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70% of Australian shares now below fair value: Time to buy?


Long-term investors should see the market fall as an opportunity to buy cheap shares.

Investors should look beyond the short-term declines and buy cheap shares, an industry expert says.

The ASX 200 index is down 15.38% year to date following a sluggish start to morning trading when the market fell 0.81%.

At the same time, the US benchmark S&P 500 is currently in a bear market, down 23.39%. The tech-heavy NASDAQ-100 has fallen nearly 32% for the year. Overall it has been the worst start since WW2.

But such is the market falls, that Morningstar's analyst Gareth James says up to 70% of shares that they analyse are now cheap.

"Equity market valuations were stretched during 2021, but Morningstar's Australian price/fair value ratio recently fell to its cheapest level since May 2020," he said.

As such, Morningstar points out it could be a time to pick up some cheap winners.

Look through the macroeconomic trends

The current market downturn is largely due to fears of rising inflation and the possibility of a recession.

To kill inflation, central banks might need to lower economic growth. Investors reposition their portfolios to align with the new economic climate as well.

But, Morningstar believes this overall bearish sentiment from the market is overblown and that investors should look at individual market sectors.

This is because as rising inflation is hitting your back pocket, it is less likely to be impacting your portfolio over the long term.

In fact, Morningstar believes that the Australian equity market has plenty of hiding places from inflationary pressures.

Financial services, energy and basic materials, health care, consumer staples and even information technology companies that have high switching costs are relatively protected from inflation and even an economic downturn.

At the same time, utilities businesses with high debts, consumer cyclical and real estate are likely to be more vulnerable to inflation-related risks.

"We recommend investors look through short-term macroeconomic risks and instead focus on intrinsic values based on likely long-term economic variables," James said.

Inflation a short-term problem

Even with surging energy prices and other inflationary pressures, James points out that Australia's economy is in a relatively strong position, which should have a flow-on impact on our markets.

Instead, Morningstar believes that inflation will subside over the medium term.

"Our expectation for inflation to subside is consistent with the Reserve Bank of Australia (RBA) and Australian government treasury economic forecasts," James said.

"Although we expect inflation to decline over the medium term, we expect interest rates to normalise closer to long-term historical averages."

Multiples may drive down prices in the short term

A key reason why shares are falling is compressing price-to-earnings (P/E) ratios.

When money effectively became free during the COVID downturn, investors were adding additional funds to the market. This drove up the price of shares.

But the current market sell-off has seen P/Es fall to relatively normal levels.

"Recent market weakness has already compressed the multiple, meaning P/E ratios on average don't look particularly stretched relative to the last 7 years," James said.

Instead, James argues, investors should be mindful that inflation arguably has a negligible impact on many equities over the long term.

"Equities differ from bonds in that the price of fixed coupon bonds typically falls when inflation and interest rates rise because a bond's yield increases to incorporate higher inflation and interest rates.

"However, equity prices don't necessarily fall because equity earnings are variable and may increase with inflation," James concludes.

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