Unsustainably high valuations within the global markets caused by “non-natural” holders of equities has led FE Alpha Manager Ben Leyland to hold 18.24 per cent of his JOHCM Global Opportunities fund in cash. 
The manager, who launched the five crown-rated portfolio in June 2012, takes a value-orientated approach to global equities but unlike his deep value peers, he priortises quality within everyone of his holdings – following the mantra “heads you win, tails you don’t lose too much’.
However, thanks to years of central bank intervention in the form of ultra-low (or even negative) interest rates and quantitative easing which has had profound effects across all financial markets, he warns there is a genuine lack of opportunities within the world of equities – especially after the surprise rally witnessed since the UK’s EU referendum.
As such, the manager has decided to use almost all of his allowed 20 per cent allocation to cash until valuations start to fall.
“The market has, for a number of years now, been in quite a complacent phase,” Leyland said.
“There are plenty of potential reasons why, but there is an element of the equity market being driven by non-natural holders of equities searching for yield or a return – part of which is to satisfy things like defined benefit pension requirements.”
Performance of indices since the EU referendum
Source: FE Analytics
He says this dynamic is particularly true of the rally since Brexit, in which the FTSE 100 has rallied by 8.34 per cent and 10 year UK gilt yields have dropped by more than 50 per cent to their lowest ever level (0.6 per cent).
Leyland argues that this has been caused by the anticipation (and eventual implementation) of a policy response from the Bank of England – which just last week cut interest rates to 0.25 per cent and embarked on a new QE programme.
He added: “In that environment, which has been carrying on for quite a while now, then equities get expensive.”
“Unless you think there is a genuinely new valuation paradigm (which we don’t) then you face a world of very expensive equities and we struggle to see many stocks we like enough to have big positions in and there are plenty of stocks we don’t want to own at all at these prices. “
Leyland has held these views for a number of years now and has held more than 10 per cent cash since July 2013 (though it hasn’t affected his fund’s performance).
That being said, he has used previous market falls to add to JOHCM Global Opportunities’ equity weighting – such as during January’s China-induced sell-off to buy companies that were hit by the negative sentiment only due to their place of listing.
He also bought a number of UK and pan-European multinationals that were hit after the Brexit vote, despite the fact most of their business is done in the US or emerging markets.
Again, though, he has let his cash weighting drift higher over recent weeks. While some would argue there are financial assets that will continue to perform well in the current environment, he says building a diversified equity portfolio without holding cash is almost impossible.
"There is no such thing as a safe asset anymore,” Leyland said.
He notes that, traditionally when yields were much higher than today, government bonds offered a high degree of protection against general market drawdowns while, within the equity market, consumer staples, and to a lesser extent the telecommunication, utilities and healthcare sectors, also played that role.
However, as bond yields have fallen, these more defensive companies have become increasingly expensive to the point where they offer little protection going forward thanks to ‘tourist’ fixed income investors who have been forced out of their natural market by central banks, according to Leyland.
Performance of index versus 10yr gilt yields over 7yrs
Source: FE Analytics
This dynamic can be highlighted in the graph above shows, which shows how the returns from the MSCI AC World Consumer Staples index and the drop in 10-year gilt yields have been almost perfectly correlated over the medium term.
“They were defensive sectors within the equity market that would preserve capital come hell or high water. That’s no longer true.”
“It's clearly not true with government bonds which have negative real yields and, in some cases, negative nominal yields and it's also not true of those more defensive sectors – which do in many cases have strong barriers to entry, pricing power and recurring revenues – because they are overvalued for the growth profile they have.”
“In certain circumstances, particularly inflationary circumstances (which obviously aren’t the base case of the market at the moment but these things can change very quickly), then any bond or bond proxy will be the most dangerous place to be.”
Leyland added: “So, there is a very obvious set of circumstances where they are not safe assets any more.”
As noted before, Leyland’s strict disciplines surrounding valuations and his propensity to hold cash when he sees a dearth of opportunities has served his investors well.
Having cut his teeth on John Wood’s popular JOHCM UK Opportunities portfolio, he launched the mirror image JOHCM Global Opportunities fund in June 2012.
According to FE Analytics, it has been a top-decile performer in the highly-competitive IA Global sector over that time with returns of 102.8 per cent, beating its MSCI AC World benchmark by some 25 percentage points in the process.
Performance of fund versus sector and index since launch
Source: FE Analytics
It has also beaten its average peer in every full calendar year over that time (and is outperforming in 2016 so far) and has been among the top decile for its annualised volatility, maximum drawdown and risk-adjusted returns (as measured by the Sharpe ratio) since inception.
Going forward, however, Leyland says he and other investors face a major challenge.
He notes that, on the one hand, there are poor quality stocks that are cheap for a reason and then there are many high quality stocks which are too expensive for their future growth potential.
Therefore, to protect his investors, he is purposely focusing on high quality stocks that are not necessarily ‘bond proxies’, but ‘compounders’ that are investing for future growth rather than jumping on the bandwagon of distributing more and more dividends to entice investors.
“There will be a de-rating of the equity market at some point because valuations are at a level that is unsustainable,” Leyland explained.
“I don’t know when that will happen and I don’t know why. But, I do know everything in the equity market will suffer because everything in the equity market is seeing that valuation overstretch.”
“What that means is, on a three-year view, for me to make any money for my clients I need to be invested in businesses that are growing under the bonnet.”
“If they aren’t growing, then all I’m going to get is the 25 per cent de-rating that is going to happen. That’s why we are emphasising compound growth and reinvestment over dividend distribution.”
