Warren Buffett, who manages $500bn, is quoted as saying: “Price is what you pay, value is what you get.” If valuations are looking rich, which seems to be the situation today, what can investors expect to get for the price they pay? Will their return represent good value, or not?
The context for valuation today is seen in the bond market where yields are compressing, in anticipation that the US Federal Reserve may be near the peak of its rate rising cycle, and in equity market p/e ratios are rising, with the bounce back following the sentiment driven sell off in Q4 2018. US and European Investment Grade bond spreads have narrowed to as little as 110-120bps over Government Bonds at a time when global growth is slowing, corporate leverage ratios have ballooned, quality of issuance has plummeted and covenants to protect investors have shrunk to historical lows. Equally, a great deal of attention is being paid to how expensive the US equity market is looking, measured by the long term Cyclically Adjusted Price Earnings (CAPE) ratio, which is close to 30x, against a long run average of around 16x (see chart below).
Source: Barclays Research
I have to sympathise with these concerns, but seasoned investors know that valuation is a very poor guide to market timing. In previous PIM Thought Pieces my colleagues have reminded us that other key market drivers must be taken into consideration, most notably liquidity and sentiment. For now, both of these key drivers appear positive for markets, although perhaps less strongly as time moves on.
Investors right now face the age old challenge of trying to identify relative value in order to optimise returns for their given level of risk. This is never an easy task. Assessing value is a highly subjective process where the ‘fair value’ of an asset is typically based on future expected cash flows discounted back to ‘value’ today. I will spend my morning commute reassembling my picture of what is ‘priced in’ to equity and bond markets and therefore where the relative risks lie on both the upside and downside. I do this through reading a broad array of research and opinion on economics, politics and financial markets across the world. It takes time. Even longer than my bus journey in fact!
The problem with this process is the myriad of areas where estimates are required of future revenues, costs, financing expenses, and taxes and then you need to apply a ‘fair’ discount rate. If you can find one you are happy with. Given this complexity, my PIM team put the greatest amount of their time into selecting the better fund managers who can demonstrate that they have the discipline, rigour, expertise and experience to undertake this work consistently, methodically and self-critically.
Our cycle of fund manager interviews allows us to understand where and why these selected managers see opportunity and where they see issues of concern in their respective asset classes. This adds to our broader understanding of where relative value lies across our multi-asset universe, especially to feed into PIM’s management of our Tactical solutions. So it is interesting that the managers who are evidencing the greatest level of excitement for value in their asset class now are running Japan funds, followed by the Emerging Markets and then the UK. Fixed Interest and Property managers are at best lukewarm, with a clear determination in Fixed Interest managers to avoid lower quality, cyclical, high beta exposure. They see that the economic growth cycle is highly extended in terms of its duration as well as in the breadth of sectors which are still advancing.
What stands out about the Japanese, EM and UK equity markets is that they are relatively unloved by most investors, thereby explaining the value that is on offer. For long term investors this represents an opportunity. In PIM’s Tactical solution we are overweight to the UK and EM, though we will remain neutral in Japan, until we see the impact of the rise in GST sales tax from 8% to 10% in October this year.
When it comes to investing there will always be opportunity, at least on a relative basis, and therefore medium to long term investors with well diversified portfolios should always remain invested. Holding cash long term is no hedge against inflation. Just how many investors were left on the side lines at Christmas last year, waiting, and for what? PIM’s focus on risk first and foremost is deliberately aimed at trying to smooth the investor journey by ironing out the peaks and troughs, and our close scrutiny of valuation is always at the heart of this work. Having conviction in selected managers to identify stocks, bonds and properties for sale at a discount to their intrinsic value is critical to achieving outcomes in line with client expectations over the medium term, regardless of the twists and turns the markets may take from month to month. As the ‘blue sky’ consensus is challenged by the maturing economic cycle, keeping our eyes fixed on valuation will be essential and it is second nature to PIM.
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.