Focus on value investments as volatility starts rocking markets
After almost a decade of complacency, it may be time to start looking at quieter corners, writes Shaun le Roux
Volatility returned to global markets in 2018. After making fresh record highs in January, most stock indices have undergone the first notable correction in two years. Yet global equities have confounded the sceptics for almost a decade and until recently complacency was abundant.
This has been against an unequivocally positive global macroeconomic backdrop. Leading economies are enjoying a rare period of sustained synchronised growth as central banks globally keep interest rates low. Central banks such as the European Central Bank and the Bank of Japan continue to run quantitative-easing programmes, while the US recently cut its corporate tax rates.
In combination, this caused the strongest rate of earnings growth since 2010 to be registered in 2017. Marking the ninth year of the global bull market, the MSCI World Index was up more than 23% and delivered positive returns in all four quarters for the first time since 1996.
Similarly, the S&P 500 Index delivered 12 positive months for the first time in its history and registered a record run of 14 consecutive monthly gains.
We believe a combination of high valuations and high complacency makes it unlikely that investors will get the results reflected in their positioning and that a focus on capital preservation will serve them better
Understandably, many global investors remain bullish. Based on sentiment and asset allocation measures, global investors are the most confident they have been in more than a decade.
This is most clearly reflected in aggressive asset allocation strategies, with individual investors generally reducing cash levels to lows last seen in the dotcom years, to buy equities. We are cautious and have been doing the opposite in our global funds.
We believe a combination of high valuations and high complacency makes it unlikely that investors will get the results reflected in their positioning and that a focus on capital preservation will serve them better. Considering cyclically adjusted price-to-earnings ratios, the US market has only been more expensive twice in the past century: just before the 1929 crash and during the dotcom bubble.
Using price-to-sales ratios as a measure, the US market is at similar levels to the dotcom bubble, which shows that valuations and margins are high.
Average annualised volatility in 2017, as measured by the VIX index, was also the lowest on record. This reflects a disconnect between pervasively bullish positioning and likely returns, a distortion amplified by passive flows, which Merrill Lynch estimates account for 70% of daily global equity trading volumes.
This is an environment in which to dial back risk. This is backed up by our bottom-up work: not only have the gaps between the share prices of the global companies we analyse and our assessments of intrinsic value narrowed, but we are finding fewer new opportunities that meet our criteria. Cash levels in our global funds are consequently at high levels, ready to be deployed when these markets once again present attractive opportunities.
It’s not all doom and gloom: market divergences continue to present opportunities
It’s not all doom and gloom, however. Market divergences continue to present opportunities. Valuation differences within equity markets (the gaps between cheap and expensive stocks) remain extraordinarily wide. Aggressive crowding in popular stocks or sectors has pushed up prices in these parts of the markets. This has been exacerbated by passive flows, which are increasingly dominant but not price sensitive.
Out-of-favour sectors provide the potential for mispricing. Recent examples include the US retail sector, in which a strong prevailing narrative is the predicted demise of brick-and-mortar retailers due to the growing dominance of Amazon and other online players.
While the narrative may generally hold true, we do not believe its broad application across the retail sector is appropriate. For example, L Brands — owner of brands such as Victoria’s Secret, Pink and the highly successful US fragrance and skincare business Bath & Body Works — is a holding in our funds. The business is a niche, vertically integrated retailer with a direct-to-consumer business model and international operations we expect to gain significant traction over the next three to five years.
Having traded at a record high of just less than $100 in recent years, the drop to a share price of as low as $35 in August 2017 offered a great opportunity to acquire a high-quality and relevant business in an unloved part of the market, at a cheap valuation and large discount to our estimate of intrinsic value.
Similarly, with Brexit negotiations under way, investors are understandably concerned about the effect the UK’s departure from the EU will have on UK markets.
Domestic-facing UK companies, which are likely to bear the brunt of any potential economic fallout, are thus trading at exceptionally low levels compared to the broader UK market. While no one can predict the outcome and economic consequences of Brexit negotiations, experience has shown that quality companies managed by able individuals are likely to be good investments if bought at sufficiently cheap valuations. We have therefore taken advantage of selective opportunities created by Brexit-related fears.
These include Babcock International, the UK’s leading engineering outsourcing firm, which provides critical solutions to clients, many of whom lack the in-house capability. The company has strong barriers to entry and a number of unique assets. Its marine services department owns two British dockyards, operates two of the UK’s three naval bases and is contracted by the Royal Navy to support its submarine fleet and maintain three-quarters of its surface fleet.
The company is also the main support partner to the British Army and Metropolitan Police Force and owns the world’s largest helicopter emergency services company.
Amid generally high global valuations, we believe a willingness to invest in good companies from less crowded parts of the market — and not to invest in popular companies that are large in the index — will continue to serve investors well.
• Le Roux is equity fund manager at PSG Asset Management.