The three most contrarian trades in the stock market
The three most contrarian trades in the stock market
The consequence of the sharp rebound in equity markets since late March is that valuations have become significantly more expensive, approaching historical peaks in some cases. Fortunately, there are still options for investors looking for relatively cheap stocks. We have presented three of them below.
Note that these are not necessarily the views of Schroders’ investment teams, rather, they highlight the areas of the market where valuations are cheap and sentiment is very negative.
We also look at the key reasons these stocks have underperformed and if there are any drivers that have turned more positive. The fortunes of struggling companies could turn, but as always, there are no guarantees - the stocks could remain cheap.
The euro area banks
In developed markets, the most unloved stocks are likely those of the euro area banks. And as the chart below shows, investors would have been right to shun them. Since December 2007, the banks within the Stoxx Europe 600 Index have underperformed by a whopping 120% on a total return basis.
No doubt, the hit from the coronavirus outbreak will have a disruptive effect on the European banking sector. The first quarter earnings reports show that banks have increased reserves for future loan losses and posted declines in the core equity capital.
The upside of this woeful performance is that the valuation gap to the overall market has widened to an extreme level. Currently, the forward price-to-earnings (P/E) ratio of banks (9.3x) is 40% lower than the market (15.5x). The discount has narrowed slightly since the end of March, as earnings expectations of banks have fallen, but is still large.
Is there any light at the end of the tunnel for banks? The European banking system is much safer now than it was before the global financial crisis. Stricter rules mean that banks have built up significant capital buffers. In fact, the issuance of new equity to shore up capital has weighed on the EPS growth through share dilution, contributing to the underperformance.
Nonetheless, two key structural issues have persisted: a large pool of non-performing loans in southern European countries, and low profitability. The latter is highlighted by the relatively low net interest income and return on equity (ROE) of the euro area banks, especially compared to the US.
Despite the uncertainty, there are some silver linings for banks in the crisis: European governments have launched credit guarantee schemes to support lending, the European Commission has proposed temporary capital relief, and the European Central Bank (ECB) announced that banks are now paid up to 1% for lending from the ECB as long as they make enough new loans.
The result of these relief measures is that the banks have kept the taps open even though normally they would cut lending in uncertain times. In March alone, euro area new corporate loans were $115 billion, an unprecedented increase. While a large part of this was short-term loans, loans with maturity of five years or more increased by a record amount as well. If banks can maintain the quality of loans, lending out the money instead of paying the ECB to store it should be positive for profitability.
Being a cyclical sector, banks usually outperform in a recovery, especially in the early stages. Should the coronavirus situation ease, the valuation discount could shrink, although bank stocks are still vulnerable to bad news from Europe. In the long term, however, improvement in the ROE is crucial and holds the key for performance.
The US energy sector
One of the biggest market casualties of the coronavirus crisis has been the US energy sector. Widespread lockdowns led to global oil demand dropping by as much as 25% in April. Saudi Arabia’s decision to sharply increase oil supply created a perfect storm for oil, culminating with the Crude oil price briefly turning negative. While the negative oil price made for spectacular headlines, the struggle of the energy sector has been a longer trend. After the latest drop, energy stocks make up only 3% of the S&P500 Index. This is down from more than 16% in 2008.
Given the high correlation between energy sector earnings and the oil price, it is not surprising that the 12-month ahead earnings expectation has fallen close to zero. With the whole industry expected to make little profit over the next year, earnings-based valuation metrics are not very useful in assessing the attractiveness of energy companies. Rather, the question is whether demand and supply will balance and companies survive this historical slump.
The good news is that oil supply cuts are finally ramping up. OPEC and its key allies agreed to cut production by almost 10 million barrels per day starting from May. In addition, US rig count has collapsed from 700 in March to just 237, paving the way for a sharp drop in US production. A lot of the cuts could be permanent, as production will not restart even if oil prices recover to the pre-crisis level.
With the lockdowns gradually lifting, demand is starting to slowly pick up as well. This has led to a rebound in the oil price. While a relief, the current price is still not sustainable in the long term. The largest integrated oil companies need to achieve at least $35/barrel to sustain cash operating costs. And, importantly, the price needs to be even higher to incentivize any new investment.
Energy sector bankruptcies are already happening, especially as financing is now much harder to obtain. The upside is that the companies that survive could greatly benefit once the situation normalizes. That is why it is paramount for investors to be selective and prefer companies with stronger balance sheets, flexible cost bases and disciplined management teams.
Clearly for oil, a lot depends on how fast normal life resumes. It is possible that people travelling less and embracing working from home could weigh on demand. Nonetheless, a broader resumption of economic activity, coupled with significantly lower supply, could eventually lead to much higher oil price.
Brazilian stocks in US dollars
Emerging market (EM) equities have underperformed their developed market counterparts in the coronavirus crisis. This has been due in part to the lower resources available to many developing countries to fight the pandemic.
Within the EM universe, one of the hardest hit countries has been Brazil. In US dollar terms, the MSCI Brazil Index has lost 49.3% this year, as at 20 May, making Brazil the worst performing country of the MSCI EM Index. Importantly, a large share of the losses have been on the currency side; in local currency, the index is down 28.4% over the same period.
Looking at valuations, perhaps surprisingly, Brazilian equities do not appear to be as cheap as one might think. Currently, the 12-month forward P/E ratio is at 12.2x, on par with the same ratio of the MSCI EM Index. However, there is a wide dispersion in the valuations of individual stocks.
A portion of the index that includes “new economy” sectors such as IT and e-commerce, has not de-rated significantly. This is because of the greater expected future growth rates, despite the weak overall economy. The bulk of the market, however, mainly banks and commodities, trades close to historic valuation lows. These sectors could recover once the situation stabilises.
Nonetheless, the greatest value in Brazil is in the currency. Even after adjusting for inflation, Brazilian real has depreciated more than 60% since 2011, falling back to the early 2000s level. This implies significant undervaluation.
Once an EM poster child, Brazil has disappointed investors over the last decade. After going through a recession in 2015-2016, the recovery has been tepid with unemployment remaining stubbornly high. The election of President Jair Bolsonaro in 2018, coupled with more orthodox economic policy and the passing of a major pension reform plan sparked a new wave of optimism.
However, the sudden re-acceleration in the fiscal deficit, in response to the pandemic, and the recent increase in the number of cases of Covid-19 has made some investors rethink. Given the negative sentiment, it is not surprising that foreign investors have been selling Brazilian assets in volume.
Similar to a number of other EM central banks, and aided by low inflation, the Central Bank of Brazil has cut the its headline interest rate to support the economy. This has further pressured the currency.
Is there any hope for Brazil?
Our Head of Latin American equities, Pablo Riveroll, certainly think so, as he discussed in a recent article.
Pablo Riveroll: “Uncertainty globally due to Covid-19 may take time to subside. But the currency looks cheap, political volatility appears to be somewhat contained, and there is support for the equity market from domestic investor flows. Moreover, there are a number of strong stock opportunities across different sectors.”
The biggest positive is that economic reforms seem to remain on track, with a credible team at helm at the finance ministry. This should increase confidence that the public accounts are managed prudently once the current crisis ends.
There is also a clear benefit from the weaker currency. Structurally lower interest rates put a greater reliance on domestic savings. The fastest way to increase savings is either through higher exports or lower imports, and a weaker currency could facilitate both.
In the near term, a significant reduction in Brazil’s current account deficit, which stood at 2.9% in the first quarter, could help to stabilise the real and provide an opportunity for investors to purchase Brazilian assets at attractive valuations.
 Net interest income refers to the spread between interest earned from loans and other interest earning assets such as bonds and the interest paid for deposits and other funding costs.
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