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Thursday, September 11, 2014 - 02:16
Finding value

There are three valuation divergences Citadel Asset Management says has developed in the markets over the past few years, and they have resulted in “attractive investment opportunities.”

These divergences are:
• the historically high global equity yields compared to historically low global bond yields;
• developed market valuations rising compared to emerging market valuations declining; and,
• the wide divergence in performance in strong domestic industrial shares compared to their weaker financial and resources counterparts.

“The divergence in global earnings yields compared to global bond yields is narrowing,” says Vanessa Hofmeyr, Portfolio Manager at Citadel. “Supported by an improving economic outlook and the reality that interest rates will increase, the market is recognising the attractiveness of global equity earnings yields over global bond yields.
“Global equity returns have been excellent and we are seeing global earnings yields returning to long-term averages. Bond yields in turn have increased significantly, resulting in negative returns for this asset class. With the normalisation of both these asset class yields and the ‘yield jaws’ narrow, the shift towards equities and away from bonds should continue for some time. This is especially true if the valuations of alternative asset classes are taken into account.”
Emerging equity market valuations have reached historical lows, and their performance continues to be disappointing. Weaker economic growth prospects (especially in China), rising geopolitical risks, volatile local currencies and the onset of rising or normalising interest rates has seen these markets continue to pull back. “The decline in the valuation of the emerging equity markets back to historical lows would imply that the market remains concerned about growth prospects,” she says. The valuation gap between the emerging equity markets compared to developed markets has reached historical trends. Growth should resume for these economies, but at a slower pace than before. The gap between emerging and developed markets should shrink as the economic outlook improves.
She believes that stock picking will be crucial to generate excess returns in the local equity market. “The domestic equity market is expensive, currently trading on a price earnings (PE) ratio of 17 times, well ahead of its long-term average. Over the past two years there has been significantly divergent sector performance within the equity market.
“During the last year, the strong returns in our equity market have largely come from the industrial sectors. Until recently, the financial and resources sector has not participated in this rally, resulting in a divergence in valuations and potential returns in a pricey market. As the divergence begins to narrow, a shift from the expensive industrial companies to the more attractively priced financial and resources shares has started to generate differentiated returns for superior stock selectors. This trend away from industrials should continue until valuations normalise.
Select factors such as size and style can differentiate portfolio returns. Shifts in fundamental valuations and select factors within our domestic equity market would appear to be offering compelling value. South Africa has seen strong returns in its equity market over the past year, generated by a small group of the market favourites such as Naspers, Richemont, SABMiller, BHP Billiton and Sasol. These stocks offer rand-hedge characteristics and are reliant on the improvement of the global economic environment. In addition, the significant weakness in the currency will affect company profits in the short term. Companies benefitting from the depreciation in general are somewhat cheaper than before the rand weakened in the last part of 2013. Resources and select industrial companies will benefit from this once-off boost in earnings.
With so much focus on these stars, some of the neglected or ‘forgotten angels’ in the mid and small cap sectors are beginning to offer compelling value, both on an absolute and a relative basis. Chart 1 shows how the mid and small cap indices typically do generate returns in excess of the market over time. More importantly this excess return can be achieved with generally lower volatility than the large shares in the FTSE/JSE All Share Top 40 Index, as shown in Chart 2.

SOURCE: Citadel Asset Management

SOURCE: Citadel Asset Management

“While large cap shares have reached expensive levels, mid and small cap shares are not as pricey,” says Hofmeyr. The PE ratio of the mid cap index is 15 times and the small cap index is 13 times. The broad selection of mid and small companies is spread across many sectors. Many companies have demonstrated excellent earnings growth over the past few years, yet the ratings do not reflect this. However, we must note the risks of a mid and small cap strategy. Many of these shares are exposed to the domestic economic environment, which will remain under some pressure. Another issue is the liquidity in trading of these shares. While the opportunities in this part of the market should be considered and additional risks should be taken into account, an overlooked, well-priced mid or small cap company with sound fundamental grounds and compelling valuations, combined with improved risks characteristics, do justify a place in a portfolio.
Valuation discrepancies in the market, while not always obvious, offer compelling value for investors. “A world that is slowly normalising will affect asset class valuations as bond yields move away from record lows, including the negative impact of a rising interest rate on emerging markets. This in turn creates opportunities when valuations have fully discounted the risks, as in the case of emerging equity markets, which now offer value. It will also have an impact on sectors, with the cyclical sectors outperforming the more expensive defensive sectors.”
Investment styles will also see a shift in a normalising world, with value outperforming both momentum and high dividend strategies. Lastly, within this market, the overlooked opportunities in the mid and small cap space are offering attractive value. Again, stock picking is crucial to generate differentiated portfolio returns.

Copyright © Insurance Times and Investments® Vol:27.9 1st September, 2014
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