Hedley Market Commentary- September 2019

Over the past 12 months it has been largely a 2 tier equity market with share prices of the so called defensive, ‘quality’ names having performed so well that they are getting to ratings never before seen. On the other hand, we have the stocks, which may well be vulnerable to a change in economic conditions, showing strong underperformance to their ‘quality’ peers.

It is true that there is certainly much going on in the world, which creates a very uncertain economic landscape and it is also rational that investors should seek out safe havens to weather any storm which may develop. However, the likes of Unilever, Diageo and Smith and Nephew in the UK on a PER of around 26x with modest earnings growth have performed stunningly well this year, while cyclical stocks such as Rio and Shell on 8x and 11x, yielding 6% and 6.8% respectively but with a more uncertain outlook have been disappointing, investors have clearly made their choice, at least for now.

However, while trends can continue for longer than you would think, it also pays not to be too complacent. In January 2000, from today’s levels of valuation, growth stocks outperformed for a further two months, before underperforming by over 50% over the next sixteen. Many investors today are looking for stocks that exhibit low volatility of earnings, top line growth and a track record of stability. This has helped to create a new ‘nifty 50’ group of stocks in Europe which are being bought on almost any valuation as investors seek their defensive qualities.

The chart showing below shows that the European ‘nifty-fifty’ now has a median PER multiple of around 25x, far greater than the average of the Stoxx 600 Index and is pretty much at an all time high.

The other chart showing below, which is based on the performance of the US ‘nifty-fifty’in the 1970’s, reflects a very strong underperformance of this set of stocks, at a time when it might be assumed this group with their defensive characteristics would be resilient, after all, the 1970’s saw one of the most vicious economic backdrops that we have ever witnessed.

The underperformance was also even more remarkable because these stocks continued to exhibit healthy earnings growth compared to the rest of the US market. However, the similarities to today are very similar and one of the reasons for the sharp falls was that they too had already reached valuations which were considered extreme. Let the buyer beware.