Asset class valuations are at best subjective and contentious. Yet the pages of financial media are strewn with unsupported statements describing companies, sectors, countries, regions or entire asset classes as ‘cheap’, ‘expensive’ or ‘fair value’. Pretty much all commentators do it and superficially at least it represents a fairly good rationale for buying, shorting, or avoiding potential investments (ie, buy low, sell high). But there is also an implicit assumption that significant analysis has been done to derive this opinion, which quite often isn’t the case.
Headline valuation metrics such as the price-to-earnings ratio, dividend yield or credit spread are usually used to back an opinion. For example, we could argue today that high yield bonds are reasonable value because spreads are still some distance from their narrowest levels and defaults are expected to remain very low. We could equally argue that high yield is expensive because absolute yields are close to their record lows and that the extra spread premium is justified by much poorer liquidity compared to before the global financial crisis.
Essentially, as a team, we buy into the concept of bottom-up equity or credit analysts making such judgements on individual securities or even sectors. For most companies you can really go to work on a firm’s financials and industry dynamics and form a valid and considered opinion of value. A key question for asset allocators is whether aggregated valuation data for a broad index of companies actually has much meaning, in absolute or relative terms, particularly when the index composition of countries varies so greatly.
It’s a fairly consensus view at the moment that US equities are quite expensive, while emerging market (EM) equities look relatively cheap on several broad measures. Russia for example, as measured by the MICEX Index, is trading on just 2.9x estimated earnings (Source: Bloomberg, as at 17 January 2014). This compares to a 7-year average of 7.4x, a high of 13.7x and a low of 2.2x. Meanwhile, the S&P 500 Index trades at 15.6x compared to an average of 14.3x (see chart).
There are some obvious but important things to note, however: almost 60% of Russia’s index is made up of resources companies, while there is no representation at all from the industrials, consumer discretionary, healthcare, or technology sectors. There are similar, if less extreme distortions in many developed and EM indices. Germany, for example, has no energy stocks at all, while Hong Kong is nearly 50% financials.
So, is it in fact sector themes that have been driving country/regional returns and valuations? Certainly resources stocks have been the big laggards of the past year or so, and that has not helped the indices of commodity-producing countries such as Brazil and Russia. But we think there’s more to it than that – a significant number of EM indices are dominated by state-owned companies that are not run in the best interests of ordinary shareholders. If you strip out these essentially state-owned index giants, multiples are at very similar levels to developed markets.
Every dog has its day, but with headwinds building in emerging economies, coupled with upcoming elections in Brazil, India, Nigeria, South Africa and Indonesia, the potential for government interference in state-run enterprises is increasing. The risk is that these apparently cheap stocks and markets can get even cheaper before they revert to fair value. It’s also a major reason why purely quantitative approaches can be flawed.
