Executive Summary
In times like these, stock fundamentals often go out the window as macro
gyrations move markets. For macro investors, this creates opportunity. For stock
pickers it creates frustration. However over the longer-term, stock fundamentals
do matter. And taking a step back when markets are in a fuss about the macro, to
take a more detailed bottom-up view can be helpful over the longer-run. That is
what this report is designed to do.
In this report, a Reality Check, we form fundamental views on non-financial
stocks in the region over the slightly longer term (2-3 years). This is an effort to
step back from the misery of recent trends in equity markets and form views on
stocks by looking at whether the individual stock valuations are fair in the
context of their return on capital. We conduct this analysis based on all our Asia
ex Japan ex financial coverage universe of stocks with a market capitalisation
above US$1 billion (384 stocks) and in Japan the MSCI Japan index nonfinancial
constituents that UBS has under coverage (119 stocks).
Our valuation metric is EV/RVC, the ratio of the Enterprise value to
Replacement Value of Capital Employed. Our measure for returns is RORVC,
the ratio of EBIT to the Replacement Value of Capital Employed. We have
adjusted capital employed for inflation and different asset life cycles, where
possible, to create a more level playing field for comparison.
We first categorise all stocks into three groups based on EV/RVC –
“Franchises” where the EV/RVC is above 1.2x, i.e. the market is currently
willing to pay a premium to the replacement value of capital employed,
implying that it thinks that company can generate superior returns (hence we call
it a franchise). “Going Concerns” where the EV/RVC is between 0.8x and 1.2x.
And “Projects” where the EV/RVC is less than 0.8, i.e. the company is trading
at a discount to its replacement value of capital employed implying that the
market believes there should be disinvestment by the company, or worse, that
capital will be destroyed through negative returns.
We then compare companies for their attractiveness within each group flagging
them as Green (most attractive), Amber (less attractive relatively) and Red (least
attractive). We use different ranking frameworks for each group. In brief, for
franchises we look at implied growth rates from current valuations; for going
concerns, we compare the ratio of returns on capital versus cost of capital to the
ratio of EV/RVC. Finally for Projects, we look at them through the prism of
private equity – are they inexpensive on an EBITDA basis - secondly are they
actually disinvesting or adding capex, and finally do returns exceed the cost of
capital? Detailed ranking framework and definitions are on page 12 onwards in
the report.
Almost all valuation measures when applied across markets have some flaw and
any attempt to neutralise accounting differences across a multitude of regimes is
also likely to be flawed. Ours is not by any means a perfect or flaw proof
approach. Our aim is to provide a better starting point for identifying value.
For some background, a similar approach was adopted by our predecessors in
the Asian Equity Strategy team (Ian McLennan and James Spence) in 2002.