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Value is abundant in expensive markets

13 June 2018Shaun le Roux, PSG Asset Management
Shaun le Roux is the fund manager of the PSG Equity and PSG Flexible Funds.

Shaun le Roux is the fund manager of the PSG Equity and PSG Flexible Funds.

Global assets are generally trading at elevated valuation levels. Given these levels, we believe that portfolio returns (on a broad basis) will be disappointing compared to the returns South African (and other) investors have become accustomed to over the past 15 years – especially after the surge in global equities in 2017.

However, if you’re prepared to look beyond the crowded stocks and sectors, the opportunity for good long-term returns is quite promising.

Contrasting valuations within markets present fertile ground for stock pickers to generate alpha and investing in cheap stocks on suppressed levels of earnings is a lower-risk way of helping clients achieve their long-term objectives.

What factors are contributing to the divergence in equity valuations? In a low-yield and high-asset-price world, investment flows that are not price sensitive can drive prices to extreme levels. It is clear to us that the ever-increasing switch from active to passive investment strategies is having a profound impact on market pricing. This has resulted in the allocation of capital to assets that have recently enjoyed strong price performance, and away from underperforming assets. We also see clear evidence of multi-year style drift by global active managers, away from value to growth (and from high to low active share) – a consequence of the decade-long consistent outperformance of growth over value and passive over active.

Strong evidence of the impact of these factors on global equity markets can be seen in the staggering outperformance by mega caps across global equity markets in 2017, to the extent that the largest handful of shares dominated last year's returns in just about every market. A cursory glance at the constituents of these global stock indices indicates the dominance of mega-cap growth and tech stocks in particular. In sharp contrast, the least liquid stocks have underperformed materially (most are negative) in all the indices. This is indicative of a rising liquidity risk premium, and clearly demonstrates that the breadth of the bull market has not been as widespread as is commonly perceived.

A market dominated by price-insensitive flows that result in wide divergences in performance and neglect for smaller-cap stocks is fertile ground for contrarian stock pickers.

To invest in securities of sufficient quality at wide margins of safety in an expensive market, we need to buy businesses that:

• are either out of favour for reasons we consider to be temporary, or
• for which we consider the likely outlook to be better than what the market is pricing in.

So where can we currently find such opportunities? Firstly, we think there are very attractive opportunities in our own backyard. Stocks that are exposed to the South African economy, the ‘SA Inc stocks’, are out of favour and have become cheap – especially the less liquid stocks that fall outside the reach of global investors, big domestic managers and index-tracking strategies. It is our view that many higher-quality SA Inc mid and small caps can be acquired at attractive valuations on low levels of earnings. This bodes well for long-term returns from this opportunity set.

Similarly, there are several countries in which negative narratives have adversely affected stock prices. For example, the Japanese authorities' unconventional zero interest rate policy has dramatically weighed on margins for many financial businesses. As a result, we think we can acquire such businesses on unsustainably low levels of earnings at very cheap prices. We also acknowledge structural (and long overdue) improvements in Japanese corporate governance, with increasing focus on shareholder returns. In combination, these factors create the potential for asymmetrical investment outcomes.

We have also actively been mining the opportunity set that has arisen from the fallout in the US retail property sector. Not only have bond yields been rising (which is negative for capitalisation rates), but brick-and-mortar sales have been declining due to growing online market share in an overbuilt mall environment. Department stores in particular have been haemorrhaging. US retail real estate investment trusts (REITs) have been heavily hit, and we have used the opportunity to acquire excellent assets at very attractive prices and yields.

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