- 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.
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.
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).
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).
Finding opportunities in long-term demand/supply imbalances
Fish farming is an industry where demand is expected to exceed supply over the long term, increasing pricing power, according to the U.N., World Bank and others. Yet so far this sector has not attracted a lot of investors’ attention. The world’s population, just over 2 billion people around 1950, is expected to be 9 billion by 2050, the bank says, noting that global population growth and increased consumption of protein, particularly in emerging markets, should drive a significant increase in demand, with global protein consumption projected to rise 55% by 2030 – roughly 5.0% annually. Sustainable aquaculture is one of the most efficient ways to source protein and has great potential to feed the world’s growing population. On the supply side, Norway and Chile account for over 80% of production – although capacity expansion is constrained in both countries (see Figure 2). The Norwegian government announced earlier this year that some farmers will be allowed to increase capacity by 5%. Chile could increase production in the south, but a lack of infrastructure there means that an upturn would likely be limited and expensive to realize.
Although the aquaculture industry faces its own challenges, mainly biological ones, it trades at single-digit price-to-earnings ratios on 2015 market-cap-weighted earnings with dividend yields in excess of 5%, according to Bloomberg.As with other stocks in our portfolio, we look to specific companies that are generating increased sales and earnings, have attractive operating margins and good balance sheets, and are available at attractive valuation levels – or roughly two-thirds the price-to-earnings ratio of the market as a whole at 9–10 times estimated earnings, with 2%–7% dividend yields. We anticipate holding them for the long term.Finding opportunities in special situations
Capital and corporate restructurings such as initial public offerings (IPOs), mergers and acquisitions, asset sales, spin-offs and split-offs, and share buybacks may also provide pockets of opportunity. These unique and special situations may offer not only the opportunity to earn attractive rates of return (see Figure 3), but less risk in many cases due to either the structure of a merger or acquisition or the discount at which they can be purchased. Many investors shun these opportunities because they lack the expertise to properly analyze and evaluate restructurings.
As an example, last June, a postal operator in Europe announced plans to go public at what appeared to be an attractive price. The business of collecting, sorting, transporting and delivering mail, parcels and packages, although somewhat cyclical, is also one for which there is relatively steady demand – a trait we find appealing because it has the potential to reduce downside risk. The company’s shares rose recently after better-than-expected earnings results due to better volumes and management-led cost reductions.
Another special situation that provided an attractive opportunity was an Irish-domiciled biotech that a U.S.-based specialty pharma company sought to acquire. The acquirer announced a stock-and-cash deal after the target had become the subject of an unsolicited approach from a financial buyer. The fully hedged merger-arbitrage spread was a fairly unattractive annualized return of about 3.0%, but analysis suggested that investors misunderstood the transaction because the acquirer’s shares had underperformed its peers by more than 10% following the deal announcement. The deal, however, allowed the acquirer to “invert” to a lower-cost tax jurisdiction (Ireland), which could drive better internal rates of return from additional product offerings via tuck-in mergers and acquisitions. We expected that this, plus operational savings, could potentially drive significant earnings accretion in future years. The possibility of asset sales after the deal closed, which could generate significant cash to pay down debt and/or return capital to shareholders, also made this special situation more attractive than market valuations suggested. Digging deep into the details of the transaction is often the key to identifying hidden future potential.
Fish farming is an industry where demand is expected to exceed supply over the long term, increasing pricing power, according to the U.N., World Bank and others. Yet so far this sector has not attracted a lot of investors’ attention. The world’s population, just over 2 billion people around 1950, is expected to be 9 billion by 2050, the bank says, noting that global population growth and increased consumption of protein, particularly in emerging markets, should drive a significant increase in demand, with global protein consumption projected to rise 55% by 2030 – roughly 5.0% annually. Sustainable aquaculture is one of the most efficient ways to source protein and has great potential to feed the world’s growing population. On the supply side, Norway and Chile account for over 80% of production – although capacity expansion is constrained in both countries (see Figure 2). The Norwegian government announced earlier this year that some farmers will be allowed to increase capacity by 5%. Chile could increase production in the south, but a lack of infrastructure there means that an upturn would likely be limited and expensive to realize.
Capital and corporate restructurings such as initial public offerings (IPOs), mergers and acquisitions, asset sales, spin-offs and split-offs, and share buybacks may also provide pockets of opportunity. These unique and special situations may offer not only the opportunity to earn attractive rates of return (see Figure 3), but less risk in many cases due to either the structure of a merger or acquisition or the discount at which they can be purchased. Many investors shun these opportunities because they lack the expertise to properly analyze and evaluate restructurings.
Another special situation that provided an attractive opportunity was an Irish-domiciled biotech that a U.S.-based specialty pharma company sought to acquire. The acquirer announced a stock-and-cash deal after the target had become the subject of an unsolicited approach from a financial buyer. The fully hedged merger-arbitrage spread was a fairly unattractive annualized return of about 3.0%, but analysis suggested that investors misunderstood the transaction because the acquirer’s shares had underperformed its peers by more than 10% following the deal announcement. The deal, however, allowed the acquirer to “invert” to a lower-cost tax jurisdiction (Ireland), which could drive better internal rates of return from additional product offerings via tuck-in mergers and acquisitions. We expected that this, plus operational savings, could potentially drive significant earnings accretion in future years. The possibility of asset sales after the deal closed, which could generate significant cash to pay down debt and/or return capital to shareholders, also made this special situation more attractive than market valuations suggested. Digging deep into the details of the transaction is often the key to identifying hidden future potential.
A focus on value
As much as the macroeconomic environment has changed, we believe the fundamental premises of value investing still apply. Stocks will often be mispriced relative to intrinsic value because of investor behavior, short-term thinking and overreaction to news. Investors with the capacity for deep, fundamental research and a long-term perspective may be positioned to find these opportunities.
As much as the macroeconomic environment has changed, we believe the fundamental premises of value investing still apply. Stocks will often be mispriced relative to intrinsic value because of investor behavior, short-term thinking and overreaction to news. Investors with the capacity for deep, fundamental research and a long-term perspective may be positioned to find these opportunities.
Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investments invalue securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Dividends are not guaranteed and are subject to change and/or elimination. Investments in companies engaged in mergers, reorganizations or liquidationsmay involve special risks as pending deals may not be completed on time or on favorable terms. Diversification does not ensure against loss.The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of the following 24 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark or registered trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Pacific Investment Management Company LLC in the United States and throughout the world.
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