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Finding bargains as stock markets continue to hit record highs is increasingly difficult, says value investor Josh Jones.
The ongoing rally means the prices of equities are rising significantly faster than their underlying earnings, creating record price/earnings ratios. It has largely been propelled by growth stocks led by tech companies, prompting fears of another market bubble.
The high valuation multiples make it harder to find inexpensive stocks – those companies whose share prices do not reflect the true earnings potential of the company – says Jones, co-Portfolio Manager of the Global Premium Equities fund.
“What we’re seeing is a very growth-driven late-cycle market where growth indexes are 6-8% above the core indexes,” says Jones. “We’re ahead of the MSCI World Value Index, but trail the MSCI World Index partially due to the high-flying growth stocks included in the index – names that we simply would not purchase based on our investment criteria.”
“Since late 2014, earnings on the S&P 500 have cumulatively grown by 4%, and the index is up almost 30%. People are chasing top-line growth and concepts, and that’s very characteristic of late-cycle investing. But we’re not going to buy expensive momentum as value is our building block, so if we’re not finding the right prices for businesses, we’re not going to chase them.”
“Some companies that historically have traded on 15-17 times earnings are now on multiples of 23-25, when their revenues and profits are slowing. These businesses are generally low-volatility stocks, mainly Consumer Staples, Utilities, Telecoms and Real Estate that are now at record valuations, despite being the same businesses, or in some cases worse businesses than they were in the past when they traded at a cheaper level.”
“The portfolio is currently valued at 15 times earnings and we’re working really hard to find businesses that are still reasonably priced. But I’m increasingly of the opinion that alpha generation in the next two to three years is going to come from what we don’t own rather than necessarily what we do own.”
Alpha generation is going to come from what we don’t own
Being a value investor also means avoiding expensive regions, and at the end of the third quarter, the fund was underweight both Europe and the US. “One of the interesting things has been is that in the past we’ve been overweight Europe by over 10% when stocks were really cheap during the European crisis, but we’ve now drifted to being underweight,” Jones says.
“Europe is pretty heavy on banks whereas the US is heavy on tech, and when you adjust for that, Europe is not cheaper than the US. Europe hasn’t had much earnings growth in the last four or five years and we see earnings momentum deteriorating at a time when valuations are up, so, generally we’ve been selling Europe.”
“The US still has a lot of momentum but it’s increasingly very expensive, which is why we’re also underweight the US. In the US, most of our exposure is centered around the banks, technology and energy, but there isn’t widespread value. If you want value, you have to go elsewhere.”
“We think the majority of emerging markets are reasonably valued – they’re not super-cheap, but there’s enough earnings momentum, so we’ve increased our weighting as we find bottom-up opportunities. We’re still cognizant that emerging markets are the tail of the dog, so if we do go into a downturn, they will underperform, and we would use that as an opportunity to add to our holdings.”
“Additionally, pockets of the domestic UK market are still cheap – not quite as cheap as they were post-Brexit, but they’re still cheaper than the rest of Europe or the US. In the UK, Lloyds Bank is an interesting one: it’s generating a 12% return on its tangible capital which means in Europe or the US it would easily trade at 12-15 times earnings, but because of skepticism around Brexit it trades at 9 times. It’s not a momentum stock now, so it might take some time, but it’s a large valuation anomaly relative to where other banks are trading.”
Meanwhile, the end may be near for the growth-fueled cycle as the US Federal Reserve becomes the first of the major central banks to begin unraveling trillion-dollar stimulus programs. “The stock market has responded to QE, and the Fed has now started to unwind its balance sheet, so this is the start of tightening liquidity, and we’re probably nearing the end of this cycle,” says Jones.
“The current high valuations would tell you to be careful. People have been prepared to pay high prices for businesses when stocks are getting very expensive, and we really do not want to overpay for businesses. If that means lagging for a bit, then we’re OK with that. You never want to lag, but we’re not going to chase stuff that’s driving the market. These things are always cyclical, and value will come back into style.”