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Undervalued assets: Treasure hunt

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27 Jul 2023

Indications in the markets suggest undervalued assets are prevalent. Andrew Holt set off to see if he could find them.

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Indications in the markets suggest undervalued assets are prevalent. Andrew Holt set off to see if he could find them.

Given the unpredictable nature of the markets, seeking out undervalued assets is an understandable pursuit. But market volatility and the subsequent falls in some asset prices have changed the game.

The upheaval that rocked the global financial markets last year is the principal catalyst behind some segments of the market being classed as undervalued.

But given the vastness of the investment universe, where should long-term, value-hungry investors look? There are, inevitably, different interpretations on which parts of the market are undervalued.

On a valuation basis, every sector across Morningstar’s coverage universe trades below its fair value estimate. This presents a wide field. It also gives an insight into the damage done by the market volatility last year.

Based on such valuations, the group sees the best positioning for long-term investors in overweight value and growth stocks, which are 15% and 16% undervalued, respectively, and underweight core stocks, which are trading closer to fair value.

A closer look at specific sectors, show that small-cap stocks remain the most undervalued on a 25% discount to fair value. And the most undervalued category in the Morningstar Style Box is small-cap value, trading at an almost 40% discount to fair value – in what should amount to a significant attraction to investors.

Real estate also features within an undervalued assessment, having become even more undervalued, trading now at a 15% discount to fair value, according to Morningstar. Sectors such as industrials are trading close to their fair value estimates, while consumer cyclicals and communications look particularly attractive.

Health and wealth

US healthcare also offers an opportunity for investors, says Blackrock’s chief investment officer of US fundamental equities, Tony DeSpirito. “He looked at the Russell 1000 for two years following the ‘yield curve inversions’ that appeared in the US market, and saw a “good performance from healthcare,” he says. “It is lagging so far in this cycle, which only makes for a more attractive entry point into a well-priced and recession-resilient sector.”

Peter Abrahams, senior investment consultant at Lane Clark & Peacock, takes a diplomatic approach to the undervalued idea, while indicating there is indeed value in some assets within the market.

“While it’s hard to describe anything as looking particularly undervalued at a time of economic uncertainty, where many assets have actually rallied so far in 2023, including a fairly narrow AI-driven rally in developed market equities, a couple of asset classes that may look attractive at present are short-dated investment grade credit, particularly in the UK, and Chinese equities.”

For short-dated UK investment grade credit, given the significant rises in short-dated UK government bond yields, the total yield now available on “high quality UK names looks pretty attractive over a two or three-year horizon,” he says.

However, Abrahams notes that with inflation looking ‘stickier’ in the UK than other major economies, there is the potential for mark-to-market losses if yields continue to push upwards. “For investors holding bonds to maturity, yields upwards of 6% per annum look an attractive return over a two to three-year horizon.” Although an economic downturn more severe than expected could lead to a pickup in defaults.

Risk and reward

For Chinese equities, a short-lived ‘post-lockdown’ rally at the start of the year has given way to losses as many investors – particularly in the West – have exited positions, he adds.

On the China theme, Abrahams notes the appeal, albeit with qualifications. “While China has looked attractive on traditional valuation metrics for quite some time, clearly there is a high degree of political risk, surprise regulation and geopolitical uncertainty weighing on prices.”

Having set out the China proviso, he sets out the China case: “Reasons to be positive in the short term however appear to be low inflation – meaning the Chinese central bank has scope to stimulate the economy with cheap money – and China’s high savings rate, which has traditionally been poured into a now-foundering property sector.”

He also notes that “while the property sector presents a macro-economic headwind, the relative unattractiveness of the asset class to the domestic investor may mean greater inflows into Chinese equity over the near term, particularly as capital controls make it difficult for Chinese investors to access overseas securities”.

Emerging value

Another keen observer on the undervalued nature of assets is Gustavo Medeiros, head of research at Ashmore, who says three emerging market asset classes remain “very undervalued”. These he lists as: emerging market equities, emerging market local currency bonds and emerging market high yield sovereign debt.

Medeiros notes that emerging market equities are trading at a large discount to US stocks, which, is “not justified by fundamentals”. Such equities account for 12% of the MSCI All Country World index, while 34% of the revenues from the indices are derived from emerging markets, that contrasts with the United States which accounts for 61% of the index, but only 31% of global revenues.

That is then reflected in the price-to-earnings multiple of MSCI Emerging Markets trading at 12.5 times earnings, much lower than the S&P500’s 19.3 times. Moreover, there are specific opportunities within emerging market equities that stand out. Small and medium companies within the “technology supply chain in South Korea and Taiwan are interesting opportunities of capturing the future potential AI growth,” he says.

Sharing Abrahams belief in the potential of China, Medeiros says Chinese stocks remain undervalued reflecting broad-based pessimism for the economy, even though policymakers stand ready to ease monetary and fiscal policies.

Large discount

In addition, Latin American stocks are also trading at a large discount to their historical valuations. The price-to-earnings multiples in Brazil, Chile, Colombia and Peru are between 1.5 and 2.5 below their 15-years mean and even Mexico trades at one standard deviation below its own mean, despite its strong macro performance and significantly benefiting from nearshoring of manufacturing production.

Not stopping there, Medeiros cites the South African and Malaysian stock markets as also trading at a large discount to their mean value. While Indonesia and India valuations are not necessarily “cheap, both countries have secular growth stories” that is likely to keep their equity markets as a bright spot in the medium to long term.

Within emerging market fixed income, emerging market local currency bonds are outperforming, rising 7.8% year-to-date with emerging market currencies rising by 2.7% against the dollar over the same period.

Here, an important factor is that local bonds are benefiting from the fact that most emerging market central banks were fast to react to inflationary pressures, with some hiking policy rates already in the first quarter of 2021.

This was in sharp contrast with the large developed market central banks that postponed their hiking cycle to 2022. And some analysts have noted that these developed markets are suffering now as a result.

The broader benefit is that inflation has declined first and faster in most emerging market countries. This means that some central banks, such as those in Brazil and Indonesia, are able to cut policy rates in the second half of 2023 while China and Vietnam have already started as their economies are affected by the slowdown in global manufacturing and poor sentiment.

US imbalance

Looking forward, Medeiros believes that the massively overvalued and imbalanced US dollar is “likely to sell-off”, which should allow for further gains in emerging market currencies. To complete the emerging market undervaluation outlook, several high-yield countries in the developing world are also trading at distressed valuations.

The jury on whether these are “cheap” or “expensive” markets will depend on which countries implement much needed fiscal and economic reforms to improve their debt and balance of payments situation, allowing them to avoid a default or implement a “light” debt re-profile that leads to higher recovery value than today.

The recent currency depreciation in Nigeria and the appointment of a market friendly nance minister and central bank governor in Turkey are encouraging steps for these countries. Argentina is again in a perilous position, but the presidential elections may lead to a transition of power to a market friendly government which will focus on implementing fiscal consolidation and gradually removing capital controls which are “chocking the economy”, a scenario far from being priced on Argentina’s bond valuations today.

This amounts to a big list of undervalued opportunities in emerging markets. Why is this the case? Medeiros’ research reveals that emerging market assets have struggled to attract significant and consistent flows during the past 10 years.

End of US exceptionalism

In this context, the balance of payment adjustment of 2013 to 2016 was followed by pro-cyclical policies by the US government that led to an exceptional amount of inflows to US capital markets, primarily stocks, explaining why the US has a $17trn (£13.3trn) net external liability to the rest of the world, which underpins the US dollar overvaluation. Over this period, the dollar outperformed significantly, leading to lower investments and GDP growth across emerging market countries.

If Medeiros is right: the poor performance of US capital markets in 2022 marked the beginning of the end of what has been termed US exceptionalism, which marks a massive development, way beyond that of market undervaluation.

It will mean investors need to diversify their exposure to other parts of the world. This will drive the US dollar weaker and the gap between “exuberant US valuations versus depressed emerging market valuations to narrow”, Medeiros says.

This gives investors much food for thought. It also reinforces the fact that the identification of undervalued assets can spread far and wide and into unexpected areas. And the reasons can be beyond the recent market turmoil and focused on how an asset, or country, offers one of growth on its own terms.

In this way, Richard Bullock, geopolitical strategist at BNY Mellon Investment Management, puts the case for investors to look at Vietnam. “The Vietnamese dong is heavily undervalued, unit labour costs are exceptionally low, even by regional standards,” he says, adding: “With the tightness of the labour market and growth in activity, real wage growth will be strong over time, boosting consumption. GDP growth is resilient and sustainable – at around 5% plus. And it is one of the only countries to avoid economic contraction during Covid.”

Indeed, according to some estimates, Vietnam will become one of the 10 largest consumer markets in the world by 2030 – bigger than Germany or the UK.

Market divergence

There is another dimension to the undervaluation argument in markets. This is simply that there can be a divergence of reasons for companies to be valued, with differences between stock markets justifying different valuations as well.

The high valuation on the US market can be seen as driven largely because its market contains several huge companies producing solidly growing earnings in high-growth sectors – inevitably in technology. Those are things investors are happy to pay high valuations for – or traditionally they have.

The UK, by contrast, is dominated by some sectors that are less highly prized, such as miners, energy companies and banks. These sectors have seen their valuations dip recently, contributing to the cheapness of the UK market overall.

Here numbers from Schroders show that valuations for companies in the UK materials sector are 22% below their 15-year average, which can also be thrown into the undervalues mix. Based on the same analysis, valuations on financials are 32% below and energy 33% below.

Other indicators show a divergence between different areas of the market. Using an earnings-per-share measurement, for example, the FTSE100 is forecast to fall 2.9% in the coming year, while it is expected to grow 7.9% for the FTSE250 and 11.6% for the FTSE Small Cap. That could suggest it is Britain’s smaller companies that have the best chance to raise their valuations from here.

But another view is the on-going economic environment will result in the undervalued trend continuing. Helen Jewell, deputy chief investment officer of EMEA at Blackrock, says: “We expect slowing growth and sticky inflation to bring greater dispersion between companies. This presents opportunities for active stock pickers to generate attractive returns – even if the market overall remains at.”

So the search for undervalued assets is something investors should be considering, if they have not done so already.

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