The value of stock selection in a low-return world
November 13, 2020
Despite this year’s extreme volatility, the past ten years have been an extraordinary time to be an equity investor. This can be seen by looking at the so-called equity risk premium, which is simply the difference between returns on global stock markets and risk-free assets, such as U.S. dollar bank deposits.
Over the very long term, the equity risk premium has historically averaged about four to five per cent annually. But over the past decade, the premium has ballooned above nine per cent annually amid a robust bull market and unprecedented central bank policies that have pushed interest rates close to zero or even below in some countries.
Said differently, investors have been extremely—perhaps abnormally—well-paid for taking stock market risk. To sustain that premium for another ten years would require global equities to more than double in absolute terms from today’s levels while holding interest rates constant. Perhaps an unlikely proposition with stock markets already at record highs. At the same time, the classic safe haven alternatives to stocks—cash and bonds—look distinctly unappealing. What are investors to do?
Active security selection potentially offers a way out of this conundrum. While broad stock market returns have been robust, there are plenty of areas of the market that have not participated. In fact on an equally-weighted basis, the average stock has been mired in a hidden bear market for some time. There are also substantial valuation dislocations within markets such as those between growth and value shares, stable businesses and cyclicals and the U.S. versus the rest of the world, particularly emerging markets.
Consider the remarkable flight to quality shares in recent years. As desirable as quality may be, the price one pays for it varies dramatically over time and even the highest-quality business can be a terrible investment at the wrong price. Today, high quality businesses—defined as those with a combination of high profitability, earnings stability and balance sheet strength—are as expensive as they have been in several decades on a normalized earnings yield basis. At current valuations, many quality shares are priced for perfection and their continued outperformance over the long term requires heroic assumptions.
Compare this to opportunities available in more cyclical businesses. To use Mitsubishi Corp. as an example, it trades below its book value despite delivering above-average return on equity. It pays a five per cent dividend yield backed by a strong balance sheet, has a progressive dividend policy and has an encouraging commitment from management to enhance shareholder returns.
While Mitsubishi is just one example, there are many shares on offer today that provide investors with greater than five per cent dividend yields and sustainable earnings growth of at least a similar magnitude. Together, this can support a solid absolute return of ten per cent annually. That’s an exciting opportunity at a time when asset prices are generally inflated and bond yields are at their lowest point in centuries.
Historically, dislocations in valuations like the ones today have been enormous opportunities for active managers. The more extreme the gaps, the greater the potential to add value through opportunistic security selection. The difficult part is knowing when the gap will close. While some investors may look for catalysts, they can be extremely hard to predict. If the catalyst is obvious, it’s probably also obvious to others and thus likely to be priced in. Rather than search for catalysts, it is often better to simply remain patient and maintain a long-term perspective. There are very few guarantees in investing, but there are also very few things that persist forever.
Graeme Forster is a portfolio manager at Orbis Investments. These views are those of the author and not necessarily those of the Canadian Investment Review.