Is the bull run sustainable or is a market correction on the way?
• Portfolio returns will be disappointing compared with what investors have become used to
Opinions on equity valuations are highly varied. Many argue that global equity markets are expensive, trading at levels only reached in times of irrational exuberance, like 1929 or 1999. They believe a material market correction is overdue.
Others reference strong economic conditions, fast growth in corporate profits and low interest rates as evidence the bull market is sustainable. Who is right? It depends on your perspective. Our perspective is that global assets are generally trading at elevated valuation levels. We expect low long-term returns from many asset classes given these levels, especially developed market bonds and the well-owned equities with which they have been competing for capital.
Long-term asset class performance needs to be seen in the context of the 30-year bond bull market that is probably approaching its end. This follows recent bouts of extraordinary and unconventional monetary stimulus, including zero interest rate policies, negative real yields and quantitative easing. This environment has been very favourable for the prices of long-duration assets, including equities — especially those perceived to yield more sustainable or faster-growing cash profits.
We believe that portfolio returns (on a broad basis) from these levels will be disappointing compared with the returns South African (and other) investors have become accustomed to over the past 15 years — especially after the surge in equities in 2017.
Due to much higher stock prices we have been finding fewer opportunities to buy highquality businesses at wide margins of safety over the past year and a half.
However, even through markets are broadly expensive, if you’re prepared to look beyond the crowded stocks and sectors, the opportunity for good longterm returns is quite promising.
Most of the globally superior companies we would love to own are very expensive. But if you look a bit deeper into equity markets and are prepared to invest in uncrowded areas, good prospects abound.
Contrasting valuations within markets present fertile ground for stock pickers to generate alpha and deliver on clients’ long-term return objectives. Investing in cheap stocks on suppressed levels of earnings is a lower-risk way of helping clients achieve these objectives.
We can hazard a few calculated guesses about the factors contributing to the divergence in equity valuations.
In a world of low yields and high asset prices, investment flows that are not price sensitive can drive prices to extreme levels. It is clear that the everincreasing switch from active to passive investment strategies is having a profound effect 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 multiyear 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. A review of global mutual funds indicates the low and ever-shrinking market share of traditional value managers relative to passive and growth strategies.
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 of smaller-cap stocks is fertile ground for contrarian pickers.
To invest in securities of sufficient quality at wide margins of safety in an expensive market, we need to buy businesses either out of favour for reasons we consider temporary or for which we consider the likely outlook better than what the market is pricing in.
There are very attractive opportunities in our backyard. Liquid stocks that are exposed to the economy — the SA Inc stocks — have repriced dramatically after the improved outlook for the political governance of the country since December.
Notably, less liquid stocks that fall outside the reach of global investors, big domestic managers and index-tracking strategies have been left behind. It is our view that many higherquality 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.
There have been 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 brickand-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 have been heavily hit, and we have used the opportunity to acquire excellent assets at very attractive prices and yields.