Aggregate Valuations Are A Reason To Favor Active Management At This Stage by Bryce Coward, CFA – Gavekal Capital Blog
It would be tough to make the case that aggregate valuations are low at this stage in the bull market, and that valuation expansion is a likely tailwind to further equity gains. Alas, aggregate valuations are only one measure, and while aggregate measures do indeed point to heightened “valuation risk”, individual company valuations remain highly disparate. This fact adds complication to passive index investing, because the indexes by definition encompass aggregate valuation levels and generally fail (except by derivative) to capture idiosyncratic opportunities that exist in the equity markets. Only truly active managers – those not constrained by sector, geographic or market cap factors – have the opportunity to fully capitalize on the existing, albeit shrinking, opportunity set of attractively priced securities.
In the first chart below we show the median price to cash flow ratio for all companies in the GKCI DM Index. At 11.5x, the median price to cash flow ratio is lower than it was a year ago and compared to 2006-2007, but it is hardly “low”. We generally think of single digit price to cash flow multiples as offering compelling prospective returns, and we are nowhere near those levels.
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Meanwhile, the median stock is trading near or above it’s own 10-year average price to cash flow ratio in all 10 economic sectors. In the next chart we show for each economic sector the median stock’s current price to cash flow ratio compared to its 10-year average. Even in energy, financials and materials (some of the most beaten down sectors over the last 18 months) the median stock is still trading at about an average valuation level. On the other end of the spectrum we can see that the median consumer staples stock is trading at a 22% premium to its 10-year average price to cash flow level.
But as we dig into the numbers further we can see that plenty of opportunity exists to buy stocks that are inexpensive relative to the recent past. Even in the consumer staples sector in which the median stock is trading at the greatest premium to average valuation levels compared to any other sector, nearly 30% of the stocks can be had at a discount to average valuations. For most of the other sectors, half or more of the stocks can be purchased at a discount to average valuation levels.
Drilling the point home, when we construct a histogram showing the breakdown of the individual stocks in the consumer staples sector (the priciest sector by some accounts) we observe something interesting. Fully 36 stocks in this sector are trading at valuation levels that are at least a 10% discount to average (the sum of the three left most bars in the chart below). Another 34 stocks can be bought at about average valuation levels (the forth bar from the left). And then the chart has a hugely long right tail showing an abnormally large number of stocks trading at significant premiums relative to their own history. Passive investing would capture the entire right tail of this chart, whereas an active manager could fully avoid the right tail if circumstances warranted.