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Eye on value investing
OF late, being a value investor has meant a fair bit of pain. The S&P 500, Nasdaq and Dow have all hit record highs in recent times. US equities ranked as one of the most expensive equity markets on our valuation models at the end of last year. Yet, they have risen a further 10 per cent since.
Gains have been driven by the most expensive part of the market, with the top 10 gainers accounting for almost half the rise of the S&P 500 index. Most of these are expensive growth names. The FANG stocks (Facebook, Amazon, Net?ix and Google) soared by a mouth-watering 30 per cent and the S&P 500 Growth index outperformed the S&P 500 Value index by over 10 per cent.
The same story repeats itself across other markets and asset classes. The German DAX index with its similarly lofty valuations has enjoyed similarly strong returns this year. The bond market on many measures is even more expensive than equities but it too has posted decent, if not spectacular, gains this year. According to Bank of America Merrill Lynch bond indices, US Treasuries (+2 per cent), UK Gilts (+2.7 per cent) and Australian sovereigns (+3.3 per cent) are all up on the year. It is only Japanese Government Bonds (JGBs) and Bunds that have failed to join the party.
It is not surprising that this market environment is pushing many investors to question the merit of valuations in their investment process. Justifying stretched valuations through valuation model alchemy has become another popular fallback.
We believe the principles of value investing are just as applicable today as they have ever been. The advice from Benjamin Graham, the father of value investing, to seek a margin of safety in every investment has never rung truer.
However, we believe that the nature of fnancial market risks has changed from the range of possible outcomes in the middle of the distribution to the loss events encapsulated by the tails of the distribution. This is why volatility is so low, while markets appear increasingly risky.
In this environment, the margin of safety that value investing offers may not ensure superior performance under a “business as usual” scenario, but it will be more than rewarded over the long term. Indeed, mean reversion is strongest over longer time periods. The more stretched valuations get, the likelier they are to snap back. Hence, an anchor in valuations may be the best downside risk protection strategy in this market environment.
European equities are in a sweet spot given the combination of three drivers: the reduction in political risk post the Dutch and French presidential elections, inexpensive valuations and strong earnings growth momentum.
While German corporates continued to deliver strong earnings growth following the global fnancial crisis (GFC), the rest of the eurozone struggled to grow earnings. More recently, however, growth and earnings have begun to play catch up outside Germany. Germany looks expensive; the rest of the eurozone, including France, Spain and Italy, is more attractively valued on both a cross-sectional as well as history-relative basis.
Emerging equities have had a good comeback, following the deep selloff that ended in early 2016. The baton has been passed from commodity exporters in Latin America and EMEA (Europe, the Middle East and Africa) that benefted from China stimulus to Asia where the resurgence of global trade has offered a strong tailwind. Valuations are no longer as compelling as they were in early 2016, but remain attractive. We like the earnings prospects more in Asia, as other regions still feel the weight of high levels of debt and slow recoveries.
A closer look at credit
Credit looks expensive, but it is worth taking a closer look to mitigate portfolio risk as most sovereigns look even less attractive, particularly those with a negative yield. The recent lift in high yield spreads might suggest to some that there is an opportunity, but for the most part they still look expensive. The risk-reward is less attractive given the decline in commodities where many high yields are exposed. We prefer investment grade in the US and Europe where spreads are not too far off from historical norms.
With the US 10-year Treasury yield setting a new low since November 2016, assessing fair value in global sovereign bonds has once again become a hot topic for investors. A more traditional assessment of the landscape for bonds would suggest that valuations are quite rich and that 10-year nominal yields well below long-term averages are decidedly unattractive. This is particularly so in an environment where we are seeing a sustained period of synchronised growth across the world’s four largest economies.
So against this economic backdrop we ask ourselves: Why would investors want to continue buying bonds and lock in such low returns? It is rational to own sovereigns as a form of safety net given the rising political risk we have seen playing out over our Twitter feeds and more serious threats such as in the Middle East and North Korea.
Our concern is how “safe” these bonds are when we know quantitative easing has and continues to create serious distortions in bond market pricing.
Emerging market local bonds may appear more risky than developed bonds, but fundamentals still drive price, and valuations are attractive. Latin America has been a bigger winner with in?ation peaking, allowing for signifcant rate cuts in places such as Brazil. Yields are also attractive in pockets of Asia such as India and China, where in?ation seems increasingly tame. Still, quality is important. Where high yields might look most attractive in places such as Turkey or South Africa, high political risk diminishes the risk-reward.
Quality at a reasonable price
Value opportunities may be less abundant these days, particularly in asset classes such as US equities, but they are out there and worth searching for. Given the distortions in bond markets caused by central banks, finding a decent quality yield is no easy task but not impossible. In the long run, we are better off owning quality at a reasonable price than chasing returns likely to be buffeted by mean-reversion to historical valuation norms or repricing of excessive political risk and external vulnerability so far ignored by markets. W
Tanuj Dutt and Robert Samson are both Senior Portfolio Manager, Multi-Asset, Nikko Asset Management