There is a memorable scene in the first Naked Gun movie where, having set off a chain of events that ends with a missile blowing up a firework factory, Leslie Nielsen’s deadpan character Lt Frank Drebin stands in front of the exploding building as people run for covers and fireworks spiral into the air, telling the growing crowd of onlookers: “Please disperse. Nothing to see here.”
And were we to tell you the opening months of the year have been pretty quiet from a value perspective – “Nothing to see here. Move on folks” – you might find that similarly implausible. After all, 2018 has brought the return of volatility to markets, the prospect of a US-China trade war and even more uncertainty – if such a thing were possible – as we count down to Brexit.
Focus on price
But think about it for a moment – yes, the UK stockmarket endured its worst opening quarter for six years and was the worst performer in that period out of all 23 developed markets, but what has really changed? That is not a facetious question so much as an acknowledgement that, while the recent falls are hardly insignificant, they do need to be viewed in the context of how far the UK market has risen over the last few years.
Broadly speaking, the businesses and industries that were cheap at the end of last year remain cheap now and the ones that were expensive six months ago are still expensive. That said, it has been interesting to note the recent poor performance of businesses, such as beverage and tobacco firms, that – increasingly prized by investors for their supposed safety and stability – have been bid up to distinctly unsafe and unstable levels.
We have been warning about the growing risks of owning these so-called ‘bond proxy’ stocks for some time now, here on The Value Perspective – for example, in Important investment lessons to take from 2016, as we made the argument that, in investment, there are no equities that are always safe or always risky – only equities that are too cheap or too expensive.
“A business could have the most volatile earnings stream in the world but, if you buy it at a 90% discount to fair value, you are giving yourself a very good chance of making money,” we went on. “Equally, you could identify the business that boasts the most stable earnings stream in history and yet, if you pay 10 times what it is worth, you are highly unlikely to make money – indeed, you are more likely to end up losing money.”
To us, that is the definition of risk and it has nothing to do with the supposed predictability and stability of an asset – only the price you pay for it. In other words, as their valuations rise, seemingly safe businesses can become very dangerous investments – raising the question of whether the reverses seen by bond proxy stocks earlier this year were just a taste of what is to come as investors start to fall out of love with them.
Be careful - think long term
Take a look at the following chart, which shows the absolute performance of the UK market by sector over the first three months of this year, alongside each sector’s cyclically-adjusted price/earnings ratio or ‘CAPE’. This investment metric encapsulates the average earnings generated by a business, sector or market over the preceding 10 years, adjusted for inflation.
As you can see, and as we suggested earlier, broadly speaking, stocks in the more expensive sectors – most obviously technology but also those bond proxy businesses, such as beverages and tobacco – fared the worst in the market falls of early 2018. At the same time stocks in the cheaper sectors – those with lower CAPEs, such as banks and basic materials – did a better job of holding their ground.
When considering this particular measure, however, investors do need to be careful. While high CAPEs tend to suggest subsequent long-term returns will be poor, the metric is a much less reliable predictor of short-term returns or market turning points. As evidence of this, you need only look at the US, which has been expensive on a CAPE basis for some years … and has only become more expensive still.
That word of warning aside, investors who have been fretting about the recent state of markets would do better – as we will always suggest, here on The Value Perspective – to think in terms of years rather than months. From that much calmer and more distant vantage point, they will be better placed to see that not so very much has changed in 2018 and what was cheap is still cheap and what was expensive remains so.