There are some areas of the market that we believe represent exceptionally good value, and we are investing actively in them. These areas include a number of Japanese industrial shares, and certain parts of the emerging markets.
You could say this is a form of defence, in line with the old saying that “the best defence is a good offence”.
Unfortunately, though, there are a limited number of areas to play offence these days. Today, defence also has to take the form of outright defence.
This means that in recent months we have let cash levels rise, shortened term on bond investments, reduced credit risk, and increased hard downside protection in our hedged equity funds.
There are always risks in markets, of course. Sometimes the risks are localised, and sometimes they are broader and more pervasive.
In late 1999, for example, during one of the great stock market bubbles, it was possible to completely avoid the ensuing downdraft in highly valued information technology shares by positioning in very cheap shares of “old world” companies with real earnings and strong balance sheets.
These shares had been passed over by investors clamouring only for Internet-related shares at any price.
For nearly two years after the market peak, investors who zeroed in on value shares of all kinds, but especially small capitalisation ones, enjoyed a stealth bull market that was not widely reported at the time but was nonetheless enormous.
This was possible because the valuation risks in late 1999 were so localized in large capitalisation technology shares. The best defence in that case was a good offence.
In 2008, and again in a smaller way in 2011, the risks that wound up mattering were not localised, they were systemic. As the financial meltdown spread, all risky assets, such as stocks and corporate bonds, suffered together.
The only protection was to be invested in risk-free assets such as cash, high quality government bonds, or to have hedged market exposure using futures or options. The best defense in that case was simply defense.
Now, in 2014, we suspect the situation is something of a mix of these two past episodes, especially at the global level.
As in 1999, there are now a number of fully priced equities of the type we listed last quarter, at valuations that imply future returns barely greater than zero, and with significant risk of loss in the medium term if valuations move to more normal levels.
At the same time, there are some overlooked areas of the markets in Asia, Europe and emerging markets where stocks with strong fundaments are trading at price/earnings ratios in the single digits.
The larger backdrop is a bit more reminiscent of 2008, and argues for more direct defence.
We continue to be amazed that so many of the largest European companies, including the banks, are still seeing their earnings fall even as their share prices (until very recently) participated fully in the global equity rally.
Eventually, fundamentals will matter and, until this divergence gets resolved, we believe the situation in Europe is a source of significant risk for investors.
• Peter Arender is CFA Chief Investment Officer, Fortress Advisory and Services Limited.
