The US equity market is incredibly diverse, so it is important to look beyond headline overvaluation metrics and understand the fundamental appeal at a more intricate level. By doing so, we can assess the opportunity set in a variety of ways including sector, size, style and even quality.
Using a long-term fundamental approach, we find that six of the 10 sectors are currently significantly overvalued. Unsurprisingly, this includes some of the so-called hot sectors, including technology, but also consumer discretionary, materials and industrials. We find the primary drivers of these overvaluations are stretched profit margins combined with high prices relative to long-term cash flows.
Has Politics had any Impact on Investments?
2017 was dominated by political events and in particular the Presidency of Donald Trump. His inauguration was followed by a wave of executive orders impacting on everything from immigration to trade. The number and scope of executive orders triggered, 17 in January alone and more than 50 in total, has firmly put to rest any hope he would back away from his more extreme campaign pledges. A cynical outsider might say Trump has tackled his first year as President like a seven-year old would a marathon. Whatever your opinion of his first year in office, Trump is clearly a man on a mission.
Therefore, with such a newsworthy approach, it is little surprise that politics has meaningfully impacted sentiment. However, we firmly believe it is imperative to look through this noise and realise that politics rarely has a significant impact on the fundamentals. This means that prices may divert away from fair values in the shorter term based on sentimental shifts, but will inevitably feel the gravitational force of its fundamental baseline.
Are There Opportunities in Smaller Companies?
Many people think about US equity exposures as either a diversifier or an opportunity to achieve better returns. By targeting the fastest-growing sectors such as technology, or the most famous brands like Google (GOOGL) and Apple (AAPL), some investors assume they can obtain better outcomes than they can otherwise obtain by investing locally.
Yet, when we apply reasoned analysis to challenge this thesis, we find that this is unlikely to be true. In fact, even when we isolate our analysis to the US market, we find that small cap growth stocks are more attractive than the tech giants on a valuation-implied basis. By digging deeper into this opportunity set, we find that small cap tech companies are still well represented, making up approximately 23% of the small cap growth segment.
However, the more attractive opportunities come from other sectors including small cap healthcare, which makes up approximately 19% of the small cap growth segment and looks considerably better valued relative to fair value.
The US Dollar: Where Next?
Currency can be difficult and is susceptible to short-term noise, but we have found one of the most reliable approaches is to compare the current exchange rate on a purchase-price parity basis. On this basis, we have conducted a raft of reasoned analysis and found that sterling is still undervalued relative to the US dollar in a long-term context, despite the recent strength.
For investors that are worried about currency-induced drawdowns, they can look to hedge offshore holdings or increase exposure to local assets. Emerging market exposure must be managed carefully in this regard, as it can often be difficult to hedge, plus emerging market currencies are vulnerable to loss during times of stress.
A version of this article appeared in FTAdviser magazine
