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Valuation is the best defence against risk in overvalued markets

03 October 2017

Dominic Fisher, portfolio manager of the VT Thistledown Income fund, explains why investors should look for value wherever they can.

By Dominic Fisher,

Thistledown Investment Management

In August, Liberal Democrat leader, Vince Cable, wrote: “Pensioners have suffered relatively little from the aftermath of the financial crisis – unless they were slow to shift savings from banks to shares or property.”

This statement is not just breathtakingly arrogant; it also flies in the face of the typical advice to pensioners to take less risk. But it makes one thing clear; savers are being pushed to take more risk to generate a return.

Take high yield bond investments in Europe; these used to be called junk. They now yield less than US 10-year government bonds.

That’s the financial equivalent of arguing no means yes and a clear example that savers, investors and managers are taking on more risk to achieve their returns.

But don’t count on professional investment managers in the high-yield space to tell you this. They get paid to beat the benchmark and are perfectly prepared to bid up assets because they’re playing a relative game, whatever their real view on the value of the bonds, and believe me very few high-yield managers find much value today.

Thankfully as I worry more about the long run return on my savings, I am not subject to the same shorter-term pressures. And while for the moment markets continue to reward these decisions, as sure as eggs are eggs, a return to more traditional relationships will yield disappointment for many.


History repeating itself

This is the third time in my investing career (which started in 1989) that I’ve seen markets this overvalued.

The 1999 tech bubble is a perfect example of another time, although at least then there were plenty of ‘old economy’ stocks that were lowly rated.

That’s not the case today as I’ve told my investors time and again over the last three or four years.  And this is why my portfolio has 60 per cent invested in equities and 40 per cent currently in short-dated bonds and cash – that’s about as bearish as I can be in the portfolio construction. But for all this caution the fund has returned 13 per cent over the last 12 months.


How can you make money in such a market?

There is lots of evidence available to support the view that undervalued assets produce better returns than more expensive ones over the long run (be that markets or individual stocks).

Furthermore because you’re buying an asset that’s cheap or undervalued, you benefit from an element of protection on the downside. This approach won’t avoid the odd duff investment; they go with the territory.

So, you should diversify – not by owning hundreds of individual stocks, but by owning 20 or 30 companies spread across countries and industries. You don’t need to diversify too extensively to reduce risk in your portfolio very significantly.

You also want to be free to look for value wherever you can. Today some value can be found in international equity markets if you search hard enough and that is what a good investment manager is supposed to do. To that extent, there is rarely anything that I wouldn’t invest in if it is quoted at the right price.

For example, I’ve held Fondul Proprietatea, a Romanian closed-ended fund, managed by Franklin Templeton Investments for a while. It distributed nearly 12 per cent last year and looks likely to pay around 6 per cent this year; income derived from its investments in large utility and oil companies with strong market positions.

Nobody could call this a conventionally low-risk investment, but a large discount to assets and a line of business different to others in the portfolio does mitigate downside risk.


Compelled into uncompelling bonds

My current asset allocation with 40 per cent in short-dated and liquid investments says more about my view on overvalued equities than a love of bonds. For the long-term, which is what I have in mind for my savings, I am convinced that equities are the right choice. Just not today. So, the 40 per cent serves as a comfort blanket for now. One which will allow me the opportunity to invest in what I expect to be a much greater opportunity set and generate higher returns in equity markets when the time is right.


Market correction?

I don’t know if there will be a market correction, but I do know that recent returns have been boosted by a re-rating of equities, where prices rise more quickly than the fundamentals. This re-rating leaves US equities highly priced. This is easy to verify – just visit the websites of the US investment managers, Research Affiliates or GMO.

Research Affiliates reckon that US small caps are at the 100th percentile of their valuation range, that’s as expensive as they have ever been, with US large caps at 98 per cent. GMO, another US firm, forecasts losses in US equities for the next seven years.

Paying a high price for an asset rarely works out well. Either you make little money for a long time or something worse.


Last word from Mr Cable

So, markets aren’t playing ball (not that they ever have), valuations are skewed and taking on higher levels of risk seems the new normal for income investors. That doesn’t mean that risks can’t be mitigated to some extent by diversification within a portfolio, but in the end valuation, for me, is the best defence against risk.

If I am right about equity markets being very overvalued then the US equity market could fall 60 per cent before it reached its average value – and falls of that magnitude rarely happen slowly.

At such a time, short-dated investments will be highly prized. Perhaps 10 years from now Mr Cable will be scolding pensioners for not having switched from properties and equities into bonds.


Dominic Fisher is portfolio manager of the VT Thistledown Income fund. The views expressed above are his own and should not be taken as investment advice.

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