By Anthony Dalwood
Despite two years of near zero returns from UK and US equity indices, relatively high cyclically adjusted P/E ratios (CAPE) and valuations of private equity deals indicates medium term returns from equity indices are likely to be relatively poor. Investors will need to explore alternative asset classes or more focused specialist strategies to generate alpha over the medium to longer term.
Despite outperforming over the long-term, value investing has been out of favour with investors with growth and momentum stocks having been in vogue for around five years. The chart below (fig.1) shows the underperformance of global value versus growth indices on a rolling 10 year basis. The underperformance is comparable today to the peak of the TMT bubble 16 years ago. This point in 2000 represents a market peak from which the FTSE All Share declined 42%, however “value” companies actually increased in price such as Imperial Tobacco which increased by 161% over that period. We believe 2016 could be the year we see value investment return to favour.
Current index valuations are high – but good investment value areas can be found
Although traditional valuation metrics do not look excessive they are at the upper end of the spectrum with average PE multiples of c.17x and a dividend yield of 2.5% for the FTSE small-cap index (ex. Investment Trusts). The extraordinary period of Quantitative easing following the financial crisis has resulted in an unprecedented low cost of capital which has helped drive corporate ROE and margins toward peak levels e.g cyclicals and defensives 40-year peak ROE of c.16-18%, with current levels at c.15%
We believe the cyclically adjusted P/E of 13.3x for the FTSE All Share also suggests that returns are likely to be below the long term average of circa 4-5% real. Further evidence that we are close to the end of another bull market cycle is provided by the average transaction multiples paid by Private Equity which has been increasing over the last five years and deals are now priced on average at 10.5x EBITDA with 5.4x Debt/EBITDA, similar to levels in 2006/07 (fig.2).
What does this mean for future returns?
Current valuations would suggest medium-longer run returns will be below long term average of 4%-5% real and investors will need to cast a wider net including alternative and more illiquid asset classes or specialist strategies to achieve attractive returns. Indices are an average and hide dispersions and, whilst areas of value do exist, investors need to do their research carefully and potentially adopt a contrarian investment strategy to generate superior returns. These areas could include the oil & gas services sector, retail services, or simply smaller, illiquid companies with “value” characteristics.
We also expect allocation into real assets to increase with investors attracted to the potential for long-term outperformance whilst owning assets backed by tangible assets that tend to be uncorrelated to traditional asset classes. Within this, we highlight timber as particularly attractive. The chart below (fig.3), compiled by GMO Woolley and based on what current valuations imply for future returns, shows forecast real returns of 4.8% p.a. in this asset class, (compared to international equities at 1.6% and emerging market debt at 2.8%). The unique characteristics of timber, including the biological growth and supply constraints generate potential for significant outperforming returns.
Cyclicality and dispersion in valuations can present great opportunities for an alpha focussed investor to generate outperformance. A Value investing style has historically generated long-term superior returns and evidence is even greater returns have been delivered through investing into smaller companies with value characteristics. Contrarian investing can be uncomfortable, however rewards have historically been significant.
Anthony Dalwood is CEO at Gresham House
