Just because one business deserves to be cheaply valued, it does not follow another in the same industry should be and, when this happens, value-oriented investors should be able to find interesting opportunities
“Regardless of the quality of the individual businesses, share prices fell across the sector until they reachedlevels that were very attractive for value investors.” So we wrote, in the context of value and emerging markets, about Chinese distillers in 2012 and Russian utilities two years later but this inclination of many investors to tar all companies in an industry with the same brush can be seen all around the world today.
Regular visitors to The Value Perspective will be well aware of our view that some parts of the stockmarket – particularly the supposedly stable, low-volatility, ‘safe-haven’ sectors, such as food, beverages and tobacco – are historically very expensive while others, such as financials and mining, remain historically cheap. As the following chart illustrates, however, valuations of businesses within the same sector are much less diverse.
FTSE Allshare X IT intra-sector valuation dispersions
Source: Soc Gen
So why do company valuations within industries appear to be bunching up so closely? Here on The Value Perspective, we suspect the explanation may lie within the wonderful world of behavioural finance and specifically in the idea of ‘anchoring’ – essentially where investors base their perceptions on the current environment rather than recognising something entirely different could happen in the future.
So, while there could be some very different factors affecting the outlooks for Financial Company A and Financial Company B, for example, the wider market finds it much easier to lump them together as ‘those nasty banks’. At the same time, the outlook for every one of those supposedly low-volatility businesses is unlikely to be as rosy as their elevated valuations suggest yet, at the moment, the market loves them all.
Anchoring is a natural human instinct and one that can often be made still more seductive by the plausible narratives – positive or negative – that can build up around different sectors. Ultimately, however, anchoring and taking stories at face value are the lazy options – ways to avoid any hard, deep or uncomfortable thinking – and can lead investors to make poor decisions.
On the bright side, whenever the wider market is ignoring companies’ individual characteristics and tarring an entire sector with the same brush, active stockpicking can really come to the fore. Just because one business deserves to be cheaply valued, it does not immediately follow another in the sector should be and it is in such situations that value-oriented investors should be able to find price inefficiencies to exploit.
There are always going to be bad businesses that are cheap for very good reasons but human nature means that, somewhere in the vicinity, there will also be companies that may look similar yet whose risk-reward balance is in your favour. Investors who take the time and trouble to look hard within cheaply valued sectors and are then willing to address some difficult questions will be well-placed to identify them.