Don't Be Fooled by Cheap Looking Stocks

Evenlode Income co-fund manager, Ben Peters discusses how investors can avoid valuation traps forming in the UK equity market and unearth compelling long term opportunities

External Writer 26 September, 2016 | 9:54AM

Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Evenlode Income co-fund manager, Ben Peters, discusses how to avoid valuation traps in stimulus-pumped UK equities.

An absolute view on valuation is an interesting question in these times of unprecedentedly low interest rates. Bonds are a recurring theme at the moment for good reason; when the equity market responds vigorously to an event such as the ten-year bund yield turning positive, one knows we’re in an unusual situation.

Some stocks have been dragged up in price by low bond yields

When we make valuation judgments on a company’s stock, we are looking at the firm on its own and compared to other businesses. We judge relative valuations after taking underlying financial leverage into account. So, as far as possible, we are not judging valuations of equities relative to bond yields.

Given the aggressive monetary stimulus we are seeing, there is the potential to distort equity valuation judgments by lowering discount rates. We believe that examining absolute valuation is particularly important at present to guard against valuation risk. Equities offer clear daylight between their own valuations and those of bonds, but caution is required. To drag prospective returns down relative to the zero available from some sovereign debt would not acceptably compensate investors for the real world risks always faced by businesses.

Calculating the Risk Premium

This appears to be a point that market participants agree on as well. It has let the market equity risk premium widen to near historic highs, i.e. future returns from equities have not followed bonds into the abyss. What that means is there is sufficient absolute value around to enable us to put together a portfolio with enough potential return to warrant continued long-term investment. Certainly, some stocks have undoubtedly benefitted from being dragged up in price by low bond yields, but we are still uncovering compelling opportunities.

To come back to the risks presented by the long list of global worries, in a way these are positive for the equity investor. If market actors are worried about prospects for sales in emerging markets for Diageo (DGE), new drugs for GlaxoSmithKline (GSK), oilfield equipment for Smiths Group (SMIN) or soap in Nigeria for PZ Cussons (PZC), it helps keep a lid on valuations and enables us to continue to invest for the long term. A helpful side effect of long-term ownership is that we can strike up a constructive dialogue with our investee firms, and get to know them very well through bad times as well as good.

Within the universe of businesses that we examine, we can tilt towards better value and away from less attractive market prices. On a long-term view, this estimation translates to the potential for high-single digit total returns per annum. But it’s important to remember in the execution of our process that the valuation of a business is one consideration amongst many. In particular, not all businesses are of equal quality, even within our slimmed-down universe of stocks.

Navigating the Stormy Seas Ahead

Our top two holdings for instance, alcoholic beverages company Diageo and consumer goods stock Unilever (ULVR), are in our view priced to deliver attractive long-term returns. However, there are stocks with higher forward cash returns in our investable universe. So why do two businesses that we accept have a lower return potential than others feature at the top of the portfolio?

It reflects the confidence we have in their repeat-purchase revenues, strong brand portfolios, diversified business models and healthy, stable cash flows. All these factors equip them well to cope with any particular bump in the road and to continue to deliver a growing dividend stream to the fund through thick and thin.

Conversely, we estimate higher forward cash returns for other companies, such as UK-focused firms retailer Halfords (HFD) and support services company Mitie (MTO). We assess that they are strong in their niches, and they tick all the boxes from our quantitative assessment of quality. But they operate in reasonably competitive spaces, and are less diversified than other firms we might invest in.

So to prudently manage the fundamental risk that is the flip side of the valuation opportunity, we hold relatively small positions. Mitie’s profit warning this week is a real-life example of these fundamental risks coming to bear as uncertainty, not least from the referendum, presents a significant headwind to current trading.

Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Diageo PLC3,281.00 GBX0.94
GlaxoSmithKline PLC1,846.00 GBX2.10
Halfords Group PLC152.00 GBX-0.98
MITIE Group PLC134.40 GBX1.05
PZ Cussons PLC200.00 GBX0.20
Smiths Group PLC1,733.00 GBX0.90

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