Market Review – Unparalleled Times?
To say 2020 has been a different year would be an understatement. No doubt most commentaries you read use the word “unprecedented” to describe the events of the last three months – a word that peaked in Google Trend’s data during March. The month of May has seen “unprecedented use of the word unprecedented” peak as a searched phrase.
Whilst the “unprecedented” trend is downward, central bank balance sheet expansion remains firmly upward. Year-to-date, the Federal Reserve has expanded its balance sheet by 66%, an annualised rate of over 300%. Attempts during the last decade to unwind quantitative easing (QE) did begin, highlighted by the much searched term of “tapering” in 2013, but the highly searched 2011 phrase of “kicking the can down the road” to describe a delay to that unwinding, may now see its popularity rise again.
Government support for the people and lives that have been effected by today’s pandemic is much needed. Accommodative support has been beneficial for financial markets too, which have continued to grind higher since our last update. But as BlackRock, one of the architects of the burgeoning exchange traded fund (ETF) market, are appointed by the Fed to purchase the corporate bond ETFs which they sell, the positive reverberations across the financial world appear to disconnect it further from the economic conditions that the everyday citizen is experiencing. The modern-day monetary experiment remains truly unparalleled.
Equity Asset Allocation
In our last update, we highlighted one holding from each of the four main asset classes in the portfolio. In this update, we want to explain how, within our equity allocation, we decide how much we should be investing in each geography.
The foundation of value investing as an investment style is built from the concept of a “margin of safety”. It is our belief that an investment should be made when there is a gap between intrinsic value and market value. This approach is used firstly as a protective measure; intrinsic value can never be calculated to a decimal point, so attempting to pay significantly less aims to build a buffer for errors in estimation. Our analysis described below is therefore guiding us to avoid the permanent impairment of capital rather than the temporary impairment, the latter of which the market is dealing with this year. The distinction between the two is vital, and with an improper time horizon, the line between temporary and permanent impairment becomes blurred in the mind of the short-term investor. A long-term time horizon sharpens an investor’s view and reduces the apprehension caused during a market downturn.
At Seneca, we split equity investments into two principal areas, UK and Overseas. To decide how much of the portfolio should be invested in these areas at any given time, we need to understand how large the opportunity set is within particular parts of the equity market, and how attractively valued our current holdings are. The cheaper the area based on valuation, the more we would like to allocate there and the more expensive, the more we think about reducing the allocation. We track and monitor the valuation data of over 15,000 listed companies across the world, split by region to determine how attractively valued equity markets are. An interesting case study today is in North America.
As at the end of April, the top 10 constituents of the S&P 500 made up over one quarter of the entire index. North America, however, is home to over 3,500 listed businesses that generate revenue and have a market capitalisation greater than £100m. Our analysis at Seneca is designed to remove the pitfalls of measuring valuation based on a market capitalisation weighted index and instead determine what percentage of equities in a particular region look attractive on an unweighted basis. If we look at the data at the end of April, the median cyclically adjusted price-to-earnings (CAPE) ratio of the universe is just 12.5x (i.e. an 8% earnings yield). The median CAPE ratio for the top 10 S&P 500 constituents is 26x, over twice the valuation of the wider universe. There are over 800 companies that have a positive CAPE ratio1 below 12.5x. The conclusion for us is there appears to be a very wide opportunity set for a highly active manager in North America and we are now close to being able to invest part of the portfolio in a manager we believe can take advantage of the above findings.
Elsewhere, we continue to believe that UK equities remain one of the most attractive regions across global equity markets, with the median CAPE ratio of the universe trading at 13.5x. For the non-financial portion of the Funds’ UK equity positions, the median CAPE ratio is just 11x, with four holdings trading below 5x (i.e. a 20% earnings yield).
While North America and the UK are displaying significant pockets of value, a region we have consistently seen opportunity in is Asia. Across Japan and the rest of Asia, which we separate into two distinct categories, traditional value investing remains alive and well, as the opportunity remains significant for those managers which are willing to limit their assets under management to invest further down the market cap spectrum. We have identified almost 900 companies that are generating free cash flow2 but have a share price trading below the tangible assets on their balance sheet, net of all liabilities. There are plenty of attractively valued assets across Asia for active managers to own.
Finally, European equities continue to form a meaningful part of the overall equity allocation. Although we currently view UK and North American valuations as relatively more attractive, European listed companies have a unique characteristic within the developed world. The median free float percentage3 for our European universe is just over 55%, compared to over 90% for North America and the UK. Europe is therefore home to businesses where on average, there is a shareholder with a large percentage ownership of the business, often a family or founder. These businesses are often conservatively managed and are willing to take a long-term view, leading to better returns than broader markets. Europe remains a rich hunting ground for an active manager.
We hope the above has provided some further explanation on our asset allocation process and equity allocation and next time, we want to discuss two other areas of the portfolio, Fixed Income and Specialist Assets. We hope you and your families remain safe and well and we would like to thank you for not only your continued support, but the additional subscriptions that have been made to the funds we manage over recent days and weeks. We truly believe that today you are invested in a uniquely attractive portfolio of assets.
1A company can have a negative CAPE ratio if on average, its costs are higher than its revenues.
2Free cash flow is measured as the cash a company has generated in the last 12 months, after expenditure required to maintain and expand its asset base.
3Common shares outstanding which are freely floated on a stock exchange.
The views expressed are those of Tom Delic at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers Limited and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content. This communication is for information purposes only and should not be read as an offer or recommendation to buy or sell any securities. If you are unsure of any investment decision you should seek a professional financial advisor. Seneca Investment Managers Limited (0151 906 2450) is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. All calls are recorded. Your capital is at risk. FP20-125.