Despite weakening economies, stock markets are still trading close to highs. There is now a very large dichotomy between the valuation of these cyclical businesses versus businesses with low volatility earnings streams or businesses where fast growth is expected to be infinite.
We have written about this unconventional period of extreme global monetary policy before. Central banks are cutting rates aggressively around the world due to low inflation and the impact of the US led global trade wars, which is driving a manufacturing recession, most obvious in Germany.
Manufacturing and services indices in the US are also falling despite still being above 50, indicating growth. We have seen some downgrades in earnings from cyclical companies like Federal Express. Cyclical industries such as industrials, banks and discretionary retail have seen large falls whereas defensive sectors such as utilities, REITs and consumer staples have benefitted from a rotation into them.
Chart 1 – Cyclical businesses' multiples are de-rating moving with 10 year bond yields
Source: Morgan Stanley research
The chart above highlights how the ratio between the valuation of cyclical industries in the US has never been this low versus defensives and how this ratio is highly correlated to interest rates. This is creating some intriguing investment opportunities while also creating investment bubbles at the same time. We have slowly been accumulating some very cheap stocks in US retail and global financials whilst taking profits from companies that have done well and now look over valued. Rather than increasing our risk exposure in the fund, we have increased our cash position to 16% and have bought some put options on the S&P 500 to protect the portfolio if markets weaken. But its hard to ignore some outstanding opportunities that are currently emerging by this unusual period in global markets.
We have recently bought into Banco Santander, which is a bank listed in Spain. However, over half of Santander’s earnings are derived outside of Europe. It has high quality banking franchises in Brazil and Mexico, which are markets with low credit penetration and higher levels of earnings growth for banks. While Santander’s Brazilian and Mexican franchises are listed and trade on a Price to earnings ratio of 12x and a Price to book value of 2x, you can buy the parent company listed in Spain for only 7x earnings and a Price to book of 0.6x. This is close to an all-time low valuation and reflects a few undercurrents in global markets at the moment.
Firstly, valuations for businesses which don’t benefit from falling interest rates, like banks, and with perceived exposure to weakening economic indicators, are trading on very low valuations. Secondly, companies are becoming more highly correlated to the sector in the geography that they are listed in, irrespective of what the actual business is and in which geographies its operations are actually in. This second phenomena is being driven by the growth of passive investing in ETFs, which I will discuss below.
Our view is that you can take advantage of mispricings today as long as you are willing to completely ignore the market and indexes, like Michael Burry did in 2007. For those who don’t know who Michael Burry is, he was depicted in the movie “The Big Short”, with Christian Bale acting as Michael. I love the scene where Christian bale is walking around in a tee shirt with music blaring, as he tries to block out the noise that the market and everyone else around him was creating when he was short subprime mortgages and the prices of these instruments kept rising. Interestingly Michael Burry is now comparing passive investing and index funds to subprime CDOs.
ETF flows distorting valuations
I have been doing a lot of digging to try to explain why this distortion in valuations exist and why it has been continuing. Why are people happy to pay 100x earnings for Netflix and 60x earnings for chipotle but only 7x earnings for a leading bank in Europe or a retailer in the US? I think a large driver of this is flows. In the chart below you can see that in the US there has been $18bn of inflows into low volatility equity ETFs this year. The other styles that are seeing inflows are quality, growth and momentum.
Chart 2 - 2019 YTD factor ETF flows (SMM)
Source: Strategas Technical strategy September 2019
This explains why quality and momentum stocks like Starbucks have re-rated from a PE of 23x to over 30x driving an increase in the stock price by over 50%, despite earnings only expected to grow by 9% next year. It also explains why companies with low volatility in their earnings at the moment like Mastercard have seen an increase in valuation to a PE multiple of 36x. I remember buying Mastercard on a PE of 14x in 2010 and its earnings were actually growing faster then, than they are today.
Mastercard is up 44% year to date and Starbucks is up 34%, despite no major changes in the outlooks for their businesses.
Now you compare this to the performance of bank stocks or retailers which are perceived to be cyclical and fall into the value style of investing. You will find it hard to find a bank in Europe or Japan that is not trading below book value and is not down this year. If you look at the US retail sector, there are also extreme price movements with companies like Capri (the owner of the Michael Kors brand and Versace) trading on a PE of 6x, having fallen 25% this year and Tapestry (the owner of the Coach brand) also falling around this amount. If you compare these brand owners to brand owners listed in Europe like LVMH and Kering, the performance is actually quite different with Tapestry and Capri trading at 50% discounts in valuations. I think part of this can be explained by the ETFs that these companies find themselves in.
As you can see in the chart above, value ETFs have seen the biggest outflows year to date. I decided to look into one of the largest ETFs in the US, the Vanguard Value ETF, which has $79.6 billion in net assets. I was not surprised to see Tapestry and Capri falling into this ETF. Obviously, the European brand owners are not in US ETFs and ironically, brands in Europe are viewed as a safe place to hide relative to banks. We have been buying into Tapestry and Capri while passive money has been selling as we believe that fundamentals will eventually prevail. As Michael Burry has recently stated:
“This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.”
Interestingly, Michael Burry has been buying a number of beaten up US retail stocks like Gamestop recently.
I was not surprised to see a number of our positions in the Vanguard value etf, like Bank of America, Nasdaq and Whirlpool. Additionally, we have recently bought into a number of other companies like Berkshire Hathaway and United Healthcare, which fall into this value index and look undervalued to us. Stock prices move simply with flows and demand and supply of the security in the short term but over a period of years end up reverting back to sensible fundamentals. I feel more comfortable buying quality stocks at value prices and buying more of them as they fall, than buying quality stocks at inflated prices.
Despite market excesses there are still a lot of opportunities
While market commentators talk of a market top, we are still finding a lot of exciting opportunities. There are some significant anomalies within markets at the moment and we think it is time to be very selective in the companies that you invest in and pay close attention to the price you pay for businesses. Happy hunting!