Equities: Finding the Path to Value? by Virginie Maisonneuve, Anne Gudefin
- Going forward, earnings growth and stock selection – more than multiple expansion and beta – will likely play a bigger role in driving positive returns.
- Our research has uncovered numerous examples of stocks trading below our estimate of intrinsic value – notably in Europe and various special situations.
- Investors with the capacity for deep, fundamental research and a long-term unconstrained equity strategy may be positioned to capitalize on these opportunities.
Investors are understandably apprehensive about equity valuations. On a total return basis, the MSCI World Index has nearly doubled and the S&P 500 Index has more than doubled since the financial crisis. The equity rally, from 9 March 2009 through 29 August 2014, has been the fourth-biggest since the Great Depression.
Many ask: “Can value still be found in equity markets?” The short answer is “yes”.
In our view, the big returns from beta may be over, but today’s higher valuations may be sustainable nonetheless. Going forward, earnings growth and stock selection – more than multiple expansion and beta – will likely play a bigger role in driving positive returns. In this environment we believe investors should consider an unconstrained equity strategy that is grounded in fundamental research and seeks to deliver excess returns while limiting downside risk and volatility.
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
Indeed, our research has uncovered numerous examples of stocks trading below our estimate of intrinsic value. Many of these companies are in Europe, where European Central Bank (ECB) accommodation and market valuations have lagged those in the U.S. and Japan; in emerging markets, which were hit hard by the onset of tapering; or in special situations, such as mergers and acquisitions, that require expertise to evaluate.
Our generally sanguine view on valuations stems from our New Neutral outlook for the next three to five years. Despite stable, albeit subdued, economic growth, we believe central banks will keep policy rates close to zero in real terms, far below historical norms. In our view, the combination of record-high leverage relative to GDP, comparatively elevated output gaps and aging populations in developed countries will constrain the ability of central bankers to normalize monetary policy.
On balance, this environment should be supportive of stocks, provided inflation stays low and earnings are delivered. Among other potential benefits, low interest rates allow healthy companies to take advantage of inexpensive financing. We also expect periods of short-term volatility because the capacity of economies to absorb shocks may be diminished amid slow growth or unanticipated geopolitical events; shocks can create “air pockets” in equity prices that provide buying opportunities for investors with a long-term horizon.
Although we believe the beta wave has crested, PIMCO’s fundamental and company-specific approach, augmented by our macroeconomic insights and global credit analysis, has the potential to uncover opportunities even amid today’s valuations.
Here are some of the areas we’ve identified:
Constructive ECB policy action and appealing European valuations
The U.S. and Japan have benefited from highly accommodative central banks, giving support to stock markets in both regions. In Europe, however, the ECB until this year had been very quiescent, and European stock markets trailed their U.S. and Japanese counterparts markedly. Valuations of many European companies have been cheaper than their global counterparts, and have provided higher dividend yields; many of Europe’s multinationals also have greater exposure to the faster-growing emerging markets.
A more accommodative ECB and modest economic recovery in Europe this year have lifted European equities, which have outperformed both Japanese equities and the MSCI World Index, while tracking the S&P 500 closely.
Nonetheless, European valuations generally remain lower, and current dividend yields tend to be higher, than those in the U.S. or the world market. Moreover, we believe the improving economic outlook in Europe will continue to support rising aggregate demand, better earnings and higher valuations – especially for the companies we own.
Consumer (and portfolio) staples
High quality consumer European staples, including food, beverages and tobacco, looked attractive to us at the beginning of the year. In general, consumer staples companies tend to exhibit stable and consistent earnings and dividend growth profiles – people tend to eat, drink and consume basic necessities no matter the economic environment. The earnings per share growth of European consumer staples last year was substantially better than their global counterparts or the MSCI World Index, yet share prices have appreciated less. In our view, European high quality staples remain underpriced in general, often even more so in specific companies (see Figure 1).
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