Time to capitalise on recent share market falls

Guessing the bottom when the market has fallen to where it has may seem like a 'no brainer'.

But there’s a growing cohort that after reading the tea leaves, believe it’s now time to tentatively search the market for attractive entry points on oversold stocks.

Given that there are no bell-ringers to signal the bottom, calls to buy now may appear a little ballsy (gender non-specific).

But with valuations (and PE ratios) of many quality businesses having fallen sharply over the last six months, Roger Montgomery CIO of Montgomery Investment Management believes savvy investors should be cashed up and ready to pounce.

While recent share market falls are no reason to be doing cartwheels down the street, Montgomery believes net buyers of equities – who buy businesses that can grow their earnings - should be somewhat titillated by recent declines.

The serious decline of high-quality companies

At time of writing 112 of the biggest 200 companies listed on the ASX were below their price at the beginning of the year, while the average decline and median decliners were -17.7% and -15.4% respectively.

While some stocks, like Zip (ASX: ZIP), Pointsbet (ASX: PBH) and Kogan (ASX: KGN) were down between -76% and -40% year-to-date, what shouldn’t be lost on investors’, adds Montgomery is that even the highest quality companies – including REA Group (ASX: REA),Wesfarmers (ASX: WES),ARB Corporation (ASX: ARB), Credit Corp (ASX: CCP) and Super Retail Group (ASX: SUL) - were also sold off between -15 and -25%.

What's often overlook, adds Montgomery is that these losses were due to inflation surprising to the upside, rather anything negative factors undermining the core earnings of these businesses.

Silver lining

We’re undeniably experiencing a correction.

But the bottom line is with PE ratios having compressed materially over the last six months the fund manager believes investors have a better chance of making attractive returns.

But that’s only assuming you buy the right businesses.

“PE compression and stock market falls may just be the rational price investors in equities and managed funds have been waiting for,” notes Montgomery.

Buy stocks that can grow their earnings

By way of explanation, the broker reminds investors that it matters not whether the stock was purchased at 10, 20 or 30 times earnings; your internal return will match the earnings growth rate - provided the shares are sold at the same PE multiple that was paid for them.

Now that PEs have compressed, Montgomery reminds investors to seek businesses whose earnings will grow and cites the immortal musings of US investment guru Warren Buffett.

“Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understood business whose earnings are virtually certain to be materially higher, five, ten, and twenty years from now.”

What a different PE makes

To labour the point, Montgomery reveals in the following table, the bonus in terms of internal rates of returns, you’ll earn from a jump in PE ratios at the time of sale.

If PE stayed at 15 at the time of sale, you would earn 10% per annum. But within this example, in the final year, the PE jumps to 20 times – the net effect is an 18% per annum return.

No dead cat bounce here

Avoid stocks with poor earnings

Echoing similar sentiment to Montgomery, Clime Investment Management recommends side-stepping companies with a high price-to-earnings (PE) ratio and particularly those with a limited earnings track-record in the IT space.

“We believe a valuation disparity between high-PE and low-PE parts of the market has further to unwind,” notes the company’s CIO Will Riggall.

Despite recent sell-offs within the sector, he foresees a sharp recovery in domestic and international airline travel, as pent-up savings are spent on experiences rather than home furnishings.

Don’t discount travel

If Riggall’s travel schedule is anything to go by, he believes any further decline in the share price will be a very attractive opportunity for long-term investors and notes the emergence of Qantas (ASX: QAN) with a lower cost base.

With evidence that inflation was more structural than cyclical, Clime swiftly removed consumer discretionary stocks from the company’s portfolios.

“We believe it is prudent to continue to avoid consumer names at present,” advises Riggall.

“However, the list of attractively priced, quality Australian companies is getting larger, and we look to the current period of volatility to buy these companies at a discount to our view of intrinsic value.”

Qantas share price over 12 months.