Nothing is more important than the price you pay

A close analysis of 150-years of US equity market data confirms an astonishing relationship between the price of an investment and its subsequent 10-year average return. The conclusion is that the entry price paid for a share is by far the most important influencer of long term return. “The one constant in stock markets, the one thing you can hang your hat on, is that the price you pay for something will always matter,” says Liam Nunn, a fund manager at global asset manager, Schroders. “The weight of stock market history confirms that the amount you make from an equity portfolio is directly linked to what you paid for your shares”. He was presenting on the first day of the Meet the Managers 2021 event, hosted by The Collaborative Exchange.

Human emotion drives market prices

The relationship between value and return exhibits in equity markets despite the great depression, two world wars, two technology bubbles and the occasional massive swing in interest rates. One of the reasons for this is that equity market price fluctuations are closely tied to human emotion. “When the outlook is dark and cloudy we get fearful and despondent and equities become cheap; when the mood becomes euphoric, we get greedy and equities become expensive,” says Nunn. Fund managers that ascribe to a value investing methodology must be cognisant of market sentiment in addition to traditional measures of value, or risk overpaying for shares. What can we learn from global equity markets circa February 2021? 

According to Schroders, global equity markets currently trade on a Schiller PE valuation in the low 20s. At this level global equities are, on aggregate, attractive. But active fund managers cannot depend on an aggregate view of markets. They are not buying an index, but rather scanning the markets for individual companies that they expect to outperform based on their investment methodology. The Schroders Global Recovery Fund, which featured during the presentation, uses a bottom-up, value investment strategy to find deep value opportunities in global equity markets. The good news is that fund managers are seeing significant value dispersion across global equity markets at present. Nunn observes that the UK market is as cheap as it has been for 50 years when compared to the rest of the world; the US, meanwhile, is on the other end of the scale! 

Tilting the value dynamic in your favour

UK businesses struggled during 2020 due to the combined impact of Brexit and Covid-19. As a result many of the old school UK-listed commodity and financial stocks have fallen in recent years. “Things are not amazingly rosy; but does the UK deserve to be one of the cheapest markets in the world?” asks Nunn. Meanwhile, investor sentiment has driven US share prices to insane levels. Massive increases in the price of technology shares such as Amazon, Apple, Facebook, Google and Microsoft have contributed to the US market capitalisation as a percentage of GDP reaching an all-time high. “The point I am making is that global equities are not a homogenous asset class; there is huge value dispersion by geography and sector,” says Nunn “Value managers must get exposure to those parts of the market where the valuation dynamic is tilted in our failure”. 

Schroders was among the handful of asset managers who used the Meet the Managers event to pose questions about the sustainability of the current bull market in US equities. “Many market commentators would have you believe we are in the foothills of a bull market; we are not so sure,” says Nunn. An important observation is that large portions of the equity market, already on high multiples prior to the pandemic, traded even higher during the crisis. The result is a bifurcated market with some stocks on depressed valuations and others driven to record levels on a wave of investor euphoria. One of the biggest mistakes assets managers can make in such conditions is to consider the market on an aggregate level. Another concern is that the stimulus supporting current prices cannot continue indefinitely. According to Nunn, markets are being falsely lifted by governments’ record fiscal and monetary policy interventions. 

Big party, nasty hangover!

“We have begun to see the sort of crazy behaviour that occurs closer to the top of market cycles than the bottom,” says Nunn. A chilling example of market exuberance comes courtesy the Goldman Sachs Non-profitable Companies Index, which was up 400% in 2020. Price action on the likes of Bitcoin, GameStop and Tesla all contribute to an aura of bullishness and out-of-control speculation. Nobody knows when the current bull market rally will end; but it is common knowledge that the last investors at the party have a hard time leaving. It is also true that the bigger the party, the worse the hangover is likely to be. 

“There are warning signs from just before the dotcom collapse that are relevant today,” says Nunn. “Value investing was out of favour, as it is today; the market was driven higher by rapid expansion in the technology sector, as it is today; and the gap between the loved and highly rated part of the market versus the least loved parts of the market had surpassed previous peak levels, as it has today”. The dotcom collapse was punctuated by a painful and drawn out correction in global equity indices, with the MCSI world index languishing below its 2000 high for another five years. As the bull market runs out of steam, you should start consider moving your clients into value. 

Addressing portfolio correlation risk

“Cheap valuations tend to yield attractive returns,” added Andrew Lyddon, fund manager at Schroders, before sharing some of the reasons why investors favour the value investment methodology. Some investors believe that value should have a permanent allocation in their portfolios, others use it as a stop gap when growth strategies become stretched. Finally, there are those who appreciate value for its role as a portfolio diversifier. “A lot of styles that have been in favour of late, whether based on growth or thematic or ESG methodologies, tend to be invested in similar stocks, thus creating closely correlated portfolios,” he says. A portfolio built on value fundamentals should mitigate this correlation risk. 

“Value is a style that tends to underperform during the tail end of the bull market; but when financial gravity starts to bite, value does pretty well,” concludes Nunn. “It is during these periods of irrational exuberance that markets present wonderful contrarian or value opportunities”. 

Writer’s thoughts:
Financial advisers offering investment advice to South African investors could be excused for asking “what market rally” given five-year returns from local equities. There will, however, be growing concern among both asset managers and financial advisers that the apparent rebound on the JSE could be scuppered by a big pull back in US and other global markets. Are your asset allocation decisions influenced by analysts’ views of where we are in the stock market cycle? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.

Comment on this Post

Name*

Email Address*

Comment*

 

Submit Comment