Value Perspective Quarterly Letter - 3Q 2014
Today, many developed equity markets are at or near their all-time highs, unprofitable companies debut on the stockmarket at eye-watering valuations and ‘high-yield bonds’ has become something of a misnomer (a recent ‘junk’ rated 5-year euro bond paid investors a paltry 1.125%). Even the spectre of rising interest rates and the withdrawal of quantitative easing (QE) are seemingly no longer a concern with equity market volatility near historical lows.
Many in the market appear to have become weary of worrying about risky scenarios, but as others become more complacent alarm bells start ringing for contrarian value investors like us. A sell-off, greater volatility and investor losses would hardly be surprising from today’s levels. However, we have oft referred to the ‘the folly of forecasting’ and we are not predicting the imminent collapse of equity markets. In fact, there is plenty of data to suit the bulls and bears alike. Consider these three themes in the market today:
- High profit margins. Most companies are in rude health. Since the financial crisis, businesses have cut costs significantly. Operational leverage has amplified profit margins as revenues have grown, and the bulls argue that stronger cash flows will allow companies to invest in growth. The bears, on the other hand, point out profit margins are a mean reverting phenomenon and they are high in context of history. As high profit margins are reflected in share prices, when the former falls so will the latter.
- Increasing number of IPOs and M&A. M&A is not yet as prevalent as before the previous stockmarket peaks in 2000 and 2007, but it has picked up substantially. Increasing M&A can be positive for investors on the receiving end of a bid. The downside is the strong positive correlation between M&A volumes and stockmarket peaks. Equally, higher IPO volumes are a sign of business and investor confidence. However, sellers of businesses are driven to get the highest possible price – which seems incongruous with buyers getting a good deal. Bears would also highlight that in the first half of 2014 72% of IPOs had no earnings; at the peak of the tech bubble the figure was 78%.
- Low bond yields. QE and ultra low interest rates have pushed bond yields down to multi-generational lows. The ‘hunt for yield’ has compressed credit spreads dramatically and today the average company can finance itself at extraordinarily low rates. Cheap debt is a boon for businesses as it feeds through to higher profitability and reduces the cost of capital. But history suggests that interest rates will not remain this low forever. When the cost of financing increases, companies that do not generate sufficient capital will find themselves in difficulty.
The ‘bullish’ or ‘bearish’ forecaster could seize upon any of these themes and create a credible scenario as to why the market will rally strongly or be subject to a sharp sell-off over the next 18 months. Of course, starting valuations are by far the most important driver of future returns – but they are only a reliable indictor over longer time periods. The FTSE 100 index level now trades near its 2000 and 2007 peaks. Those respective peaks were followed by the ‘dot-com bust’ in 2001 and ‘credit crunch’ of 2008 but, as chart 1 shows, fourteen years of earnings growth means that despite today’s index level valuations are not as over-extended as they were in the past.
When the equity market reaches extremes it gives value investors a clear indication of what to do. At times of fear and panic, investors should take advantage of bargain prices; and when euphoria prevails, selling is the obvious, though not always the easy, decision. Today the UK equity market is at neither extreme, and as a consequence the range of possible outcomes is diverse. What we know is that as bargains become harder to find many investors will take greater risks for lesser rewards – either by increasing exposure to risky assets or leveraging up the safer ones – and there is evidence that this is happening today. As value investors it is imperative that we seek out opportunities that are genuinely undervalued in the context of history. It is only by doing so that we can protect clients’ capital and deliver the long-term outperformance that the value-investing style has delivered over the past hundred years.
Source: Datastream, 24 September 2014
The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.
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