17th June 2022
In early May, Ben Conway wrote a Crescendo entitled ‘Valuation Matters’, which highlighted that the recent equity market sell off has been heavily driven by expensive growth stocks which have sold off aggressively as bond markets have suffered their worst start to a year in history. Government bond yields have risen sharply (i.e. the UK 10 year yield has risen from 0.8% at the end of December 2021 to 2.6% today), credit spreads have widened, and there have been rising concerns about recessionary risk with inflation at the highest level in decades. The cheapest stocks across equity markets have been clearly outperforming, although have still struggled to deliver positive absolute returns. Valuation has started to matter again.
As valuation focused fund managers, this has been a good environment for us in relative terms. Our job is to identify attractively valued asset classes where the return profile is skewed to a much higher probability of positive returns vs negative returns (i.e. exhibits convexity). As well as find the best active managers to exploit those opportunities successfully to deliver attractive long term returns for our investors. The price we pay is one of the most important determinants of future returns – the higher the price, the lower the expected return. Valuation is a poor timing tool, but an incredibly powerful driver of long-term value creation (or destruction!).
Year to date, valuations have moved significantly. US equities have entered bear market territory (defined as being down over 20% from their peak), whilst the NASDAQ is down around 30%. Do we think that these indices are now offering good value and attractive long term return prospects? No. Certainly, they are less expensive than they have been over the past 2 years. But all that has happened during the recent drawdown is the froth from the significant valuation expansion seen since 2019, which took US equities to their most expensive levels in history according to many valuation measures, has partially washed out. Partially washed out. Not fully. Valuations for those indices remain elevated relative to their own history. When you factor in that analysts are still expecting earnings growth of around 10% for US stocks this year, despite economic growth rolling over sharply, in reality valuations are likely more elevated than they currently appear.
We like to look at sector neutralised, cyclically adjusted price to earnings measures when looking at regional equity markets. This allows us to get a good feel for how different regional equity market valuations compare against their own history without being skewed by changing sector weights and adjusting for earnings through a cycle. On this measure, the US is still around 30x CAPE – it has only been higher during the dotcom bubble and the past two years valuation expansion. The last time the US 10-year yield was above 3% was in 2018, and the US was on 20x CAPE at the time – it would take a 33% further drawdown to get to that level today. Ouch.
How are other regional equity markets stacking up on this measure? Europe is trading around fair value vs long term history, although remains elevated relative to the post GFC average. The UK is roughly in line with its long-term average valuation multiple, Japan is cheap relative to history, and Asia more broadly has cheapened to just below longer-term average. Compared to the US, other regional equity markets appear good value, but they cannot be classified as cheap relative to their longer-term histories. Looking below the surface however, there is significant dispersion particularly in the UK, Japan and Asia that is creating rich hunting grounds for active managers to exploit. Much of the value we are finding resides in small and mid-cap stocks that sit outside mainstream indices – for instance see Ben M’s recent Crescendo on UK equity opportunities in ‘Going against the grain’.
When prices and valuations move around so quickly, it is vital to maintain a rational head and keep searching for the most attractive long-term opportunities and not get swept up in the noise. That is what we are fully focused on doing, and we are excited about some of the opportunities we are unearthing that should lay the foundation for our long-term performance.
Dan Cartridge – Assistant Fund Manager
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