Low PE stocks: Is good value just an illusion?

At the beginning of the year, there were 29 larger cap companies trading at a single digit price-to-earnings ratio. A low PE ratio often creates the illusion that a stock is cheap or undervalued but is this really the case?

A quick recap

A few key things to note from my first piece about the 29 stocks with $1 billion or more market caps trading at single digit PEs:

Performance (as at 4 January 2023)

• Top performers: Whitehaven Coal (+219.5%), Stanmore Resources (+196.6%), New Hope (+148.4%) and Yancoal (+102.8%)

• Worst performers: Summerset Group (-36.1%), Fletcher Building (-37.1%), Healius (-41.1%) and Magellan Financial Group (-56.6%)

• Average 12-month return: 14.6%

• Average 12-month return ex-coal: -9.7%

Key takeaways

• Cyclicals: A low PE ratio tends to mark the peak of the cycle for resource and cyclical stocks

• Price leads earnings: The 'P' can often fall first and give the stock the appearance of a low PE ratio. In the subsequent period, the 'E' then catches up

Larger cap stocks with low PE ratios: Then vs. now

This is the list of companies with market caps of over $1 billion that traded at a single digit PE ratio on 4 January (then) vs. 15 March (now).

Performance recap

• Top performers: Are still coal stocks but gains have pulled back sharply. The average coal performance was 166%, now it's 81% (worth noting that these stocks have gone ex-div and paid out pretty large dividends)

• Worst performers: Mostly unchanged (Magellan, Healius, Fletcher and Summerset) but the stocks haven't dipped any lower

• Average 12-month return has shrunk from 14.6% to 1.15%

• Average 12-month return ex-coal is -11.7% from -9.7%

• The ASX 200 is down 0.5% in the last 12 months

In a nutshell

Before some more in-depth observations, let's quickly summarise how things have gone for these low PE stocks:

• Resources ease: Resource-related stocks like coal (Whitehaven, Yancoal, New Hope and Stanmore), aluminium (South32), oil (Beach Energy) and agriculture (Elders, Graincorp and Australian Agricultural) have all topped as commodity prices ease from 2022 highs

• Retailers struggle: Harvey Norman and JB Hi-Fi continue to fall as trading updates flag a softening outlook for FY23

• PEs expand: Healius' underlying profit for 1H23 was down -96.7% to $8.1 million as PCR testing revenues disappear. The stock's PE ratio has jumped from 6.1 to 56. This might be a trend to watch out for cyclical sectors as well

The ones that outperformed

There were 11 (38%) stocks out of the 29 that managed to stop the bleeding and trade a little higher since the beginning of the year.

Here's a deeper dive into the two I found most interesting.

Sonic Healthcare: Going full circle

Sonic shares rallied 14.3% on its half-year results on 16 February, which explains the bulk of its recent turnaround. The stock has been on a pretty volatile journey since Covid and in summary:

• Sonic shares rallied 50% between February 2020 to January 2022

• Earnings were supercharged by Covid-testing revenues. In FY21, net profits jumped 149% to $1.3bn

• Between January 2022 and February 2023, the stock de-rated almost 40%

• As Covid-related revenues became a thing of the past, 1H23 net profits fell 54% to $382 million

• Sonic management reiterated the fact that earnings per share is "an amazing 50% higher than in the most recent pre-pandemic comparable period, being H1 FY20."

At Sonic's tough on 13 February, the stock was trading around 10% below where it was pre-Covid, which makes sense given the lack of Covid-related revenues.

The half-year result inspired a strong re-rate as its base business posted organic revenue growth of 6.0% and EPS was up 50% against pre-Covid levels.

Sonic's PE has risen substantially from 9.9 at the beginning of the year to 15.8. To add some perspective, the stock has traded at an average PE ratio of 21.6 over the last eight years.

Sonic Healthcare 5-year chart (Source: Market Index)

Viva Energy: A value-add cyclical

Viva Energy reported its FY22 results during February reporting season, with revenues up 66% to $26.4 billion and underlying earnings per share up 221.7% to 38.6 cents.

The buoyant result reflected strong refining margins in an environment where global energy demand was recovering and domestic refining capacity was constrained due to closures and outages.

Macquarie expects earnings to plateau in the near term, with FY23 and FY24 EPS to fall to 28.8 cents and 28.20 cents respectively.

Despite the lack of earnings upside, UBS believes the company offers a diversified mix of quality earnings from retail and commercial fuel markets.

Viva Energy 5-year chart (Source: Market Index)