Two key risks the market is ignoring – Part 2: Valuation risk

For much of the last decade, it appeared as if company valuations no longer mattered – but investors should not forget that, like an elastic band stretched to its limit, valuations can snap back very quickly indeed

28/04/2020

Liam Nunn

Liam Nunn

Fund Manager, Equity Value

Simon Adler

Simon Adler

Fund Manager, Equity Value

In Two key risks – Part 1, we argued the recent market sell-off has thus far seen investors significantly underappreciating two important sources of equity risk. One, which we covered in that piece, is balance sheet risk while the other, which we will focus on this time, is valuation risk. If we are correct in our analysis, this would mean both the present situation and recent market trends are inherently unsustainable.

For the best part of a very long – and at times, for disciplined value investors, very painful – decade, it appeared as if fundamental company valuations simply no longer mattered. The mantra of the bull market that has just come crashing to a halt was all about growth, all about quality, all about momentum – do not worry about the price you are paying, the message seemed to be, just focus on the attributes of businesses.

Forgive how busy the following chart looks. It is not borrowed from Tate Modern but is a dramatic illustration of the extremes to which this kind of thinking has driven the levels of valuation dispersion within the market. Or, to put it another way, it shows just how far the elastic band of valuation has stretched between growth, quality and momentum styles on the one hand and value on the other.

07005chart.PNG

Pay particular attention to the line that has recently plummeted to zero in the bottom right-hand corner – it represents the value style of investing, as defined by a composite measure of price/earnings and price/book ratios and dividend yield. Simply put, that line hitting zero means the cheapest 20% of the global equity market has never been this cheap relative to the most expensive 20% at any point in the last 30 years.

Even at the height of the dotcom boom – in many ways, a market bubble so bubbly it was almost a parody of stockmarket irrationality – we did not reach the levels of valuation dispersion we are seeing today. The market has arguably never – in modern history at least – been so blind to the underlying valuation of shares. It is no exaggeration, then, to suggest this is uncharted territory for value investing.

To flip that point on its head and look at it from the other angle, the other three lines show just how extreme the valuations applied to the highest quality, the highest growth and the highest momentum areas of the market are today. At their 99th percentile, the premium the market is applying to each of these three factors is about as extreme as it has ever been.

‘One-dimensional’ reaction

This is what we were alluding to in Two key risks – Part 1 when we described the initial market reaction to the Covid-19 pandemic as ‘one-dimensional’. A lot of the selling pressure in recent weeks has come down hard on sectors such as financials, mining, oil and gas and traditional media, where valuations were already at very low levels heading into this crisis.

In contrast, many of the areas that have been comparatively resilient so far are those that have been priced for perfection. Yet no matter how high-quality a business people think they have bought, everything really does have a price and a fair value. You cannot ignore or escape valuation forever. It is the financial equivalent of gravity – always, eventually, pulling company share prices back down to earth.

Sooner or later, then, the pendulum will swing the other way, as the market wakes up and realises there are a lot of fundamentally overvalued companies out there and that they are more at risk from this kind of market shake-out than the obvious cyclical names. Expectations for those, meanwhile, were already pretty depressed heading into the sell-off and, consequently, their prices now stand at extremely pessimistic levels.

When the tide turns

As the above chart shows, we have just surpassed the crazy levels of valuation dispersion at the height of the tech bubble at the turn of the millennium. As such, it is worth reminding ourselves how that particular episode of market history ended. Global equity indices peaked in March 2000 before entering a painful and drawn-out bear market period that did not actually trough until March 2003.

And yet, during that three-year bear market, global value investors enjoyed one of their best-ever periods of outperformance, with the MSCI Value index besting its MSCI Growth counterpart by some 45%. Clearly we do not know whether history will repeat itself to that extent – indeed, there are plenty of reasons why you might argue ‘this time it’s different’ – but, when the tide turns, it can do so more violently than people realise.

Today, there is no shortage of market watchers, who will tell you that value is still the riskiest place to be, that the same sectors that led the market rally over the last decade are going to be the safest port in this current storm – and that they will also be the best place to be for the next cycle. They are entitled to their views – and yet the vast weight of stockmarket history suggests all of that is very unlikely.

Riskiest market areas

For our part, here on The Value Perspective, we believe it is pretty clear from looking at charts such as the one above where the riskiest areas of the market are today and where investors are at most risk of permanent capital loss over the medium term. At the same time, we appreciate value is not an easy strategy to love – indeed it can be very painful at times – but we remain fully convinced it is the right approach for the long run.

And while we acknowledge we may have sounded pretty downbeat in highlighting the significant dangers associated with the current market, we would also stress that, from our perspective as deep-value investors, rather than a risk, this could ultimately prove an incredible opportunity as common sense prevails and value, once again, enjoys its time in the sun.

Author

Liam Nunn

Liam Nunn

Fund Manager, Equity Value

His investment career commenced in 2011 at Schroders as a European equity analyst. He moved to Merian Global Investors in 2015 to work as an equity analyst & fund manager before returning to Schroders to join the Global Value team in January 2019.

Simon Adler

Simon Adler

Fund Manager, Equity Value

I joined Schroders in 2008 as an analyst in the UK equity team, ultimately analysing the Media, Transport, Leisure, Chemicals and Utility sectors. In 2014 I moved into a fund management role and have had experience managing Global ESG and Pan-European funds.  I joined the Value investment team in July 2016 to focus on UK institutional and ethical-value portfolios.

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