Login / Register
Corporate valuations are the bread and butter of stock market participants. And with so many participants, you might think that the valuation of each company would always be in the right ballpark. Yet this is far from the case, at least in the eyes of fund managers focused on the least expensive securities relative to their earnings or balance sheet value. In their view, huge swathes of the market look extremely undervalued, particularly as the discount on neglected stocks has tended to widen over the last ten years and more. Since their peak in 2007, indices of relatively cheap stocks – known as “value stocks” in financial jargon because of the hidden value that is not reflected in their share prices – have lost practically no ground versus companies qualified as growth stocks that trade on higher price earnings multiples. As with social inequalities, valuation inequalities in listed securities have widened: the winner takes it all!
There are good reasons for this: an innovative company with high growth levels should be more expensive, particularly if this growth is sustainable. But the premium granted to the most expensive companies depends on the macroeconomic environment. And this could change, potentially paving the way for a structural shift away from the domination of highly valued stocks into those trading at a discount.
There were a few signs of this potential shift in 2021. In Europe, although tech stocks – typical of the highly valued growth segment – performed very well, it was the long-neglected banking sector that came out on top. And this trend is even clearer since the start of this year.
Are we on the threshold of a pendulum swing for valuations? This question has been asked many times, and frequently revealed nothing but a flash in the pan. It could be the same again now, although some aspects of the market suggest that this time could be different.
A case in point is the fact that practically all central banks have, to varying degrees, started to reduce their asset purchases, or indeed, as in the case of the Fed, to move towards raising interest rates or even reducing their bond holdings. As rates rise, the most expensive stocks, whose prices are justified by long-term growth, must offset this with additional growth or risk becoming less attractive. Not all are able to do this, so selection becomes even more crucial.
Another factor is a risk of a structural rise in inflation. Of course, inflation is currently at abnormally high levels and is likely to fall in the short term. But after this interim peak, it could remain at a higher level than that seen in recent years. There are many reasons for this: less globalisation due to the structural conflict between the US and China; more or less full employment in the US; rising demand for oil whilst extraction is becoming more difficult and finance increasingly hard to come by; a probable rise in the price of the metals necessary for energy transition; etc.
So in an inflationary environment, rates will tend to rise, although this is neither automatic nor immediate. Uncertainty surrounding long-term rates is enough to put additional demands on valuations. Here again, securities selection needs to be tightened up.
There’s an end to every reign. Academic research has not demonstrated any advantage in investing in the most expensive stocks over the long term – quite the reverse. So at some point, realignment is necessary. For some stocks, in particular the US and Chinese tech heavyweights, the trigger could come from renewed political pressure aimed at restricting their omnipotence, and therefore their stock market appeal.
Such a shift would not penalise all highly valued or innovative companies. There will always be a premium for rising stars, and that’s good for innovation. The market is based on this appeal and, at a deeper level, human nature. But this will provide an opportunity for some long-neglected stocks. We may have witnessed a wakeup call for justice for all in valuations.
Written on 7.1.2022 by Alexis Bienvenu, Fund Manager and Olivier de Berranger, CIO