Buy low, sell high—a sure way to make money. But today, stock market valuations look high in several regions. On a price-to-earnings basis, the US market has been this expensive only 12 per cent of the time over the past 40 years, for example. If we aim to buy low and sell high, what can we do in this environment? 
As always, we focus on finding undervalued individual securities. In mature bull markets there are often good opportunities among “defensive” shares — businesses with steady growth, stable profits, and solid balance sheets.
Through booms and busts, people still buy food, medicine, and electricity, so companies in the consumer staples, healthcare, and utility sectors tend to be less cyclical. When these defensive businesses are available at reasonable valuations, they have historically offered good protection against wider market declines.
We have seen this three times since 1990. In the run-up to the Japan bubble in 1990, the tech bubble in 2000, and the global financial crisis in 2008, boring defensives became attractively priced as excited investors flocked to more exciting shares. When the bubbles burst, defensives held up well, as investors rediscovered their appreciation of reliable fundamentals.
The situation today looks different. Markets are expensive, but so are defensives. Investors haven’t lost their appreciation of reliable fundamentals — if anything, they look to be placing too much value on predictability.
One reason is the unprecedented quantitative easing (QE) from central banks globally since the financial crisis.
As central banks buy up bonds, their yields decline, forcing investors to go elsewhere for returns. This supports demand for equities, but it also affects valuations within equities, because some equities are more sensitive to bond yields than others.
If a stock and bond offered the same potential return, who would choose to invest in the stock? To take the risk of owning a stock, you’d expect a higher return than you could get from owning a bond. This so-called “equity risk premium” will be larger for companies with risky or hard-to-predict fundamentals.
On the other hand, you might need less compensation to invest in companies like the defensives, which have very dependable profits. This smaller risk premium makes predictable companies more “bond-like”, so their valuations should be more sensitive to changes in yields.
As QE has suppressed bond yields, we would expect to see defensive stocks benefit disproportionately from higher valuations.
This is borne out in the data. Looking back to 1990, we can compare the valuations of defensives to those of broader global equities, then test the relationship between this “relative valuation” and the level of prevailing bond yields.
From 1990 to the beginning of the “QE era” in December 2008, the correlation between bond yields and the valuation of defensives was -0.2, suggesting little relationship between the two. Since 2008, however, the correlation has been -0.9 — an ironclad link.
When bond yields fall, defensives get more expensive, and when bond yields rise, defensives get cheaper.
Though global bond yields have bounced from the levels of mid-2016, they remain near record lows. This leaves bond-like equities potentially vulnerable to a rise in bond yields. With rich valuations and unfavourable exposure to higher interest rates, defensives look anything but.
There are exceptions. We have found attractive opportunities in healthcare stocks such as AbbVie, for example. We believe these shares will ultimately provide ample compensation for accepting a little bit of uncertainty. And in more cyclical areas, we believe uncertainty has left a larger number of shares trading at attractive prices given their long-term prospects. For XPO Logistics, investors fret about the company’s acquisition strategy. For Chinese e-commerce firm JD.com, uncertainty comes from competition with Alibaba. For radio systems leader Motorola Solutions, the uncertainty is around the company’s growth potential in public safety systems.
In each case, we see quality businesses with a high chance of delivering good fundamental results.
The range of fundamental outcomes for each company may be wider than for a Unilever or a Johnson and Johnson, but so long as that range of outcomes is favourable, we are happy to be roughly right.
Accepting some uncertainty lets investors seek protection against losses in the best way we know — buying assets for less than we think they are worth.
Rob Perrone is an investment counsellor at Orbis Investments.The views expressed above are his own and should not be taken as investment advice.