Monday, 31 October 2016

Time to get excited about market valuations?

Investors should be excited about attractively-valued and under-the-radar opportunities at the moment rather than worrying about the strong performance of most major indices. The increasing popularity of high-quality, dividend-paying stocks has led to industry ‘laggards’ trading on attractive valuations and the price of value plays tends to have an inverse relationship with their returns and is therefore seeing plenty of opportunities across markets.

This comes at a time when many investors have been worried about valuations, with a number of managers opting to position themselves away from traditional assets given low yields on bonds and strong returns of dividend-paying blue-chips. However, given the high levels of geopolitical and macroeconomic uncertainty on the horizon, many are continuing to buy dividend-paying stalwarts in a bid to protect their portfolios.

A general focus on yield has morphed into a focus on buying high-quality companies, which has in turn led to a select group of defensive mega-caps performing exceptionally well over the last five years. As a result, there has been a greater dispersion between this select pool of stocks and those which fall outside of this category.

The aggregate valuation suggests that market ‘laggards’ are historically cheap and, although past performance is no guide to future returns, we could be near a turning point where value stocks will outperform growth holdings. However, investors need to have a long-term time horizon to utilize this trend and this is why active managers have struggled to outperform recently – not only have expensive, low-volatility stocks surged in popularity and outperformed, they are often extremely large companies and are therefore well-represented in their respective indices.

As such active managers would have to hold incredibly high weightings in these businesses in order to beat their benchmarks and, given that such companies don’t tend to offer the best returns over the long term, they are often overweight smaller companies instead.

From a regional perspective, we are underweight the US market for valuation reasons.  When looking at the S&P 500 index’s price-to-revenue ratio versus its real rate of return (return minus inflation), the index achieves a stronger performance when it is on a lower starting value. As you would expect, the lower the starting value the higher the subsequent return, which is a good sign – starting valuations really matter.

Bear in mind that inflows at the moment are all into S&P 500 trackers. Wake up everybody – I don’t know what you’re expecting but there’s a high risk you’re going to be disappointed. Instead, the area of the market we see the most opportunities in is emerging markets, although isn’t a blanket call as there are lots of different areas and pockets of opportunity throughout the sector.

As with other major indices, there are larger companies which also account for large portions of the indices that investors would do well to avoid. In developed markets companies with growth potential – the Amazons, the Microsofts – they’re really well-recognised and you pay massive multiples for them.

In emerging markets, companies with very good growth potential are far cheaper. This is where your macro risk comes in. A lot of people were saying this time last year that emerging markets are very risky and, low and behold, they’ve been the best-performing equity region this year. We have seen this start to unwind a little but we still think it has a long way to go. If you look at the price-to-revenue metric again, the divergence between emerging and developed markets is almost back to where it was in the early 2000s which saw significant emerging market outperformance. As always seek professional advice where appropriate.

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