The price of safety and the value of distress
A flight to safety has pushed up the prices of typically low risk asset classes to levels where they have become risky and have beaten down the prices of many high risk investments to a level where they offer relatively more long term protection in real t
For example, great uncertainty in the Euro area is leading to massive risk aversion among global investors. Investors are fleeing risky assets like equities and seeking safety in what is traditionally considered low risk investments like government bonds and cash. But the risk of any asset - the probability that it produces a permanent capital loss and the magnitude of such a loss – is not only a function of the general characteristics of the asset and the prevailing fundamentals. It is most significantly a function of the price paid relative to the value received. With “low risk” investments currently in high demand and “high risk” investments being avoided at all costs, “low risk” investments have become less attractively priced and more risky and “high risk” investments have become more attractively priced and less risky.
Chart 1: US and Germany 10-year Government Bond Yields and European Stock Market Earnings Yield
(Click on image to enlarge)
Source: Thomson Reuters Datastream
Chart 1 shows 10-year US and German government bonds yields, relative to the European stock market earnings yield. Currently investors are lending money to the German government for the next 10 years at a record low rate of 1.39% per year. These investors are after what is perceived to be the safest investment in Europe. However, at such high prices, or low yields, the bonds do not appear nearly as safe as their status suggests. Yields could rise significantly and prices could fall over the next 10 years. There is actually a significant risk of losing money, irrespective of whether Germany actually defaults on its mounting loan obligations or not. And even in the unlikely scenario that yields are stable and one holds until maturity, one will end up earning what it says on the label – 1.39% per annum. Locking in such a low nominal rate of return increases the odds of losing money after inflation is taken into account. The European stock market, on the other hand, is understood to be a very unsafe place at the moment. As a result, it is priced to pay investors close to a 10% initial yield plus any growth. Total returns could thus turn out to be at least 14% per year, even if economic – and therefore corporate earnings growth – turns out to be an anaemic 4% per annum from the current low base. Evidently, the market pays little attention to price. As a result, the assets considered to be safest are in fact tremendously unsafe, while the assets that are considered most unsafe are in fact much safer than believed. The same theme evident across asset classes has manifested within the equity market, where there’s a strong preference for low risk predictable income streams over high risk cyclical income streams. When times are tough, investors intuitively prefer to invest in companies that can withstand the downturn, like food producers, brewers, tobacco and other fast moving consumer goods (FMCG) companies as opposed to cyclical businesses that are highly leveraged to economic activity. Needless to say, in recent times the share prices of defensive companies have increased while the share prices of cyclical companies have fallen significantly. As a result, defensive companies have lost their defensiveness, while cyclical companies have become relatively safe. This is illustrated in Chart 2, which shows the market’s valuation, measured by the price-to-book (P/B) ratio, of a group of cyclical companies relative to a group of defensive companies over the past 30 years. The index has been constructed from the World Steel and Iron Index, World Paper Index, World Chemical Index, World Cement Index and World Platinum Index, relative to the World Consumer Staples Index, consisting of 200 household FMCG companies like SA Breweries, Nestlé, and Procter & Gamble. We like to call this particular collaboration of cyclical indexes the World Ugly Index and the collaboration of FMCG companies the Warm and Fuzzy Index. Chart 2: World Cyclical Index P/B ratio Relative to World Consumer Staples
Sources: Thomson Reuters Datastream, RE:CM analyst The low points on the chart are where the market has historically undervalued cyclical companies relative to defensive companies; the high points are where the market has historically paid up for cyclical companies relative to defensive companies. Why do professional investors get it so severely wrong, as they did in 1981-1982, 1988-1990, 1998-2000 and 2007-2008? The short answer is: short memories and investment time horizons, emotion and career risk. An investigation of these permanent inefficiencies in the market explains why a long term approach is the only real advantage investors can have. Currently, the market is abandoning cyclical businesses which offer a great opportunity for long term investors. Cyclical industries that are particularly attractive include platinum, global steel and global cement.
Sources: Thomson Reuters Datastream, RE:CM analyst The low points on the chart are where the market has historically undervalued cyclical companies relative to defensive companies; the high points are where the market has historically paid up for cyclical companies relative to defensive companies. Why do professional investors get it so severely wrong, as they did in 1981-1982, 1988-1990, 1998-2000 and 2007-2008? The short answer is: short memories and investment time horizons, emotion and career risk. An investigation of these permanent inefficiencies in the market explains why a long term approach is the only real advantage investors can have. Currently, the market is abandoning cyclical businesses which offer a great opportunity for long term investors. Cyclical industries that are particularly attractive include platinum, global steel and global cement.
(Click on image to enlarge)
Source: Thomson Reuters Datastream
Chart 1 shows 10-year US and German government bonds yields, relative to the European stock market earnings yield. Currently investors are lending money to the German government for the next 10 years at a record low rate of 1.39% per year. These investors are after what is perceived to be the safest investment in Europe. However, at such high prices, or low yields, the bonds do not appear nearly as safe as their status suggests. Yields could rise significantly and prices could fall over the next 10 years. There is actually a significant risk of losing money, irrespective of whether Germany actually defaults on its mounting loan obligations or not. And even in the unlikely scenario that yields are stable and one holds until maturity, one will end up earning what it says on the label – 1.39% per annum. Locking in such a low nominal rate of return increases the odds of losing money after inflation is taken into account.
The European stock market, on the other hand, is understood to be a very unsafe place at the moment. As a result, it is priced to pay investors close to a 10% initial yield plus any growth. Total
returns could thus turn out to be at least 14% per year, even if economic – and therefore corporate earnings growth – turns out to be an anaemic 4% per annum from the current low base. Evidently, the market pays little attention to price. As a result, the assets considered to be safest are in fact tremendously unsafe, while the assets that are considered most unsafe are in fact much safer than believed.
The same theme evident across asset classes has manifested within the equity market, where there’s a strong preference for low risk predictable income streams over high risk cyclical income streams.
When times are tough, investors intuitively prefer to invest in companies that can withstand the downturn, like food producers, brewers, tobacco and other fast moving consumer goods (FMCG) companies as opposed to cyclical businesses that are highly leveraged to economic activity. Needless to say, in recent times the share prices of defensive companies have increased while the share prices of cyclical companies have fallen significantly. As a result, defensive companies have lost their defensiveness, while cyclical companies have become relatively safe.
This is illustrated in Chart 2, which shows the market’s valuation, measured by the price-to-book (P/B) ratio, of a group of cyclical companies relative to a group of defensive companies over the past 30 years. The index has been constructed from the World Steel and Iron Index, World Paper Index, World Chemical Index, World Cement Index and World Platinum Index, relative to the World Consumer Staples Index, consisting of 200 household FMCG companies like SA Breweries, Nestlé, and Procter & Gamble. We like to call this particular collaboration of cyclical indexes the World Ugly Index and the collaboration of FMCG companies the Warm and Fuzzy Index.
Chart 2: World Cyclical Index P/B ratio Relative to World Consumer Staples
(Click on image to enlarge)
Sources: Thomson Reuters Datastream, RE:CM analyst The low points on the chart are where the market has historically undervalued cyclical companies relative to defensive companies; the high points are where the market has historically paid up for cyclical companies relative to defensive companies. Why do professional investors get it so severely wrong, as they did in 1981-1982, 1988-1990, 1998-2000 and 2007-2008? The short answer is: short memories and investment time horizons, emotion and career risk. An investigation of these permanent inefficiencies in the market explains why a long term approach is the only real advantage investors can have. Currently, the market is abandoning cyclical businesses which offer a great opportunity for long term investors. Cyclical industries that are particularly attractive include platinum, global steel and global cement.
Sources: Thomson Reuters Datastream, RE:CM analyst
The low points on the chart are where the market has historically undervalued cyclical companies relative to defensive companies; the high points are where the market has historically paid up for cyclical companies relative to defensive companies. Why do professional investors get it so severely wrong, as they did in 1981-1982, 1988-1990, 1998-2000 and 2007-2008? The short answer is: short memories and investment time horizons, emotion and career risk. An investigation of these permanent inefficiencies in the market explains why a long term approach is the only real advantage investors can have.
Currently, the market is abandoning cyclical businesses which offer a great opportunity for long term investors. Cyclical industries that are particularly attractive include platinum, global steel and global cement.
