Value traps are easier to find in this market than value opportunities, as any manager dedicated to the style should be able to tell you.
For instance, Citywire A-rated Scott Moore – co-manager of the Nuance Mid Cap Value fund, the strategy with the best risk-adjusted returns in the Mid-Cap Value sector over the past three years – highlighted just how expensive the market has become.
Moore’s firm maintains a list of around 250 leading businesses based on its own internal research, and he cautioned that these companies are overvalued by between 20% and 25%. Their mid-cycle price-to-earnings ratios have expanded from nine or 10 to a ‘historically high level’ of 24 or 25, he said, noting that this implied a potential downside in a recessionary environment of as much as 65%.
‘We are not suggesting that a market downturn is imminent, but we do suggest that the market is not considering risk items such as a potential recession after eight years of economic expansion, debt levels at the corporate and government level being above average or valuation being at historically high levels,’ Moore said.
He added that ‘opportunities are limited,’ and his mid-cap portfolio entered 2018 with a cash allocation of 8%. ‘Patience is valid and appropriate,’ he said.
Nevertheless, Moore was able to identify several appealing areas of the market amid these elevated valuations. One, following the series of natural disasters in late 2017, was the insurance industry. For example, he has recently bought the Travelers Companies, Everest Re Group and Metlife.
‘All three of these companies have strong market share positions, leading balance sheets and are all underearning their long-term potential,’ Moore explained. ‘Their price-to-earnings multiples compare favorably with our entire universe, which is currently trading at approximately 23 or 24 times our estimate of normalized earnings. We are overweight the insurance industry as a result.’
Moore has also backed several names in consumer staples, including Colgate-Palmolive, Clorox and Kimberly-Clark. He observed that consumer staples had lagged the market following their outperformance when investors were chasing yield. They were also held back by negative sentiment toward emerging markets, where they have been building franchises.
‘We believe these events are transitory and that these will remain high-quality businesses over the long term,’ Moore said. ‘Equally as important, the more stable growth profiles and the low volatility of these businesses also lead us to believe that they carry less downside risk than most of the market.’
The finance and consumer categories also interested + rated Richard Pzena, who runs the Pzena Mid Cap Value fund and possesses the sector’s fourth-best manager ratio over the past three years. He focused, though, on the threat posed to them by disruptors.
In the case of banks, that means fintech – but Pzena concluded that ‘rather than disrupting the banks, fintech has largely been an enhancer of their value proposition.’
And in the consumer space, he wondered about the ‘Amazon effect’ on retailers. Pzena supposed that ecommerce worked best for ‘high-value items where shipping costs are low relative to the value of the article,’ such as electronic goods, but less well for ‘relatively low-cost, fast-moving, often bulky’ items such as groceries.