James SullivanWe began the year with a relatively defensive suite of portfolios, carrying little more than what we would deem a defensive to neutral allocation to equities.

That equity book was made up of markets and themes that were towards the ‘value’ end of the spectrum, with arguable overweight’s in Japan and the UK domestic market. We had complemented that with an overlay of global beta and some selective Asian and EM exposures, but nothing to write home about.

The weakness in stock markets has been utterly destructive, displaying levels of volatility that are rarely witnessed.

It is deeply frustrating to display NAV weakness at the best of times, let alone when you are confident the portfolio is set up in a robust fashion. However, the more we appraise the moves in some of our own stocks and themes, the more we conclude that a large part of the weakness we have suffered is a result of indiscriminate selling. This offers great optimism that the fundamentals remain largely intact and presents an opportunity to deploy some more cash back into our core themes.

Let’s look at our Japanese equity book…

An issue many investors have had with the Japanese market is the dilutive effect balance sheets have on EPS and ROE. The cash on the balance sheet weighing heavy in an upwardly mobile market. It’s a fair observation, but one would also expect that to work for investors on the way down. The Topix (yen) is down 24% over 1month, which does compare relatively favourably to the highly geared S&P 500 which is down 29% in dollar terms, but still feels like an overreaction. The Price to Book ratio, once deemed an archaic way of ascertaining value but now relevant once again with the uncertainty of forward Earnings, is today 0.9x.

The market hasn’t been that cheap since 2012 and before that March 2009, the absolute nadir of the Financial Crisis.

To drill down further on the theme of Japanese equity, one stock we own is Schroder Japan Growth, an Investment Trust with a value bias, and we estimate trades on a lower multiple than the market. It is down 31% over 1 month as its discount moved from -10% which is where it commonly trades, to -24% (according to Bloomberg) amplifying the ‘loss’. One can essentially buy £1 of assets at 76p.

So we have a very cheap stock buying in to a decade cheap market. It’s challenging to accept it’s come to this, but it’s a good starting point for a meaningful recovery, and certainly not the fundamentals one would want to be selling in to.

Let’s look at our UK equity book…

The FTSE100 is down 30% over 1m, with the FTSE250 down 41% over the same period. However the FTSE250 has witnessed a complete suppression of its Price to Book ratio, collapsing from 1.87x to 1.06x over a 1m period. During the immediate aftermath of the BREXIT referendum in June 2016, the FTSE250 PB fell from 2.3x to 1.9x in what was supposed to be a catastrophic result for domestic UK stocks; that rating now looks pretty healthy. In fact, the last time we had a multiple this low on the 250 was, again, March 2009. It puts the cheapness of the current figure into perspective.

One collective we use to expose our funds to the mid and smaller end of the spectrum is Aberforth UK Smaller Companies; an Investment Trust with a value bias which tends to display a high correlation to the 250 index in a ‘normal’ environment. That stock is down 57% over 1m, a hugely exaggerated move as its discount has widened to mid teen double digits.

Pair this with the fact the FTSE250 now has an 14 day Relative Strength Index score of 15; the level of which we haven’t witnessed since late 2008. The indicators are absolutely flashing ‘oversold’.

There are numerous examples we could point to within our portfolio where prices have been bullied down to extreme levels as volumes remain thin and panic remains elevated, thus creating a self-perpetuating downward cycle.

Could the data get worse? Yes.
Could the fundamentals soften further? Yes.

But what is being priced in right now to ‘some’ stocks and ‘some’ markets appears to be something akin to the 2008/09 crisis. The top line of the market is just noise, it is only the valuation that matters.

Over the last week we have seen central banks and governments in Europe and the US deliver significant stimulus in order to support economies during the inevitable slowdown. While in the main, the financial system is nothing like as fragile as it was during the 2008 crisis, there has been some dislocation in the corporate bond market as yield spreads have widened sharply in line with the sell-off in equities.

Today the Bank of England announced a rate cut to 0.10% from 0.25%. While this at least shows willing, it is unlikely to dramatically help the current situation. More interesting is the announcement that the Bank will increase its balance sheet through quantitative easing/asset purchase programme by £200bn and will buy government debt. Earlier in the week the UK Chancellor announced a £330 billion fiscal package to fight the impact the crisis is having on the economy. The Bank is effectively printing money to fund the rescue package. Unlike the QE that evolved after 2008 when central bank money went into the financial markets, this current stimulus will end up in the real economy.

While the short-term outlook is very uncertain and impossible to predict, the message from policy makers is clear: ‘we will do whatever it takes’. The implications for markets over the medium term is poor for government bonds and positive for equities as inflation must be a possible outcome of the current stimulus. In terms of the UK, this is particularly pertinent given the expansionary budget delivered last week and which excluded the funding of the current crisis. The steepening of government yield curves over the last week might be the beginning of markets looking through the short-term issues.

So in summary, we have bottom up valuations (in parts) that we’d argue look as cheap as any we have witnessed since the GFC, paired with incredibly accommodative top down measures. Morally things don’t always stack up, and we continue to witness the hangover of 2008/09 all around us, but putting current sentiment to one side, objectively we observe that certain markets are ripe for something quite spectacular over the next cycle and the opportunity cost of backing out now may be pronounced.

Source: Bloomberg (as at 19/03/2020)


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