Risk is arguably the most important yet least understood concept in investing. Many investors tend to focus on volatility or beta as a way to assess the risk of a portfolio or a given security. While these metrics can be useful to some extent, they are completely inadequate when it comes to the real risk that matters most to investors – the risk of losing money.
Assessment of risk is further complicated by the dynamic nature of market sentiment. What is commonly perceived as “risky” tends to change over time and can sometimes become unhinged from underlying fundamentals. Counterintuitively, it is often the “safest” bets that turn out to be the most risky and vice-versa.
The Tech bubble of the late 1990s provides a historical lesson. Back then, “risk” could almost be defined as the fear of missing out on spectacular returns in tech stocks that were busy changing the world. On the other hand, there was very little interest in shares of Old Economy companies that were perceived to be in terminal decline. In the fullness of time, it became clear that the real risk was chasing the overvalued tech shares and ignoring the phenomenal bargains on offer among the less exciting areas of the market.
Today’s market environment isn’t nearly as extreme as that era, but there are some parallels. The second half of 2018 was a classic kneejerk “risk off” environment in which shares of defensive businesses outperformed by a wide margin. These included traditional pharmaceuticals such as Novartis, Roche, Sanofi, AstraZeneca, and Novo Nordisk, along with dominant consumer staples names like Nestlé, Unilever, and Diageo.
We have researched each of these businesses in recent years and would argue that they are far less defensive than meets the eye. For example, many of the big pharma companies have been plagued by weak research and development productivity, drug pricing pressure, patent expiration and poor capital allocation. Companies that make food and household essentials tend to have better fundamentals, but at current prices they are a far cry from the type of valuations that make for compelling long-term investments.
Given the run global markets have been on for the last decade, it is somewhat unusual to see shares with defensive characteristics so richly priced. This dynamic is captured in the accompanying chart. The graphic shows the price-to-book ratio of defensive sectors (Health Care, Utilities and Consumer Staples) relative to the wider world stock market. Quite simply, when the line is high, defensive sectors are relatively more expensive on a price-to-book basis. As you can see, at the top of the last three bubbles – Japan, Tech and the Global Financial Crisis – defensive shares looked very cheap relative to the rest of the market, but that is not the case today.
Valuation of Defensive Sectors
Defensive sectors looked cheap during past
market crashes, while currently they’re looking
expensive. Are investors confusing stability
with safety?
Relative valuation of defensives
(higher = more expensive)
2.0
1.8
1.6
1.4
1.2
Japan asset
price bubble
Tech
bubble
Global financial
crisis
1.0
1990
‘92
‘94
‘96
‘98
‘00
‘02
‘04
‘06
‘08
‘10
‘12
‘14
‘16
‘18
Note: Defensives are defined as shares in the
consumer staples, utilities, and health care
sectors. Relative valuation is the weighted
average price-to-book ratio of the three
defensive sectors divided by that of the wider
world stock market.
THE GLOBE AND MAIL,
SOURCE: Datastream; Orbis
Valuation of Defensive Sectors
Defensive sectors looked cheap during past market
crashes, whille currently they’re looking expensive.
Are investors confusing stability with safety?
Relative valuation of defensives
(higher = more expensive)
2.0
1.8
1.6
1.4
1.2
Japan asset
price bubble
Tech
bubble
Global financial
crisis
1.0
1990
‘92
‘94
‘96
‘98
‘00
‘02
‘04
‘06
‘08
‘10
‘12
‘14
‘16
‘18
Note: Defensives are defined as shares in the consumer
staples, utilities, and health care sectors. Relative
valuation is the weighted average price-to-book ratio
of the three defensive sectors divided by that
of the wider world stock market.
THE GLOBE AND MAIL, SOURCE: Datastream; Orbis
Valuation of Defensive Sectors
Defensive sectors looked cheap during past market crashes, while currently they’re looking
expensive. Are investors confusing stability with safety?
Relative valuation of defensives (higher = more expensive)
2.0
1.8
1.6
1.4
1.2
Japan asset
price bubble
Tech
bubble
Global financial
crisis
1.0
1990
‘92
‘94
‘96
‘98
‘00
‘02
‘04
‘06
‘08
‘10
‘12
‘14
‘16
‘18
Note: Defensives are defined as shares in the consumer staples, utilities, and health care
sectors. Relative valuation is the weighted average price-to-book ratio of the three defensive
sectors divided by that of the wider world stock market.
THE GLOBE AND MAIL, SOURCE: Datastream; Orbis
So what’s going on? In short, we think investors are putting a big premium on stability and are at risk of confusing stability with “safety.”
Our favourite example of this extreme overpricing can be found at nearly every sushi counter. At the start of 2018, Japanese soy sauce maker Kikkoman sold at a multiple of almost 40 times earnings – on par with Microsoft in 1999 and unusually high for a company with only modest earnings growth. Despite this lofty valuation, Kikkoman shares rose by over 30 per cent last year when measured in U.S. dollars . Another example is WD-40, best known for its all-purpose lubricant. WD-40 shares started 2018 at over 30 times earnings, again extremely high for a business with understandably modest growth expectations, yet still managed to deliver a 50-per-cent return in U.S. dollars last year .
To be fair to the class of 1999, at least some of those companies actually did change the world with their technology. At least to us, the business case for some of today’s most expensive shares is less obvious. Perhaps we are missing the opportunity for WD-40 to grease blockchains or the potential for Soy-Sauce-as-a-Service? Make no mistake: Kikkoman and WD-40 are solid businesses that have stood the test of time and likely will for many years to come. But we believe that many investors are paying a price that is far too high for the relative predictability that these businesses offer.
As contrarian investors, we have found that it is actually the more volatile shares that present the better value in many cases. A good example today is Taiwan Semiconductor Manufacturing Co. (TSMC) , which is the largest pure-play semiconductor foundry in the world. At a time when chip suppliers have consolidated, there is an inflection point in the demand for leading-edge chips looming on the horizon. This has been driven by an arms race for computationally intensive innovations across a number of areas such as machine learning, autonomous vehicles, digitization of machinery, and the Internet of Things.
With these tailwinds, we believe TSMC has an opportunity to deliver earnings growth above 10% per annum for the foreseeable future while also paying a healthy 3.5% dividend yield. Yet TSMC shares delivered negative returns in 2018 – presumably a function of its economic sensitivity and emerging markets moniker – and ended the year trading at just 17 times earnings.
While these are admittedly only a small number of examples, we believe they are indicative of a broader mispricing, which has been driven by equity investors’ increasing preference for stability. In the short term, this has been painful for investors who are focused on fundamental value, but it also creates excellent longer-term opportunities for those who can be patient and take a different perspective on risk.
Graeme Forster, PhD, CFA, is a portfolio manager at Orbis Investments and is responsible for the Orbis International Equity and Orbis Optimal Strategies.