CPD: The first layer of defence – value

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How do you figure out what something is ‘worth’?

Buying any asset – equities, bonds, property, infrastructure – at the right price increases the probability of having a successful investing outcome. However the price you pay is, on its own, a very poor indicator of what something is ‘worth’.

There is an old joke which asks, “What’s the definition of a stock which has lost 90%?” The answer? “A stock which fell 80% and then halved.” Whist not a particularly witty punchline, it is worth remembering that you can still lose all your money in a stock that has previously already fallen a great deal. Establishing what is an investment’s ‘fair value’ (or the intrinsic value) is extremely important, and then aim to pay significantly less than that and certainly not more than that.

Having a disciplined approach to identifying high-quality, attractively valued investment opportunities – irrespective of the security or asset class – will set you apart for generations.

However, markets also have a tendency to overshoot fair value in the short term. In 1996, Alan Greenspan (the then Chair of the Federal Reserve in the US) spoke of the market’s “irrational exuberance” at that time. Following his statement, the NASDAQ index soared 400% higher from that point, until March 2000 when it then proceeded to fall 80% over the following three years.

Any value-based investment approach must be able to withstand the fact that asset prices can diverge wildly from assessments of ‘fair value’ for an extended period of time. This is due to two very basic human emotions – fear and greed. It is these two emotions which create opportunities for patient and disciplined investors. So how do we put that in practice?

One method is to supplement your valuation signal with an assessment of the strength of the economic cycle and the market’s momentum to help time the entry into, and exit from, positions held. Done continuously, and dynamically, seeking to structure portfolios to benefit from more upside and less downside should events take a turn for the worse. The following example helps to illustrate this value-based defensive portfolio construction approach.

European equities – Value or value trap?

In late 2014, European equity valuations, based on our proprietary measures, were trading at significant discounts to US equity valuations and were also very attractively priced versus the very low yields of European government bonds.

However, European equities had been “cheap” for quite a while and we had, until this point, resisted taking an overweight position given the various macro and structural concerns including downgrades to economic growth forecasts and the potential for Greece to exit the Euro. Simply put, the economic environment was weak and momentum was poor and this mitigated the strong valuation signal keeping us out of the position.

“Be greedy when others are fearful”

Over the period from the end of 2007 to December 2014, European equity earnings had fallen 38% and the Euro Stoxx 50 (an index comprised of the top 50 Eurozone companies, from across 11 countries) had underperformed the S&P 500 by a staggering 70%. We wanted to understand not only the potential positive catalysts – and the potential upside for investors – but also conversely, how we could be wrong and how to best implement and risk manage an investment if Europe became even cheaper.

 

 

Up to the end of 2014, US equities had benefited from resilient company earnings and a relatively healthy economy compared with Europe. However, there were early signs that this comparatively better corporate performance was beginning to wane. Most of the gains from US equities had come from valuation expansion, a trend which was unlikely to continue with the prospect of US interest rate increases. Furthermore, a stronger US dollar presented a headwind to the foreign earnings of many US companies.

We continued to expect the US economy to perform relatively better than Europe; however share markets and economic performance can often diverge. Based on market pricing and expectations, we believed markets had fully priced in this relative growth differential (at that point in time), as well as ignoring the potential for upside surprise in Europe stemming from:

  • Potential quantitative easing weakening the euro and boosting foreign sales (in Euro terms);
  • Operational leverage, and
  • Reduced write-offs from the financial sector.

We made the decision to reduce the portfolio’s US equity positions in favour of less expensive European equities, whilst adding protection for investors against a ‘worst-case’ scenario.

How to structure more upside and less downside into portfolios

Our analysis indicated the two main risks for being overweight European equities were:

  • deflation taking hold in the region therefore making fair value measures unreliable, and/or
  • Greece exiting the European Union (EU).

We expected that if deflation was to accelerate in the region, there was a high probability that the European Central Bank would undertake a large scale quantitative easing programme, depressing the Euro. Similarly, if Greece exited the EU, a flight to quality was likely to ensue with capital fleeing Europe and instead being invested in US dollar denominated assets.

Consequently, a weaker Euro was likely under both the base case scenario of relatively stronger US growth, as well as the two worst case scenarios outlined above.

As a result, we paired the long European equity position we held with a short EUR/USD position on the basis that there was limited upside for the Euro and this would be a potential hedge against many of the macro risks which could trigger a fall in European equity markets. The size of the position was determined through our risk budgeting framework which seeks to balance the conviction we have in any one position with the equally important objective of maintaining sufficient portfolio diversification. This gave us the confidence that the portfolio was well protected against an equity market decline, while potentially allowing investors to benefit from an improvement in confidence.

What was the outcome?

 

 

As seen in Chart 2 (above), over the course of our investments (the period between the two trades highlighted in late 2014 and mid 2015), European equities rose 14.5% and the EUR/USD fell 10.5%. For investors this meant that both the European equity overweight and short Euro position added significant value. Once European equities had reached our target, we took profits from the position. Importantly, had the outcome been different, and a less sanguine outcome eventuated, the portfolio would have been well protected from a European equity market decline.

Then when the markets experienced a correction, we bought call options. The Euro was unlikely to weaken further than it already had, so rotating our position to purchasing call options allowed investors to participate in a rising market with the benefit of knowing the maximum downside was limited to the cost of the option premium.

In conclusion – Value opportunities can help both protect and grow

The above trades in European equities provide a great example of how you are able to rotate portfolio positioning to make the most of rising markets, while helping to protect investors against unforeseen and unpredictable events. In this example, it was able to be achieved firstly, by using currency as a “shock absorber”, and secondly, by using call options to participate with a rising market, where the potential loss of capital for our investors is capped.

However, as with all investing, ‘value’ opportunities are not without risk, and can often come with significant challenges. It can take years for the value to be realised, and it may be that a ‘value opportunity’ ultimately turns into a ‘value trap’. Therefore, we believe not only does it require diligence, patience and discipline to invest successfully, but of equal importance, are the strategies employed to help manage those risks. And while those strategies will change over time as the portfolio is constantly monitored and evolved, what does not change is our steadfast attention to the price we pay for assets today to help deliver on our investors’ desired outcomes for tomorrow.

 

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Read the CPD: The second layer of defence – intelligent diversification

Read the CPD: The third layer of defence – portfolio protection

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This information has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 and issued by Perpetual Trustee Company Limited (PTCo) ABN 42 000 001 007, AFSL 236643. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The PDS for the Perpetual Diversified Real Return Fund, issued by PIML, should be considered before deciding whether to acquire or hold units in the fund. The PDS can be obtained by calling 1800 022 033 or visiting our website www.perpetual.com.au. No company in the Perpetual Group (Perpetual Group means Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital. Past performance is not indicative of future performance. The Fund gains its exposure to Australian shares by investing in underlying Australian Share Funds which primarily invest in Australian listed or soon to be listed shares but may have exposure to stocks outside Australia. The investment guidelines showing the Fund’s maximum investment in international shares do not include this potential additional exposure. Currency hedges may be used from time to time.

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