via morningstar: Dan Kemp outlines five contrarian portfolio ideas that appear to offer superior risk-adjusted returns. Are you brave enough to invest in the unloved?
Investment markets are always moving and finding the best opportunities requires a deep understanding of both risk and reward. This can be a relentless exercise, as the market pays no attention to your past and is always looking forward. There is no scope for complacency when attempting to express your “edge”.
With this in mind, we take the opportunity to explore the current landscape and outline five ideas that appear to offer superior risk-adjusted returns. As you will see, many of these pockets of opportunity are quite granular and often unloved.
UK Multinational Companies
UK investors are being forced to contemplate some incredibly difficult decisions. With Brexit considered to be a major fundamental risk, nervousness has taken hold and outflows are mounting. In this regard, speculation and volatility are a valuation-driven investor’s friends. Without them, contrarian opportunities cease to exist.
The first thing to acknowledge is that the UK economy is not the UK equity market. For example, approximately 70% of the FTSE 100’s earnings come from overseas, and one must appreciate that the fundamentals of corporate Britain has been reasonably resilient. If anything, earnings of the FTSE 100 have actually started to rebound through 2017 and early 2018 after steadily falling by as much as 20% in the five years prior. This is a long-term development that must be reinforced.
In contemplating the investment thesis, it is important to consider the opportunity set in both relative and absolute terms. We must recognise that fundamental uncertainty is ever-present, but often overhyped. At the same time, sentiment has clearly turned negative for the multinationals, and this negativity is being priced into the asset class – creating the cornerstone of a contrarian opportunity.
European Energy Companies
We all know the European political landscape is fragile, with periodic uncertainty creating emotional responses. We also know that the oil market has been through a lot of volatility in recent years, causing people to second-guess and implicate the energy sector as a result. When you put the two together, European energy is unlikely to reach the best-sellers list.
One way of viewing this, which is likely to align with the investing public, is to conclude it is too risky of a proposition, regardless of price. The other, which makes far more sense to us, is to obtain a structural understanding of the key drivers and assess how much bad news is already priced into the asset class.
When viewed this way, we find European energy to be an unloved asset that makes for a relatively attractive investment proposition.
If European energy is a concern to some, Russian equities must be outright disturbing to others. There is no hiding that Russian political anxiety has a pronounced impact on western thinking. Vladimir Putin’s latest moves add another sentimental blow to these developments, with concerns likely to remain and asset prices in the region likely to be influenced by the negative sentiment.
Yet, societal concerns aside, we see an opportunity to benefit from Russian anxiety. Specifically, we continue to look favourably on Russian equities, especially relative to many of the expensive developed market peers.
This verdict in favour of Russian equities may seem controversial, although really highlights the way collective behaviour creates valuation-driven opportunities. In the case of Russia, we have witnessed a gradual improvement in earnings, cash flows and dividends – all growing faster than western peers in nominal terms.
Over the very long term we would not be surprised if Russian risk remained elevated, although it could easily subside from current levels. This collective overreaction should therefore gradually subside too, meaning Russia could benefit from a tailwind of both stronger earnings and improving sentiment.
European Telecoms Companies
Telecommunications is a sector that carries unique attributes and has significantly underperformed relative to the broader market. We find that European telecommunications have become increasingly attractive from a valuation perspective, although it is important to acknowledge that assets typically become cheap for a reason. In the case of European telecommunication companies, one must recognise that the fundamentals are currently very weak, with stagnant real revenue, compressed profit margins and return-on-equity at a 14-year low.
It is on this basis that the telecommunication sector makes for fascinating analysis. On the one hand, it is a troubled sector that faces several shorter-term risks including very high payout ratios and elevated debt levels. However, for longer-term investors that stand willing to look through shorter-term noise, there appears to be sufficient reward for risk on a relative basis.
Changing inflation expectations tend to trigger speculation as to whether we are in the midst of a cyclical or structural phenomenon. However, we are believers in applying much needed perspective. Specifically, the link between short-term inflation data and the long-term returns on assets tends to be weak. Moreover, it tends to highlight several behavioural biases that accompany inflation forecasting.
We believe investors should instead anchor to the fundamental value of U.S. Treasuries. This means we favour them over say U.K. Gilts, especially for shorter-dated issuance, primarily due to a combination of a higher yield and lower duration.