Alas not everything you read should be taken at face value. Besides, I dread roller coasters, and I’m also pretty thrill-adverse in my investments.
For equity investors with one eye on future market turbulence, a modern obsession is with reading valuation metrics. Surely, if you can buy cheap you diminish the downside risk?
The problem is with developed markets trading at near all-time highs, the bargain hunters are having something of a tough time (though they may not always admit it).
A shifting message
With this in mind, we’ve been hearing a lot of stock pickers recently claiming to be “valuation aware” rather than “valuation driven”. What does this mean in practice? It depends on the fund house, but clearly there’s been a shift in message to an emphasis on the flexible and the pragmatic, with momentum investing no longer such a deadly sin.
“Price is what you pay, value is what you get,” is a quote attributed to Warren Buffett. But while the price is obvious, value is less easy to determine, especially when there are so many different ways to measure it including PE trailing and forward measures, enterprise-value-to-sales, and price-to-book.
“There are so many valuation multiples available that at any one time it is possible to find at least one that makes equities look expensive or cheap,” warns Lars Kreckel, equity strategist at Legal & General Investment Management.
“Confirmation bias makes it tempting to focus on the multiples that support one’s case.”
Still, even if you can find good stocks on low valuations, it doesn’t mean they are protection against excessive losses. Kreckel points to the example of Gazprom, which traded on what by most standards is an extremely low PE of 3x before the Crimea invasion earlier this year. However, the stock still lost almost a quarter of its value – roughly the Russian market average – in the weeks that followed.
“Just because equities are cheap or expensive by historic standards it has absolute no bearing on whether they will go up or down in the next year or two,” he explains.
Taking short cuts
“By using multiples you are taking a short-cut that makes many implicit assumptions and just because a stock may be cheap, it is no realist protection against painful losses.”
Still Kreckel does believe in the use of certain valuation metrics over a longer-term course of 10 years plus, so much so that LGIM has created its own ‘Z-Factor’ composite valuation indicator which predicts US equities will deliver an annualised total return of 4.5% over the next decade.
Assuming that prediction is correct, equities should remain a good bet for the foreseeable future, albeit not quite the excitement I would expect from a career in roller coaster testing.
