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Friday, 17 November 2017
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Quality versus price

I was asked about a stock called Cochlear this week. A client was thinking of buying it. You have probably heard of it, if you are one of their clients you may well have had your life changed by it. It is of course a manufacturer and distributor of cochlear implantable devices for the hearing impaired.

But that’s enough about the company because when an investor asks anything about a company they are really asking about the stock, the stock that is listed on the stock exchange, not the company that is headquartered in Macquarie University in NSW. It is an important difference. The company can be great, but the share price can be bad. Mercedes make a great car for instance, but would we pay a million dollars for one? No. It’s the same with Cochlear.

Cochlear is a company with a return on equity of over forty percent and consistently so. The consistency of growth and earnings makes it a very high-quality company. Revenue growth is consistently above ten percent and earnings growth is between eleven percent and thirty percent. That’s the company. It’s a Mercedes.

But when you look at the price, well, it's high. The stock currently trades on a price to earnings ratio of 41.1 times earnings and 35.6 times earnings next year. If the average stock trades on around 16 times earnings you can see, Cochlear is twice as expensive as the average stock. This is not what you would consider a cheap stock. Neither is it an income investment by the way, not with a gross yield of just 2.5 percent.

If a share price is a combination of value and sentiment, then the numbers tell you that, at the moment, Cochlear is trading on very positive sentiment, the quality always does when the market is running. Of course stocks can do this for long periods of time, especially if they are high growth stocks and especially if they keep upgrading earnings ahead of the market’s expectations.

But at the moment, with Cochlear, the brokers and the analysts don’t expect that. At this point they almost all think it is expensive. In fact the share price is trading at a 27.9 percent premium to the average broker target price. It is also trading at a 94.3 percent premium to its intrinsic value. Brokers think it is overpriced.

Obviously the brokers could be wrong, but they are not generally stupid, and out of nine brokers that cover the stock and have recently published research, four say “Hold” and five say “Sell”. There are no brokers recommending you buy it. On price. They all know it’s a quality company, blind Freddy knows its a quality company, but it can still be cheap or expensive.

Last year the company had a seismic sentiment loss as the share price fell 22% on concerns over cheap Chinese competition. At some point the market will lose faith again, in either itself or the stock, and long-term investors, who are not currently shareholders, will get an opportunity to buy it. At some point it will happen again.

Until then the lessons from the difference between Cochlear the company and Cochlear the stock are numerous:

  • Quality companies can be both cheap and expensive, the stock market is not just about identifying quality.
  • Stocks are a combination of value and sentiment. Active investors should be looking to take advantage of the extremes in that sentiment, not holding through thick and thin. It is OK to sell quality stocks when they are expensive and you don’t have to hold a stock forever just because it is a quality company.
  • You are not the only person to identify that the game is to buy quality companies cheaply. But they rarely are. So understand that the only time you’ll ever buy cheap quality stocks is when the sky falls in. They are rare moments. When they appear you have to be watching the herd, not running with it.

Back to Cochlear. The golden rule of the stock market is that you “Run with the Bulls” until they stop running. Wait for it don’t predict it. Yes Cochlear is expensive, yes it is vulnerable to a correction in the market, but as long as it keeps going up, just hold on. But when it all falls over, don’t stand there saying “But it’s a quality company”.


Here is the Marcus Today STOCK BOX for COH:

 

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