We’ve all felt the euphoria of finding that sought-after purchase at a bargain price. And there are certainly bargains to be found in equities in the current environment. But I think investors should proceed with caution to avoid the investment equivalent of a ‘fashion faux pas’ – the bargain item that was a ‘must-have’ in the shop, but which rapidly lost its appeal the next day! That said, I’m seeing some interesting signals in the market.
The Bank of America Merrill Lynch (BAML) monthly Global Fund Manager Survey published last week found that in February, fund managers’ cash levels are at their highest point since November 2001. BAML noted that cash levels at 5.6% had triggered an ‘unambiguous buy signal’ according to the survey’s cash rule that generates a contrarian buy signal when the average cash balance rises above 4.5%. However, the survey also showed that while fund managers’ overweight to equities has fallen sharply to its lowest level since 2012, it is still a marginal overweight. Previous cyclical entry points into risk assets – in 2002, 2009 and 2011 – came after investors had gone underweight equities. So while this signal suggests that maybe we’re not quite in bargain basement territory yet, I think it highlights the direction of travel.
In the low interest rate and low growth environment that has dominated pretty much since 2008, investors have been risk averse, preferring defensive bond-proxies in their search for safe-havens and good equity yields. Quality as a style has therefore performed well. The flipside to this is that value has been shunned. Today, value is exceptionally cheap relative to growth across the world and is back to levels last seen around the tech bubble in 2000. Across all regions, cheap stocks are trading at unprecedented discounts to their expensive peers, close to 2 standard deviations below their 25-year history. The gap between the cheapest part of the market and the most expensive has rarely been wider.
In the past, when value has been this cheap it has subsequently outperformed very strongly. Ignoring the tech bubble (which would positively distort the result), the average outperformance of value following a crisis (2003, 2009 and 2012) is about 20% over the following 12 months. I know the ‘value is cheap’ call has been voiced for some time now – and given its prolonged underperformance investors are right to be cautious – but as valuations become more and more stretched, the pull of mean reversion becomes stronger as a force in itself. I haven’t got a crystal ball, but surely the greater the valuation stretch, the greater the probability and speed of a spring back?
What is even more interesting though is the value dispersion within sectors. In the US and Europe, intra-sector dispersion is the widest it has been since 2009. According to research from Bernstein “this spread between the cheap and expensive stocks within industries is the widest it has ever been in Europe, and the second widest in the US with the exception of one month during the internet bubble”. Not only have investors crowded into defensive assets, they have also more broadly favoured certain companies within each sector. And these extreme valuation spreads are not just concentrated in one or two sectors – they are sector wide. When markets are nervous, investors tend to crowd into the best stocks in a sector. Additionally, the valuation gap between sectors on a price-to-book basis is also high.
I believe this unprecedented ‘cheapness’ of value across a diverse range of sectors represents a significant opportunity. Any rally in value and a turn in sentiment could happen very quickly. For the long-term investor employing rigorous fundamental analysis, periods of heightened volatility – such as those we’ve experienced this year – provide a good entry point to buy into undervalued companies and to capture the value exposure.
 198 fund managers with US$591 billion in assets were surveyed between 5-11 February
 Global Quantitative Strategy: Is Value ‘Dead’? No! Bernstein 12 February 2016.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.