2020

The valuation premium for quality and growth has hit new decade highs, driving the ASX200 average forward PE to sit ~14% above the 20-year average. But the average always hides the detail: industrial PEs are sitting 36% above the 20-year average, miners 18% below and banks 15% below.

The most recent correction in momentum stocks sees this factor at a new YTD low. However, the valuation dispersion looks little changed with the bubble in the defensive and quality/growth names still at extreme levels, as shown in the following charts.

Chart 1: High PE firms trade an average forward PE of 36.7x, which is 45% above the 20-year average

Source: Goldman Sachs, as at November 2019

Chart 2: High-quality forms trading at levels above that seen during the 2000 tech bubble

Source: Goldman Sachs, as at November 2019

The door opens for a value bounce back

  1. Interest rates at multi-decade lows are causing bubble-like valuations across growth and quality names that will eventually burst given the heady multiples being paid.

  2. Donald Trump appears keen to sign a mini-deal with China to avoid further tariffs that may hurt US voters prior to the 2020 presidential election.

  3. A no-deal Brexit tail risk has essentially become very unlikely and thus any further clarity on a sensible Brexit or a ‘remain’ will be viewed positively.

  4. The global manufacturing downturn is now essentially halfway through a typical three-year cycle with the 2H traditionally a bottoming out and recovery. Therefore, potential for reflation in 2020 as global PMIs trough is a powerful driver of the market. In times like this, cyclicals and economically sensitive stocks do well, and we expect defensive, growth and low vol stocks should reverse some of the exorbitant valuation multiples they are priced on.

  5. Geopolitics has been one of the largest drivers of the slump in global growth and corporate profits over the past year. Therefore, less stress can be a powerful catalyst for a cyclical revival. Compounding this is the cheap valuations and extreme positioning of the market that has the potential for violent rotations into the value end of the markets.

In summary

As a value manager, our conviction lies in a process that is based on long-term sustainable earnings and cash flows, priced on appropriate multiples. 

So, when the market reverts to more normal conditions, a patient active value manager (and investor) can benefit enormously. 

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Comments

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Jerram Robinson

I think this article raises some good points, and I agree that every investor should have at least some exposure to value stocks through a well diversified portfolio. There's no doubt that it has been very uncomfortable being a value investor or value Manager during this extended bull run, but I'm not so sure that we can talk about high PE's from the early 2000's and make comparisons with the market today. For one thing, the investing exuberance of the Tech boom was largely because the internet was a relatively new thing, and PE's were being driven up based on grandiose ideas and visions, and not much more than that. What strikes me as different about today's market is that it is a relatively small number of stocks driving the market to new highs, but these companies (such as the FANG's) are now well established, hugely profitable and will remain hugely influential for a long time to come. So while I agree they are expensive, there is every chance that they could get pushed further up the growth curve and become even more expensive. The flip side of this argument is that when a market correction comes, and it will come eventually, then even these stocks will be punished severely and this is where value could really shine. As an example, even though growth stocks had outperformed value stocks for most of the decade preceding the early 2000's Tech bubble crash, just a single year of value out-performance after that crash was enough to tip the favour back to value for almost that entire period. So the impact can be profound. Interesting times we live in.

Ivaylo Vasilev

In my opinion it is not only to consider value vs growth. During the last few years markets punish severely companies with higher capital intensity which impacts stock returns. "We have long believed that the capital intensity of a business and the nature of its intangible assets are a more subtle and more profitable framework for marking distinctions among companies. Companies that depend primarily on physical assets like real estate, factories and machinery for their competitive advantage are unlikely to earn reliably superior returns on their invested capital over the long term. Physical assets invite replication by competitors which often leads to excess capacity, price competition and erosion of returns on capital. In contrast, companies whose decisive assets are intangible, such as brands, patents, licenses, copyrights and distribution networks, can earn consistently superior returns on relatively smaller amounts of invested capital." Morgan Stanley Investment Management