Discretionary Investment Management | Ravenscroft Group | Bob Tannahill
20 Jul 20
Weekly update - A question of reality
Has the market lost touch with reality? I don’t think so, but mind the FANGs (or should it be ANTS?)
In a time when the future looks more uncertain than ever (I seem to keep saying that!), one thing everyone can agree on is that the huge rebound we have seen in markets since the March lows has surprised all but the most optimistic investors. We are used to markets looking forward, and often looking to a recovery when pain is still being felt, but with the world in the grip of the worst pandemic in a century, surely a 40%+ rally in stocks is on the optimistic side? While we think caution is warranted at current share prices, we don’t think the answer to this question is as obvious as it might initially appear. We think there are a few things worth knowing about markets today and we would like to share them with you:
The rally has been selective
If you look under the bonnet of the indices, the stocks that have won or lost since March follow a clear logic. The market has bid up tech stocks like Amazon and healthcare stocks like Eli Lilly. At the bottom of the pack are the big banks (who face a tough few years), energy companies and hotel chains. Marriot hotels for example is still down over 40% on the year. So markets have been thoughtful in what has rebound from the lows and you can see this in the sector breakdown.
Source: MSCI Data in USD Price terms from 31st Dec 2019 to 17th July 2020
What has been notable is how narrow the rally has been. There are over 1,400 stocks in the MSCI World Index yet just 10 of them (1%) account for nearly 50% of all the positive performance in the market this year. There are so few in fact that here they are in full.
Source: MSCI Data in USD Price terms from 31st Dec 2019 to 16th July 2020
Some stocks do look risky at current prices
As we have seen the whole market hasn’t rebounded since March, which is why we don’t think it is obvious that the current rally is disconnected from the real world. So what about the hottest stocks? Has their rally gone too far? While valuing individual stocks is too large a topic to cover here, we think there are stocks that look more and less reasonable within this list.
Hot - Tesla (which we don't like)
While I know plenty of people love this stock, I think we can all agree that it is a high-risk proposition at current prices. Today it is valued at a colossal $278 billion, more than six times the market value of BMW at $44 billion. Tesla may be ahead of BMW in the race to mass-market electric cars but is that lead worth $200 billion? It is worth bearing in mind that in 2019 BMW made a profit of over $5 billion while Tesla lost nearly $1 billion. Now I am not saying that Tesla cannot justify this price, but a lot has to go right in the next few years to do so and any failure will be costly to anyone buying shares today.
Source: BMW and Tesla accounts
Warm - Microsoft (which we do like)
On the other hand, you have stocks like Microsoft which are hard to argue are cheap, but you can make a case for the current share price. A key part of valuing companies comes down to how aggressive you have to be in your assumptions to justify the price the market is asking you to pay today. In the aftermath of the 2008 global financial crisis, when stocks were pricing in the collapse of the global financial system, there was a lot of room for positive surprises. Share prices today are dependant on the current environment persisting and are more vulnerable to negative developments. Current valuations assume interest rates will stay low and that there will not be a major secondary shock from coronavirus in the autumn. These assumptions may not be unreasonable but we must be conscious that they are assumptions that could be painful if they are proven wrong. To put today’s price in context, let us imagine we had a spare $1.5 trillion and we bought the whole of Microsoft. What would we get in return? The earnings from the company would pay you around 3% per annum and they would grow at something like 10% each year based on the current share price. Compared to long term bond yields, which today sit around 1.3% and offer no growth (based on the 20 year US Treasury bond), you can see why that is attractive in the current low interest rate world.
Source: Microsoft website and the US Department of the Treasury
Any shocks could be painful
So while we believe that you can build portfolios today that are fairly priced for the current environment, we are also conscious that there are plenty of risks out there and any disappointments could be painful. The list of potential risks is extensive and leaves us feeling that defence is the stance to be favoured today. Some of the things we are thinking about include:
- Interest rates rise making high stock valuations less sustainable
- COVID 19 proves harder to control and does more economic damage than expected
- The US election triggers corporate tax rises or action against healthcare companies
- Anti-trust action (especially from the EU) undermines the current technology giants
So while we remain invested, we are looking to do so in a defensive manner and in what we see as the lower risk stocks. As Charles Gave, one of our favourite commentators recently put it, now is the time for a Jeep portfolio and not a Ferrari (or should that be a Tesla?).
* FANG refers to Facebook, Amazon, Netflix and Alphabet (was Google) and ANTS refers to Amazon, Netflix, Tesla and Salesforce
** The price-to-earnings ratio (P/E ratio) is a ratio for valuing a company that compares its current share price to its per-share earnings (EPS). Lower ratios are generally an indication of cheaper companies although earnings growth rates need to be taken into account. Typical values are between 5x and 35x depending on the company and its situation. The ratio is shown here to illustrate the presence of a small number of extreme outliers. FINANCIAL PROMOTION: The value of investments and the income derived from them may go down as well as up and you may not receive back all the money which you invested. Any information relating to past performance of an investment service is not a guide to future performance.