When the emperor has no clothes, scratch around for value
In an uncertain world, one of the risks you can control is the price you pay for assets
We find ourselves in an environment in which there is more to be worried about than usual, including an escalation of the China-US trade war, fallout from a no-deal Brexit and erratic or aggressive US Federal Reserve policy decisions.
Then for good measure we can add a dose of yield curve inversion in the US, a phenomenon that has been followed by a recession every time in the past 60 years, with just one exception in the late 1960s.
Altogether, this makes for a high-risk economic and political cocktail. Yet, notwithstanding this, markets have pushed into territory of crazy valuations and perverse investment activity.
Take Denmark’s Jyske Bank, which recently launched the world’s first negative interest rate mortgage, offering home loans at minus 0.5% a year on a 10-year mortgage. Negative interest rates in effect mean the bank pays you to take its money. Over the life of the loan you pay back less than you borrowed.
The insanity of “upside-down banking” spread from bond markets, where Germany recently sold the world’s first 30-year bond offering a zero coupon. The German bond was issued on an effective yield of minus 0.2%, meaning investors are guaranteed to lose money on the 30-year investment. In total, about half of all European government bonds have a negative yield and globally there is $15-trillion in negative-yield debt.
Equity markets have produced some astounding valuations, seen in profitless initial public offerings (IPOs). Loss-making Uber came to market at a share price of $45 in May, valuing it at $82bn, or seven times annual revenue. The global average for all businesses is less than two times revenue. Likewise, shared-space office company WeWork announced a September IPO at a $47bn valuation, more than 25 times annual revenue — a staggering sum for a company that isn’t profitable and may never make money.
When valuations get carried away, whether bonds, equities, tech or tulips, it never ends well. Yet investment decisions have become heavily distracted by breathless storytelling of new business models, disruptive technologies and quantitative easing, leading to lofty valuations.
To manage this risk and successfully navigate the current environment we should remember that sound investment decisions are founded on a core principle of buying good assets at good prices. Importantly, the one doesn’t replace the other: paying a low price for a bad asset is a bad investment.
Using these criteria, the most loved destinations for investors with low risk appetites — cash and bonds — start to look risky. Negative interest rates are high risk. By contrast, precious metals, which are widely shunned for paying zero interest, might be a sensible bet. Consider that at $1,500/oz the gold price has risen 26% over the past year and silver almost 20%.
In equities, new business models might be wearing the emperor’s clothes. Uber came to market with the largest loss for an IPO. The share price is down 25% since listing. There is a growing view that it may never produce a profit, potentially leaving the business worth substantially less than the $82bn price tag at IPO.
With excessive valuation marked as a key risk, the most sought-after equity markets, including the loved US, safe Switzerland and fast-growing India, might also prove dangerous. Using cash flow, revenue, earnings and balance sheet valuations, these three markets are trading at substantial premiums to the world average. By contrast, snubbed China, stalled SA and sleepy Japan are trading at discounts of between 20% and 30% to the global average.
This isn’t a case for throwing out US stocks in favour of Chinese stocks, or putting European bonds aside in favour of gold. But with risk management as the foundation of investing, one of the primary risks that we can control is the price we pay for any asset. When the market is extremely optimistic you need to be cautious; and when investors are pessimistic, that’s when to look hard: when buyers arrive, it’s too late to start looking, and when sellers arrive, it’s too late to start selling.
Digging into the detail of these markets throws up potentially rich payload. Consider Apple and Xiaomi. Apple, the world’s second-largest company with a market value of $895bn and 12% of the smartphone market, is widely loved and admired. As a result, Apple trades at hefty multiples of 3.8 times sales, 18 times earnings and 10 times net asset value (NAV). By comparison, China’s Xiaomi, founded in 2010, holds 8% of the smartphone market and is valued at 0.7 times sales, nine times earnings and three times NAV.
In the space of a few years Xiaomi’s top-of-the range smartphones have caught up to Apple in performance yet retail is at half the price. Indeed, the Chinese company is becoming increasingly known for its phenomenal value for money, pledging to earn no more than 5% profit on any of its hardware.
Perhaps in selling down Apple investors would also be well advised to sell loss-making Uber in exchange for SA-listed Super Group, which is trading at seven times earnings, is below NAV (0.9 times), boasts a level 1 BEE rating, has R3.5bn cash on its balance sheet against a market valuation of R10.2bn, and earns half its revenue outside SA. Surely, this is a sweeter ride?
• Dr Saville is CEO of Cannon Asset Managers.