Good companies around the world offer compelling valuations
Japanese investment headlines over the past few weeks have provided an excellent illustration of what is happening in global equity markets today.
Glamorously, the Financial Times “unmasked” Japanese conglomerate Softbank on September 4 as “the whale of the Nasdaq” which had bought billions of dollars in call options on US technology stocks. Call options offer a form of leveraged bet on further price increases, in this case a bet on the continuation of momentum in the tech industry. In a sense, Softbank’s bets were no different than an army of retail speculators on low-cost trading platforms like Robinhood.
At the significantly less glamorous end of the spectrum, Warren Buffett’s American company Berkshire Hathaway announced in late August an investment of around $ 6 billion in Japan’s five largest trading companies, known locally as sogo shosha. These trading houses were originally established to serve as intermediaries between Japan and the rest of the world and, over time, have developed into industrial conglomerates that span a wide range of businesses. Despite Buffett’s reputation as a legendary bargain hunter, and the 4.6% average dividend yield available in these stocks, the market essentially responded by… yawning.
We believe this is symptomatic of the extreme divergence of opportunities facing investors today.
The current stock market highs include a relatively small number of companies, typically mega-caps, which are extremely concentrated in the tech sector. They have for the most part been great beneficiaries of the covid-19 pandemic. For example, the CEO of Microsoft, an obvious member of this group, recently said: “we have witnessed two years of digital transformation in two months. It would be just as accurate to say that these stocks posted two-year returns in two months. In the nine months to September 30, the MSCI World Technology sector had risen by 27%, massively outpacing the gain in the MSCI World Index over the same period by 2%.
But, as we all know, an explanation of this arrived is not a guide for what what will happen in the future. While the pandemic has accelerated the adoption of online shopping and many other business models, the momentum of 2020 cannot last forever. Fortunately, there are only 24 hours available each day for Zoom meetings. But the longer it lasts – and the higher the valuations you pay for those stocks – the less margin for error you have as an investor. Even the best companies can be terrible investments if you buy them while they’re priced to perfection. This matters both to investors in the tech sector, but also increasingly to leading stock market indices.
To illustrate the risk to major stock indexes, let’s assume that the 50 largest US companies are a good indicator of the stock market darlings of 2020. The dark blue line in the chart below shows how well these 50 stocks are doing. have behaved since 2018, and the particularly spectacular rebound they have experienced since the stock market crash of February and March 2020.
The graph shows the disproportionate effect these 50 companies had on the performance of major stock indexes. The 50 largest US stocks now include many of the largest companies in the world in terms of market capitalization (the total value of shares issued). The middle line (light blue) of the graph represents the performance of the MSCI World Index weighted by market capitalization. A market capitalization index weights constituent companies based on their size, which means that the performance of large companies has a greater impact on the overall index than that of small companies.
In short, the strong performance of the 50 largest US stocks had a disproportionate effect on the performance of all indices.
The good news is that these flagship indices roughly represent the opportunities available to bottom-up stock pickers. As you can also see from the graph, the performance of the capitalization weighted index is significantly better than if the performance of each stock is treated equally (yellow line). If we look at the average stock globally on an equal weight basis, we see that the average stock remains stuck in a bear market that started in early 2018.
This excites us, because it suggests that there are many companies where valuations can be much more attractive. Indeed, in our opinion, there are many good companies in the world that may not be obvious beneficiaries of covid-19, but also whose long-term investment value has not been affected by crisis. These companies may offer little short-term excitement, and they lack an obvious catalyst, but for long-term investors, this is an advantage: as a general rule, you are very unlikely to find deals in parts of the market that everyone is excited about.
As an example, we think German chemicals maker Covestro, US health insurers such as Anthem and UnitedHealth, and trading companies in Japan all fall into this category. What unites them is that the market is (in our opinion) too pessimistic about their long-term prospects and, as a result, they are selling at values below our estimate of their true worth. These undemanding valuations create the potential for attractive long-term returns and should also provide absolute loss protection.
So the market is now split between the obvious beneficiaries of the crisis that investors want to own, almost regardless of valuations, and pretty much everything else. Given that investors’ time horizons differ, this divergence may not be so surprising in the end. It may well be that Softbank and Berkshire Hathaway are both “right” – the US tech sector could continue to do well in the short term, and Japanese trading houses could be great long-term investments.
But investing with a short-term horizon is difficult: the risk of owning popular stocks is that the markets can turn in no time. No one rings the bell at the top, and if sentiment changes, high starting valuations can lead to steep price declines. Conversely, history shows that time and time again, the best long-term investments are those that attract little attention (or even contempt) when they are made.
The longer a trend persists in the markets and the more there is a consensus that “Sector X” is the only place you should invest, the higher the returns can be by finding a different path. In our view, this gap and the opportunities that flow from it today are unusually wide.
Further reading: How the markets are behaving amid the Covid-19 crisis