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How to assess the value of stocks with extreme PE multiples

How to assess the value of stocks with extreme PE multiples

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You’ve probably heard bullish commentators argue that declining interest rates explain, and justify, the extraordinary price to earnings (PE) multiples being paid for growth stocks.  Many of these commentators also maintain that, because rates are going to stay lower for longer, these stocks are a defensive, sensible, and even safe investment.  But are they right?

Do low rates explain the expansion in PE multiples? 

At Montgomery we decided to explore the theory to answer the question of whether low rates were responsible for the massive expansion in PE multiples now widely accepted as normal by many, especially bullish, investors.

The theory goes something like this: equity investors demand a return – commensurate for the risk of investing in equities – above the risk-free rate (RFR) and through the actions required to satisfy the need for an appropriate return, markets will find an equilibrium. The market’s equilibrium PE multiple can then be explained by a formula that takes the risk-free rate and equity market risk premium in account with an adjustment for growth.

A quick example here may be useful. Rates on long term government bonds are widely employed as proxies for the risk-free rate. The Australian government recently sold 31-year government bonds at around 1.90 per cent. The equity market risk premium is currently estimated to be around three per cent. Add the two together and we arrive at a theoretical equilibrium earnings yields of around five per cent.  The PE ratio is the inverse of the earnings yield so if we divide one by five per cent, we derive the equilibrium PE ratio of about 20 times earnings. The current PE for the ASX200 is about 19.85 times, suggesting it is about fair value.

The above however doesn’t take into account growth. To do that we need to subtract the growth rate from the earnings yield in the denominator. In the above example, if growth is two per cent then we subtract two per cent from the five per cent to arrive at three per cent. Divide one by three per cent and we arrive at a fair value PE of 30 times. Perhaps unsurprisingly, if we remove financials from the ASX200, its PE is about 30 times.

With the current market PE aligning with the theoretical PE, bullish investors retire to their den for a scotch and cigar content in the knowledge they are right and should remain fully invested in high growth names.

The problem is that for the theory to be reliable, the inputs need to be reliable. At Montgomery we just aren’t sure interest rates actually have the relationship to equities that many theorists have relied on to argue their case, especially for current market valuations.

What does the Price Earnings (CAPE) ratio tell us?

Nobel Laureate Robert Shiller developed the Cyclically Adjusted Price Earnings (CAPE) ratio and produced a retrospective series back to 1881. The data is widely considered high quality and certainly long-term.

At first glance, it appears that the series supports the expected relationship between interest rates and PEs. The low points in the CAPE in 1921 and the early 1980s corresponding with interest rate peaks.

But two convergences don’t make a summer. The apparent relationship fails on closer inspection. There were several decades of both CAPE and interest rates rising together in the 1950s and 1960s and pronounced peaks in CAPE in 1929 and 2000 occurring at moderate levels of interest rates.

Image 1

Source: Montgomery Investment Management

Thanks to statistical analysis we can also more formally express the strength or weakness of the relationship. We can convert Shiller’s data into monthly or annual changes to interest rates and CAPE and use regression analysis to determine the strength of the relationship between the two. We can also convert interest rates to a notional equity discount rate by adding, say, a constant six per cent equity risk premium (ERP) and use change to this notional discount rate as the independent variable.

This analysis indicates there is no significant relationship between changes to interest rates and changes to CAPE. The regression analysis suggests that changes in interest rates explain virtually none of the observed variation in CAPE over time. If we repeat this analysis using estimated real discount rates (calculated by subtracting actual change in CPI from the nominal rates) we again find only a very weak relationship between interest rates and CAPE.

As a further check, we undertook a (broadly) similar analysis on the Australian market, using changes to Australian discount rates (estimated as the 10-year bond rate plus six per cent) as the independent variable and change to the All Ordinaries Index (due to shorter timeframes we did not use a CAPE equivalent) as the dependent variable. Available data allows us to undertake this analysis over 50 years from 1970. In this case we did see a statistically significant relationship but only a small component of changes to the All Ordinaries Index is explained by changes to interest rates.

To put some dimensions to this, the regression analysis indicates that a reduction in interest rates of six percent (comparable to what we have seen in the last 10 years) might be associated with only a circa 13 per cent increase in the level of the All Ordinaries Index, beyond the level it would otherwise attain.

Why is this important?

The last 30-40 years have seen a marked decline in long-term interest rates in Australia and the US. Yields have seen more-or-less a steady decline since peaking in the early 1980s.

The current COVID-19 pandemic has contributed further to this dynamic, with yields – which had been rising in recent years – again turning down. In addition, there is an increasing expectation that low rates are likely to be sustained for some years.

There is virtual consensus that by keeping rates low, central banks around the world are supporting equity markets. The belief in the relationship between low rates and higher equity markets, and particularly high growth equities, whose value is concentrated more in future periods, is sacrosanct.

What our analysis suggests is that there are other explanations for the extreme PEs we are currently seeing. Some of these alternative explanations include the possibility that bond rates are not a good proxy for the long-term risk-free rate and that the market might not fully embrace the capital asset pricing model.  But another explanation may be equally valid – we are in the middle of a good old-fashioned bubble in technology and growth stocks.

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Nansen third-party vendor suffers security breach, affects user data

The crypto analytics provider says a security breach of a third-party vendor has affected nearly 7% of users in the system who were promptly informed of…

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The crypto analytics provider says a security breach of a third-party vendor has affected nearly 7% of users in the system who were promptly informed of the incident.

The prominent crypto and blockchain analytics company Nansen posted on social media platform X that one of its third-party vendors suffered a security breach that affected 6.8% of its users. 

According to Nansen, the breach gave hackers access to admin rights for an account used to “provision customer access” to its platform.

Without directly naming the company affected, it said this vendor is “an established company that is used by many Fortune 500 companies” along with other companies in the industry for the purpose of managing data. 

The users who were affected by the breach reportedly had their email addresses exposed, along with some password hashes and a small group had their blockchain addresses compromised.

Nansen said it has identified and informed those affected of the matter and asked all to change their passwords. It also clarified that wallet funds were unaffected by the event. 

Related: PayPal’s PYUSD struggles with early adoption — Nansen

Nansen is a prominent resource in the crypto space and provides on-chain analytics about many of the industry’s major players. 

In a recent interview with Cointelegraph, the CEO of Nansen, Alex Svanevik commented that he believes in the future a protocol will exist that creates a balance between blockchain transparency and user privacy and is compliant with regulators.

Back in May, the company was among the many that felt the effects of the ongoing bear market and laid off around 30% of its workforce. 

Magazine: How to protect your crypto in a volatile market: Bitcoin OGs and experts weigh in

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How air pollution is making life tougher for bugs

We’re making life tough for insects – and not just by swatting them away with a newspaper.

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Air pollution is the latest threat facing our insects. Robbie Girling/Inka Lusebrink, CC BY-NC-SA

Whether you love them or loathe them, we all depend on bugs. Insects help to pollinate three-quarters of the world’s crop varieties, making them a treasured resource.

But we’re making the lives of insects tough – and not just by swatting them away with a newspaper. Insect populations worldwide are in sharp decline as they battle against climate change, habitat loss and pesticides.

Now, we can add air pollution to the list of threats. Our research from 2022 revealed that when exposed to two common air pollutants at concentrations within EU air quality limits, the visits of pollinating insects to flowers plummeted by as much as 90%.

Over a span of two years, we artificially elevated the levels of either ozone or diesel exhaust fumes around plots of flowering black mustard plants, all within fields of non-flowering wheat. We carefully monitored and controlled the release of pollutants using rings constructed around each plot.

This method allowed us to monitor the number of pollinating insects visiting the flowers in polluted plots and draw comparisons with plots devoid of pollutants.

We were surprised by what we found. In the rings where we released ozone or diesel exhaust fumes, the number of pollinating insects decreased by 70% and overall pollination success rates decreased by up to 31%.

It wasn’t just bees and butterflies that were affected. Ground-dwelling insects suffered too, with exposure to these pollutants causing their numbers to decrease by as much as 36%.

A fenced off ring in the middle of a field.
Eight rings were used to elevate pollution levels around flowering black mustard plants. Neil Mullinger, CC BY-NC-SA

Why air pollution makes life so hard

Many insects rely on their sense of smell to locate flowers. When they feed on nectar, they quickly connect the flower’s scent with its sugary reward. Consequently, when they come across the same scent later on, they track its trail in pursuit of another tasty treat.

Thus, flowers serve a dual purpose. They are not just pretty to look at but also function as beacons that release a specific blend of fragrant chemicals designed to attract pollinators.

But these signals are under threat. Air pollutants like ozone are highly reactive and can degrade the signals by destroying the chemicals that make up a flower’s scent.

In our more recent research, we simulated a floral scent in a 20-metre long wind tunnel and then mapped out how the levels of each of the chemicals that made up the scent changed in response to increasing ozone pollution. We found that ozone quickly ate away at the edges of the plume, reducing both its width and length.

Essentially, the chemical signal could travel only a shorter distance, which limited the number of insects it could reach.

Adding ozone also changes the smell of each of the chemicals that make up a flower’s scent. By observing these changes in a wind tunnel, we could measure the speed at which these chemical changes occur.

Some chemicals degraded within seconds, whereas others were not affected at all. How far away you are from the scent’s source appears to change how the scent smells.

Pavlov’s Bees

To understand how changes to the floral scent might affect pollinators, we taught honeybees to recognise the same floral scent that we released into the wind tunnel. Much like Pavlov’s dogs drooling at the sound of a dinner bell, bees stick out their proboscis (tube-like tongue) when they sniff an odour they have learned to associate with a sugary reward. This allowed us to see how many bees could still recognise the floral scent once it had been exposed to ozone pollution.

Like Pavlov’s dogs, bees can be trained to respond to a dinner bell – or in their case, the scent of a flower.

We first tested the honeybees with scent blends replicating those observed at the plume centre when ozone levels were elevated. At a distance of six metres from the flower, 52% of bees recognised the scent. This fell to only 38% at a distance of 12 metres.

We then tested the response of honeybees to the more degraded plume edges. Only 32% of the bees responded at six metres, falling to just 10% at 12 metres.

These results help to explain the significant decline in the number and diversity of insect visits and pollination rates observed in our field trials. Put simply, ozone pollution limits the reach of chemical signals and changes their meaning, leaving insects confused.

Two diagrams showing how ozone disrupts a flower's scent.
Ozone makes it difficult for insects to sniff out flowers. Ben Langford, CC BY-NC-SA

But this is unlikely to be the full story. Although we replicated the effects of ozone pollution on floral scents, we never exposed the bees directly to ozone. Separate research carried out in France suggests that direct exposure to ozone might also impair the ability of bees to detect floral scents.

The full extent to which air pollution is impacting the insects we all depend on is only just beginning to be revealed. So, the next time you lift your newspaper to swat a bug, take a second and ask yourself – don’t they have it tough enough already?

Ben Langford receives funding from the Natural Environmental Research Council

James Ryalls has received funding from The Leverhulme Trust and The Royal Society to conduct research on this topic.

Robbie Girling has received funding to conduct research on this topic from the Natural Environment Research Council, the Leverhulme Trust and the Gerald Kerkut Charitable Trust.

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Fast fashion’s waste problem could be solved by recycled textiles but brands need to help boost production

Brands like Zara and H&M are teaming up with recycled textile producers but more collaboration is needed.

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Fascinadora/Shutterstock

Earlier this year, fast fashion retailer Zara released its first womenswear collection made of recycled poly-cotton textile waste. The collection is available for sale in 11 countries, helping clothing made of blended textile waste reach the mass market.

The collection came about after Zara’s parent company Inditex invested in textile recycler Circ. This follows a €100 million (£87 million) deal between Inditex and Finnish textile recycler Infinited Fiber Company for 30% of its recycled output. Zara’s fast fashion rival H&M has also entered a five-year contract with Swedish textile recycler Renewcell to acquire 9,072 tonnes of recycled fibre – equivalent to 50 million T-shirts.

There is a growing appetite among some fashion retailers to turn old clothes into high-quality fibres, and then into new clothes. But even though well-known brands are developing lines using recycled textiles, this movement has not yet reached the scale needed to have a truly global impact.

Before this recent growth in interest in textile recycling, fast fashion’s efforts to tackle throwaway attitudes towards affordable clothing often simply added to the global textile waste mountain – especially in developing countries, say campaigners like Greenpeace.

For example, a skirt deposited at a London chain store under a take-back scheme was reportedly found in a landfill in Bamako, Mali. This is not an isolated incident, it’s a sector-wide problem that sees old clothes being collected but not disposed of properly. An estimated 15 million used clothing items are shipped to Ghana each week from around the world and many end up in the country’s landfills. This is often referred to as waste colonialism.

The fast fashion industry needs greater access to recycled textiles to address this problem. But this means having the means to track “thrown-away” garments to collect those suitable for recycling. The industry also needs facilities that are big enough to turn this waste into new materials for clothing at the scale needed to meet mass market demand.

This is particularly important as these firms prepare for an EU crackdown on the region’s own waste mountain. Following the EU strategy for Sustainable and Circular textiles 2022, the European Commission is drafting new legislation over the next five years to make the fashion industry pay for the cost of processing discarded clothing.

Under the new EU rules, companies will be expected to collect waste equivalent to a certain percentage of their production. While the exact amount has not yet been confirmed yet, European commissioner for the environment Virginijus Sinkevičius has said it will “definitely” be more than 5% of production. Companies may have to pay a fee (reportedly equivalent to €0.12 per T-shirt) towards local authorities’ waste collection work.

White store background with sales display of grey coat, tree and light behind white clothing collection bin.
Many stores offer collection bins for old clothes. Inditex

But fast fashion brands must ensure that this doesn’t just dump the problem of textile waste into other countries’ landfills. Instead, developing lines out of recycled textiles could give these old clothes a new lease of life.

A Fashion Pact signed by more than 160 brands (a third of the sector by volume) commits companies to ensure that, by 2025, 25% of the raw materials such as textiles that they use have a low impact on the environment – recycled fibre is considered a low-impact material. Some brands have set more ambitious targets, including Adidas, which has committed to using 100% recycled plastics by 2024, and Zara-owner Inditex, which pledged to source 40% of its fibres from recycling processes by 2030.

These impending deadlines, plus the EU legislation, should motivate brands to use more recycled fibres. While the supply of such material is currently limited, an influx of recycling start-ups are finding ways to turn old clothes into new fibres that replicate the look and feel of virgin materials.

Start-ups like Spinnova, Renewcell and Infinited Fibre have developed chemical recycling technologies to create new fibres from cotton-rich clothing. And while cheap low-cost blended materials like poly-cotton are difficult to separate and recycle, firms like Worn Again, Envrnu, and Circ are tackling this problem, too.

Worn Again plans to build a new recycling demo plant in Switzerland, paving the way for 40 licensed plants by 2040, which would be capable of processing 1.8 million tonnes of textile waste per year.

Taking textile recycling from hype to reality

Up to 26% of Europe’s textile waste could be recycled by 2030, according to some estimates, according to a 2022 McKinsey report. This would generate €3.5-€4.5 billion in economic output for the EU, create 15,000 new jobs, and save 3.6 million tonnes of CO². But only 1% of textiles are currently being recycled globally into new clothes – the recycling technology needed for this shift is still in its infancy.

Part of the challenge in scaling up textile recycling to this degree is the lack of information available about what happens to clothes that are thrown away. Sharing data on the volume, locations and compositions of waste generated in the supply chain and collected post-consumption would help evaluate the full potential of textile recycling. Companies like Reverse Resources already provide online databases of information on textile waste – in this case for a global network of 70 recyclers, 44 waste handlers and 1,287 manufacturers in 24 countries.

Bales of clothes stacked in piles in a warehouse.
A textile recycling centre. Martin de Jong/Shutterstock

Increasing textile recycling will require a collaborative approach, as will the development of the technology needed to create high-quality recycled textiles. Brands, investors, suppliers, recyclers, technology providers and local governments must come together to find ways to grow the textile recycling industry. The recent New Cotton Project that involves 12 brands (including H&M group and Adidas), manufacturers, suppliers and research institutes is a first step towards increasing textile recycling.

More money is also needed from all of these groups. To reach the recycling rate of 18%-26% by 2030, it will take billions in infrastructure investment for collecting, sorting and processing textile waste.

Textile recycling is no longer for a few “sustainable” fashion firms – it is quickly becoming a reality that no fast fashion firm can ignore. Shoppers must demand that the brands they love show their commitment to textile recycling beyond marketing campaigns and low-volume fashion collections.

The authors do not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.

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