The constant references to cheap valuations in equity markets is misleading, according to MAM’s James Sullivan
, who says the unprecedented macro environment makes historical comparisons completely worthless.
), an FE Alpha Manager who co-heads the CF Miton Special Situations
portfolios with Martin Gray
, says the high levels of debt and stagnant growth in Western economies will ensure markets remain volatile for the foreseeable future.
Unless you have a particularly long time horizon, Sullivan believes investors should err on the side of caution, rather than blindly backing “cheap” markets.
“Historic price-to-earnings [P/E] ratios are worthless most of the time in my opinion, because the macro environment is always changing, but this is particularly the case now given what’s happened in the last five years,” he said.
“According to backward looking data, P/E ratios were at fair value in 1996 and 2007, and look what happened there. It’s complete nonsense – you’re not comparing apples with apples.”
Performance of indices over 20yrs
Source: FE Analytics
Sullivan believes there will be a time to back equities, but not until there are big changes in either the macro outlook, or in valuations.
“I’m not saying we need a resolution in the eurozone or the debt crisis in general to invest in equities,” he explained. “We need either that, or for prices to be much, much cheaper.”
“I think we’d need to see high single digit P/E’s and a yield of close to 5 per cent before we start buying aggressively.
The FTSE 100 is currently on a P/E ratio of around 11 times, and is yielding around 3.5 per cent.
Though Sullivan and Gray have the flexibility to invest up to 100 per cent in equities, the CF Miton Special Situations Portfolio currently has only 29 per cent in the market – the majority of which is in low beta, defensive plays.
Though some experts have pointed to dividend paying stocks as being overvalued, Sullivan says he is much more comfortable holding defensives over “cheaper” cyclicals.
“We prefer funds that focus on cash rich companies – the “titans”, which have high barriers to entry and the ability to buy back shares,” he said.
“If volatility persists in the way we expect, I believe it will be the cyclicals that break first, not the defensives.”
Sullivan thinks the expensiveness of dividend paying companies has been overstated.
“In three of the last four years, growth has outperformed,” he said. “It’s not like equity income is at the top and growth at the bottom.”
Year-on-year performance of sectors
Source: FE Analytics
“There is a time and place for owning cyclicals, but it’s not right now.”
The fund has a significant degree exposure to the US dollar which has an inverse relationship with equity markets, thus acting as a hedge.
“We currently have 20 per cent in either T-bills [treasuries] or dollar-denominated assets. It’s a powerful hedge for the portfolio.”
One of the few areas that Sullivan is relatively optimistic about is Japan, which he believes is better insulated from Western problems than most markets.
“On a valuation metric, Japan is trading below book, has a yield of 2.5 per cent and relative to the FTSE 100 and S&P 500, is attractive,” he said. “Inflation is at 0.5 per cent, and if there is a catalyst, we could really see that market take off.”
Sullivan thinks Europe could be set for a lost decade for equities similar to the one experienced by Japan in the 1990s. The manager doesn’t believe quantitative easing (QE) will cause inflation for many years
, and thinks deflation is a very real possibility.
“If we go through a Japanese-style period, I think we would have got off lightly,” he said. “Many countries haven’t even started the deleveraging phase yet, and austerity cuts are yet to be felt.”
“Our financial system is in far worse shape. Greece is now in its sixth year of recession, and it hardly looks like it’s on the road to recovery.”
The CF Miton Special Situations and Strategic portfolios are both fund of funds, and sit in the IMA Flexible Investment
sector. According to FE data, Special Sits is a top decile performer over a 10 year period, with returns of 188.26 per cent. It is also significantly less volaitle, and has performed much better in down markets.
Performance of fund and sector over 10yrs
Source: FE Analytics
The Strategic Portfolio is only a second quartile performer, but has been even less volatile over the period.
They both have a minimum investment of £1,000, but the Special Sits portfolio is much cheaper, with a total expense ratio (TER) of 1.73 per cent compared to Strategic’s 2.13 per cent.
Gray began running the funds back in the late 1990s, and was joined by Sullivan in June 2008.