From The CIO’s Office

The Bull Market in stocks is 10 years old but what happens now?

This month, the US stockmarket rally celebrated a decade long rally. Depending on which market historian you follow, it is the longest or second longest rally in history. In any case, it is clearly an impressive sustained performance and it followed the sharp declines and collapse in valuations is seen during the 2007/08  lobal Financial Crisis.

The charts indicate that the S&P 500 bottomed with a post-crisis low (an intraday level of 677.93) on the 5th March 2009 and the Nasdaq Index (CCMP) on the same date also hit an intra-day low (of 1268.6). According to Bloomberg, since then the S&P 500 has given at total return of 407% (17.5% per annum) and Nasdaq has returned 564% (or 20.7% per annum) over 10 years.

This has clearly been a golden period for stock investors. However,  throughout this period, the market has climbed a wall of worry. The memory of the losses in 2008/09 meant that investors have often been worried that the markets were overvalued and therefore were about to fall. The general ascent in the indices have been relatively smooth though there have been some sharp periodic corrections such as in early 2016 and more notably in the last quarter of  2018 when markets fell sharply just after Apple and then Amazon both briefly hit USD 1 trillion valuation. The decline in Q4 2018 was relatively sharp and accompanied by a high degree of volatility at the end of 2018.

The rise in the market over the decade has been driven by Technology stocks particularly but not exclusively the FAANG stocks. Over this long period, the number of listed companies has fallen as the number of IPOS has declined while takeovers, mergers and other corporate activity has reduced the number of listed companies. These factors among others, mean that the advance of the market has narrowed and become more concentrated over time.

So far in 2019, the market indices have risen sharply but many stocks remain below the levels seen on August / September 2019.

Investors are currently worried particularly about the slowdown in growth in China and worries about recession in Europe as well as nervousness about the significant trade war between the US and China. In addition, there is a huge flow of IPOs about to hit the market particularly issues such as UBER, AIRBNB etc. At the end of last year, the markets were worried about the Federal Reserve raising interest rates up to three times in calendar 2019 and continuing reduction in the US Federal Reserve’s Balance Sheet. This year, following much more dovish comments from Fed officials, market expectations have changed completely. The Fed has stated that the reduction in the
balance sheet will end by September 2019 and market now do not expect an interest rate cut this year.

So much for history, the question investors now have is are the markets overvalued now and will they go down now. This is of course a very difficult question to answer though that does not stop a lot of people from offering answers.

It is difficult question for bottom up analysts like ourselves as the Market Index by definition is an average and consists of a heterogenous groups of companies, industries and sectors with very different characteristics and therefore it is difficult to talk about the market except in the most general terms. We also find it difficult to address these questions as we do not have a reliable method to forecast either the direction or the timing of the movements of the market index in the short term.

What we can talk about (at length and in as much detail as you want!) is valuations. Valuations show a big dispersion between stocks, sectors and markets – Valuations are very high in technology and some other specific sectors and valuations are relatively low in some other sectors. In the UK market, the ongoing saga about Brexit has meant that many UK companies especially in the UK FTSE 250 Index look relatively cheap on some valuation metrics in particular those such as Free Cash flow Yield, Dividend Yield and PE Ratio.

The best way to illustrate this is, as always, by looking at the detailed data for a lot of companies.

Below we show a selection of companies which are broadly on the technology space. In general, these companies look overvalued. This can be seen in the table below.

The table shows that while companies such as Apple, Cisco and Ebay are reasonably valued, most other technology companies, where growth prospects are thought to be higher, such as Netflix, Square, Veeva Systems and so on are much higher valuations where it is measured by PE Ratios, Yields or Valuation Models.

On the other hand, we can see many other sectors where valuations are much more reasonable. These disparities reflect the fact that there is lot of investor interest and therefore strong price momentum in Technology stocks and other selected sectors. On the other hand, there are a lot of other sectors such as Brick and Mortar Retail, Asset Management Companies, Banks UK Housebuilders, Chemicals, Semiconductors etc where there a lot of well-known worries about prospects, which mean that their stock prices are low and valuations are more reasonable.

The table above shows some valuation metrics for listed asset managers in the USA. These indicate that valuations on some metrics appear to be attractive. In particular these stocks are trading attractive levels on valuation metrics such as Free Cash Flow Yields , Earnings Yields and modelled valuations such DCF and EPV.

The problems of the sector are long standing and well known. The growth of passive investing strategies and instruments such as ETFS has put great pressure on fees and revenues. These events have affected valuations The prices of US listed asset managers have fallen about 17% on average in the past year while the S&P 500 rose 12% over the same period.

The valuations of these firms look attractive enough if one believes these companies are not in permanent decline in which case the selloff presents an opportunity for long-term patient investors.

The share price of Franklin Resources (BEN), which has declined roughly 40% in share value over the past five years. The firm’s focus has been on value investing since the days of the legendary investor John Templeton. A quick look at the balance sheet indicates that about 50% of the total assets of USD 14.4bn is made up of cash and short term investments.

Asset managers historically have sold for 2.7% of their assets under management (AUM) and Invesco’s pending acquisition of Oppenheimer Funds represents a multiple of about 2.4% of AUM. These numbers to some extent cover a time period when the prospects for the industry were better than is the case currently. The key question is the extent to which the fundamental outlook for the industry has worsened so much that a much lower valuation is justified.

Franklin currently trades at 1.5% of AUM and this could be attractive enough for buyers including the current 40% controlling shareholders or private equity vehicles who could buy out existing minority shareholders and take the company private.

Legg Mason (LM) has declined by 31% over the past year and about 50% over the past five years, is even cheaper than Franklin Resources (currently trading at 0.6% of AUM) and is worth investigating further as a potential candidate for investment. It currently offers a dividend yield of 5.2% and the company’s cash flow is strong enough to allow it to buy back around USD 300mn to 350mn worth of stock every year for the last five years and this accounts for about 12% of the current market cap.

Financial stock valuations also look quite modest especially if one looks at PE Ratios, Earnings and Price to Book ratios as outlined above. The table some selected data on the large US banks.

These worries reflect global recession worries, a poor run of results in their all important financial trading businesses and more recently worries about their ability to generate income in a world of much flatter bond yield curves.

Therefore the stock prices of financial stocks have underperformed in recent years. In the last two years the XLF financial sector index has risen by about 5% per annum while the S&P has returned over 10% per annum over the same period.

The Chemical sectors also appears to have attractive fundamentals and this may reflect worries about a likely slow down in the global economy and its impact on cyclical stocks.

These few quick illustrations show there are sectors and markets where valuations are attractive enough to encourage greater interest and investigation by Value Investors. At the same time, many other sectors, particularly in the technology space, are likely to prove to be of interest to growth investors.

We have devised both Value and Growth Investment strategies. These require somewhat different investment approaches. Value investors are a diverse breed but are attracted to cheap stocks and believe that buying at the right price should give a good margin of safely against likely future bad news and other turbulence. However, Value Investors have to be careful to avoid value traps.

These are stocks whose valuations are cheap on a number of parameters but do not have trigger or catalyst to appreciate upwards to a more reasonable value. In some cases, stocks may appreciate but do so very slowly that the returns measure as a periodic percentage return are likely to be sub-par. In short, an investment is likely to prove to become “dead” money.

Growth investors are more relaxed about valuations at the point of investment but face the risk of overpaying for future growth if future events proved that they were too optimistic about the magnitude or duration of the growth that was likely to occur. In this case, the passage of time could show that price paid was too high.

In our value strategy our task is to buy stocks at the correct price and at a cheap valuation while avoiding value traps. There is no simple generally applicable process and it has to be done at the stock level. We can consider some stocks and show the numbers and ideas used to consider whether to invest and how to avoid value traps. We may well do this in a future edition of the CIO letter. In growth strategies we use techniques to quantify the growth premium that might exist by inverting.

Weekly Market Movement Wrap

Last week saw a positive end to a positive quarter with the S&P 500 and Nasdaq rising 1.2% and 1.1% respectively over the quarter.

Equity Indices: Developed Markets

Equity Indices: Asian Markets

Commodities

Bonds: Developed Markets

Fx:

Bonds: EM Bonds (Local Currency)

Annexe 1

Please find below a small selection of stocks that we have looked at in detail. We will be constantly adding to this list.