17 May 2019
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Valuations of a number of traditional ‘safe-haven’ stocks are high. If not at ‘expensive defensives’, where should investors be looking? Simon Edelsten considers the options.
They were dark days. Yet it is now over 10 years since equities’ lows after the financial crisis of 2008/9. Investors in global equities have made very large profits if they invested then. Valuations have also risen from historically very attractive levels to more demanding ones. Growth stocks, in particular, have led the market higher; and there now seems to be a proliferation of new funds investing in the likes of Amazon and Unilever as if these are the only stocks in global equities worth owning.
Historically, when most investors are looking in one direction, it is worth looking the other way. Some have noted the significant under-performance of value stocks this cycle and asked whether this is where future opportunities lie.
The traditional measures used by value investors are low price-to-book value or low price-to-sales – in line with the advice given by Ben Graham in his 1947 book, The Intelligent Investor. Unfortunately, there are few stocks quoted in western markets outside the banking sector on low price-to-book ratios – and we have recently seen that bank assets can go down as well as up. Also, there are few stocks on low price-to-sales outside retail and these businesses seem challenged by Amazon. Indeed, it is striking that Warren Buffet, famously taught by Ben Graham, has recently invested in Amazon through his Berkshire Hathaway company – itself hardly a value stock.
Japan and China still offer opportunities to value investors, with a range of companies trading below book value in Japan, especially if you adjust for balance sheet strength. It should be no surprise that these value markets are also overshadowed by negative perceptions: value investing generally involves being prepared to invest in unfashionable areas. It also demands patience and one can only hold a stock for a long period if it has the financial and commercial resilience to revive itself. We have a modest exposure to such opportunities in Asia.
So we follow a different route when looking for defensive investments in this market. Firstly, we avoid sectors that see significant revenue falls when the economic cycle turns – like the construction, retail, automotive and chemicals sectors.
Secondly, we avoid companies that rely on benign capital markets and low interest rates. One of the new features of many large companies today is the strength of their balance sheets compared to previous cycles. Not only have the companies we hold generated significant cash earnings over the past decade, they have also not forgotten the lessons of the financial crisis.
Lastly, once we have selected companies with resilient income and strong balance sheets, we then bias our holdings towards those that still seem to be on reasonable valuations against current cash earnings. We also concentrate on companies that have invested consistently over the years and have built up a stock of new products to drive their earnings going forward.
Companies with good barrier to entry and low price-to-asset value (on our analysis), include Nippon Telegraph and Telephone (0.99x book, 10.24x earnings), China Merchant – China’s main port operator globally (0.66x book, 9.42x earnings) and Unibail – Europe’s largest property company (0.75x book, yield of 7.53%).*
We also continue to find strong businesses on attractive valuations in the automation sector (notably in Japan) and pharmaceutical companies leading the way in cancer immunotherapies in Europe and the US.
The wider market, meanwhile, has been led higher on the back of the popularity of a particularly concentrated group of very large businesses, such as the FANGs (Facebook, Apple, Netflix and Google). Many of these look highly priced, which we think makes them vulnerable in a big correction. We now own none of these fashionable stocks.
Bull markets do not die of old age, but they can die from over-valuation and investors acting as a herd. We prefer to leave some parties early – especially when there are more interesting places to go that are less crowded.
*Source: Bloomberg. Displays 12 month forward P/E and P/book data as at 16 May 2019. Prospective yield as at 16 May 2019
Simon Edelsten manages the Artemis Global Select Fund; visit the fund page at artemisfunds.com for further information about its performance and current positioning.
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