Identifying the value opportunities in volatile markets

Many asset classes have sold off sharply and look cheap. But cheap valuations alone are no indication of a market bottom. They could get cheaper. Markets remain predictably volatile in the face of continued uncertainty regarding the COVID-19 situation. Against the overwhelming tide of negative sentiment, fundamentals and valuations have unfortunately been swept aside.

We have seen the primary impact of COVID-19 hit the markets. At the time of writing, the MSCI AC Asia ex Japan has fallen by 18% year-to-date with China declining the least on news that it has been able to get the virus under control. See Fig 1. But many other countries continue to struggle to contain the virus. Market volatility is likely to persist as the economic and financial fallout across the globe becomes more evident.

The next phase may be when credit defaults hit the banking system (yet to be seen) and job losses hurt demand. Governments are doing all they can to keep the affected industries afloat. Central banks globally are trying to ensure sufficient liquidity exists in the system to maintain financial stability. Both monetary and fiscal ammunition have come fast and furious. It remains to be seen how effective these will be in combating the impact on the economies.

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Meanwhile financial markets will likely continue to reflect this uncertainty. Investing in the current environment requires discipline. Stock selection is key. The question is whether the sell-offs are now presenting value opportunities or value traps.

Fig 1 : Global equity markets have fallen sharply year-to-date1

identifying-the-value-chart-01

Staying the value course

That being the case, what should investors be focussing on? Here are 3 key steps our equity investment team is adopting to stay the value course.

First and foremost, maintaining process discipline around price and valuation is vitally important in the current environment to potentially capture future outsized returns. Extreme investor sentiment can contribute to significant mispricing of assets and history shows that low company valuations tend to offer longer term outperformance.

Second, the team believes it is important to “look through” the current market noise and assess whether the current environment is having more effect on short-term sentiment and earnings, which has less impact on valuations, or whether it is more structural in nature and may affect long-term earnings, which is the key driver of the team’s valuation models. To this end, we aim to identify the medium-term sustainable earnings profile of companies and understand their key drivers of earnings.

Third, the team looks at balance sheet quality and stability to see if we are being paid to take on more or less balance sheet risk now. We have been through every stock in the portfolio to make sure the balance sheet strength of the businesses we own is being fairly reflected in our valuation models.

Amidst this period of stress, focussing on valuations is key as is ensuring a detailed understanding of the companies the team invests in. Further, our teams continue to screen the entire equity universe to identify new potential investment ideas that appear to have overreacted to the latest headlines and are worth researching.

Our current positionings

Our country and sector positionings are a result of the bottom up stock picks. The team is overweight large cap and liquid banks in China which have high provision levels and better balance sheet strength than during the 2008 financial crisis. They have been relatively defensive in the down market. In contrast, we remain underweight Australian banks; as a commodity-driven economy this market and its currency have sold off heavily on big daily moves related to the China slowdown. As a whole the team is overweight financials.

We have also been overweight selected technology names having found many attractively valued stocks in the sector across the region from Korea, Taiwan and China. Many of these stocks have held up relatively well.

The team has been a little cautious on attractively valued Energy and Materials names over recent years given that many are heavily dependent on the commodity cycle. The existing exposure is biased towards companies that have opportunities less sensitive to commodity prices. Hence, we believe our positioning to be relatively resilient despite having seen these names suffer in the recent turmoil.

Healthcare stocks have performed well given the recent global focus on this area however these stocks were expensive before the collapse in equity markets and remain relatively expensive. Hence the team has very little exposure to these names. Similarly, the popular consumer discretionary names have been expensive and offered little opportunity, however this has dented performance as a few large names that have benefitted from an increase in home shopping have performed relatively well.

From a country perspective, our views are again driven by stock specific opportunities, however these tend to be somewhat aligned with where top down valuations lie. The largest underweight has been to Australia due to the underweight to the consumer, healthcare and banks names, the latter of which has been under substantial regulatory scrutiny in recent years. India is another underweight with few attractively valued names. Nonetheless there are more stocks of interest coming onto our research agenda in recent months.

The largest pockets of attractively valued stocks are in South Korea and Singapore. Many of these names have been underappreciated due to the market’s focus on the near term and cyclical concerns. But on a medium to long-term perspective, these are attractive opportunities.

Fig 2: Valuations are below the 10-year averages2

identifying-the-value-chart-02

Rewards await the patient investors

The global outlook remains cloudy and we are in unchartered territory. Share prices seem to be discounting, in fair measure, the risks. Many asset classes do appear cheap, but investors will probably want to see how badly economic growth and earnings have been affected before taking the plunge. But sitting on the side lines may mean missing out on an opportunity.

To navigate the above dilemma, an active, bottom-up stock selection strategy is key to identify companies that offer longer term investment opportunities. Investors can seek out active fund managers to help them ride out the storm.

Rewards are typically commensurate with the risks. There are opportunities in the current environment. But that could be some time away. It is worth noting that patience rewards!

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