Valuation, valuation, valuation

Written by Ben, 29 January 2013

Apologies for the variation on a now-hackneyed title. I will do my best to steer clear of '...tions' in triplicate in the future. It does describe one of the twin pillars of our investment process quite succinctly though. As we’ve seen some fairly unusual market movements of late, here I will describe our view of the value in asset classes, as ever a central consideration for our process. Another vital element is assessing the quality of companies, a topic Hugh has covered extensively in his regular investment views (which I of course commend to you, they can be found here).

Equities - Still some value

Lately, Mr Equity Market has been feeling on top of the world, all around the world. Indices from west to east, north to south have inched upwards pretty much daily all year, following the bemusing phenomenon of the Santa Rally. Volatility has collapsed. I could spend the entire post pontificating on why this is the case, probably covering the macroeconomic environment, monetary and fiscal policy globally, US growth and savings rates, impact of ECB action on Spanish borrowing costs, corporate cash piles etc etc. These are all worthy topics for discussion, but ultimately of limited use to us as investment practitioners. This is for two reasons.

First, the rise in equity values and collapse in volatility has already happened. Not being in possession of a flux capacitor or some other time-travel device makes it hard to profit from this post-hoc observation alone. Second, while we might have a view on where all these economic factors will take us, the likelihood of us hitting the macroeconomic nail on the head is slim (again, a time machine or simple crystal ball would be helpful in this regard). That's not to say the economic environment won't affect the companies/governments/individuals that operate within it. Indeed, we view a large part of our job as insulating our clients from as wide a range of adverse scenarios as possible. We are aware of the economic climate but we can't be certain what might happen next or how it will affect the investment entities in question.

My cringe-inducing title addresses our response to the problem of risk. When we look at investments we must assess whether the potential return is sufficient, given the potential risks. The potential return is determined by the valuation of a financial asset. The more I pay, the lower the potential return, and the greater the likelihood that I am not being adequately rewarded for the risk I'm taking on. There are risks associated with all financial assets, even the coins in your pocket, as I discovered yesterday when spilling my loose change all over the leisure centre floor (no capital loss you’ll be glad to know, just a little dent to pride). With companies, we view risk at a fundamental level, i.e. how robust is the firm's operating performance to things like competitive threat, changing consumer tastes, economic shocks and so forth. We don't view risk in terms of share price volatility where stock selection is concerned.

That said, I can make one prediction with a high degree of certainty. At some point this year volatility will return to equity markets. And volatility is usually associated with a falling market. This is a central feature of investing in shares and shouldn't be forgotten, especially when things are looking benign as seems to be the market zeitgeist of the moment. We choose to accept this volatility, but only at a price that covers the fundamental risks.

So, as we see prices rise, future potential returns fall. Are we still being adequately rewarded for the risks of investing in shares? According to our analyses the answer is a qualified yes. The qualification is that there is a spread of valuations within the market, some of which are attractive and some of which aren't. This is usual, a factor of Mr Market's attention flitting from one sector or company to another as we pass through time. Talking crudely, of the quality firms in our investable universe there is currently a split between large and small companies, with the larger offering better value. There is apparently enthusiasm in the market for a subset of cyclical companies that might be geared into a global economic recovery. Many of these are of great quality, and we would want to own them at the right balance of risk and reward. As prices have been bid upwards we don't have the right balance at the moment.

Another split worth noting is between the US and the rest of the world. It appears to me that the US market is somewhat overvalued as a whole, a view shared by many US-focused investors/commentators that I read. However, there are still some quality US-based companies that can be purchased at reasonable prices, and we own some of these in the Evenlode Income fund.

Bonds - Very little value

I wrote recently about valuation in the bond market here. The conclusion I made there still stands - bonds (of a governmental or corporate flavour) are way too expensive. There have been some developments since then. Sovereign yields of countries considered to be safe havens have risen a bit. It's now possible to get over 2% on a 10 year gilt, still inadequate compensation at a percentage point or so less than inflation but better than it was. The more palatable part of the UK market that I discussed, index linked bonds, has gone the other way however. That's thanks to the ONS's decision not to alter the way RPI inflation is calculated to a slower rate. This is a technical consideration with real-world implications, but ultimately index linkers have got a little less appealing as their prices have risen.

I am not alone in calling government bonds expensive. The sad-but-true fact is that I have been saying this for a long time, and have seen the asset class rise as I have been repeating my "bonds are overvalued" mantra. So I find it reassuring to also repeat why I think this, my comfort blanket being spot valuation and a little history. In straight-forward terms, if yields and inflation don't change, we're looking at a negative real return (I discussed what might happen if they do change in my previous article). That's probably enough on it's own, but there's more. Over a long period of history including a very drawn out bear and bull market, investors have demanded overall a real return of around 3% per annum. The approximately four percentage point difference is wide enough that I remain confident in my assessment, even though I am unsure as to when things might change.

Conclusion

Equities have risen, and there are consequently lower returns on offer as a result. Nonetheless, overall valuations remain ok and we can still find decent prospective returns on offer from quality companies. This is much more than can be said for bonds, where potential returns look unappealing to say the least.

One final thought is on what has been dubbed the ‘great rotation’. This is the idea that investors, fed up with miniscule yields on bonds, will sell up and buy equities, thus pushing the prices of shares up. This, to my mind, is a form of the Keynsian beauty contest, and should not be an argument that drives investment decisions. But if I can read between the lines of this line of reasoning, I do agree on the fundamental point that the potential excess returns from equities over bonds are more than sufficient to pay for the extra risks involved, particularly where quality companies are concerned. Show me the valuation!

Ben Peters, 29th January 2013

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