmark across the software as a service industry. So we think they're at the start of a really positive growth journey and that's another one of the small cap picks that we see at the moment.

Lochlan, thank you for talking to Fear and Greed.

Lochlan, thank you for talking to Fear and Greed.

Great to be here. Thanks.

Great to be here. Thanks.

That was Morningstar equity market strategist Lochlan Hallaway. This is the Fear and Greed Business Interview. Remember this is general information only and you should see professional advice before making investment decisions. Join us every morning for the full episode of Fear and Greed, daily business news for people who make their own decisions. I'm Sean Aylmer. Enjoy your day.

That was Morningstar equity market strategist Lochlan Hallaway. This is the Fear and Greed Business Interview. Remember this is general information only and you should see professional advice before making investment decisions. Join us every morning for the full episode of Fear and Greed, daily business news for people who make their own decisions. I'm Sean Aylmer. Enjoy your day.