This can arise when the market has underestimated the duration of the earnings growth opportunity, when the quality characteristics are improving, or where the market is questioning the quality characteristics. This often means adopting a contrarian approach to buying quality companies when they are out of favour with the market.
Drivers of markets
A range of factors has driven some peculiar market outcomes this year.
Supply issues in Brazil have pushed up iron ore prices aggressively, the Coalition won the federal election in spectacular fashion and central banks have begun a new easing cycle on the back of a subdued economic climate. Low interest rates are causing a reassessment of valuations of equities as investors are squeezed into higher risk assets. We have seen a range of sectors trade at large valuation premiums to historic levels.
Technology stocks have very strong earnings growth but excitement levels are high, causing valuations, in some instances, to look stretched. A low interest rate environment means it is easier to justify high valuations for companies with strong and sustainable earnings growth (given we are now discounting earnings using a lower discount rate). However, as interest rates fall, a larger proportion of the valuation of these types of business is in the terminal value (+10 years). Many of these businesses are new, in a sector rapidly changing. The disrupted could become disrupted and regulation could alter the landscape. These types of risks are difficult to account for in valuations and as such, are often underrepresented.
Likewise, defensive companies with bond-like earnings profiles have enjoyed very strong share price movements as the market prices in low interest rates in an uncertain climate. The largest A-REIT in the Australian market is Goodman (GMG) and its valuation is at two standard deviations above its average.
If the bond market is correctly pricing a deflationary economic outlook, these assets are more attractive. Our concern is that even if we assume rates go lower, we cannot reconcile the current valuations.
Are we experiencing a mid-cycle slowdown or something more severe?
Global data has been soft over the past six months as earlier tightening in China and the US, and heightened anxiety caused by Brexit and Chinese trade wars weighed on conference. This has been reflected in a range of manufacturing indicators.
All in all, the slowdown has been mainly policy-driven and that headwind should ease (although we are relying on some easing in trade tension for that to occur). Looking back, the surprise end of the trade truce in May, the peaking of fiscal stimulus and an overly tight US Federal Reserve policy all continue to impact economic data and confidence, especially in the manufacturing and trade sectors. Looking forward, financial markets will anticipate an end to downward pressure on profits and pricing power. This is likely to drive a modest change in interest rate expectations and a rotation among the current winners in the market. However, the risk is trade wars worsen and political instability in Europe cause the recent softness to extend – so the risks remain balanced at present.
What happens if deflation expectations moderate?
Despite rising share prices, there has been significant divergence in the market. The gap between the high-value stocks and the cheap stocks is wide by historic standards. In some respects this is understandable. Disruption means the gap between good business models and poor business models has widened. Stocks with perceived risks are trading cheaply, while stocks with earnings certainty are trading expensively. Examples include businesses:
- models under structural threats from disruption or regulation
- exposed to uncertainties such as Brexit or trade wars
- exposed to cyclical headwinds
However, the extreme move and positioning by the market suggest that any moderation in risks would result in a sharp rotation. This could arise with a pick-up in global economic activity or an easing of some of the global tensions (although the recent acceleration in trade wars appears to be extending the valuation mismatch). Or it could be at the individual stock level where risks ease.
During periods of dislocation, we often find opportunities to buy quality companies at discounts as the market becomes indiscriminate in its selling.
Jamie Nicol, chief investment officer, DNR Capital
