Dan Kemp argues for compelling value opportunities across unloved geographies and sectors

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Dan Kemp, Chief Investment Officer, EMEA, Morningstar Investment Management, argues that the dispersion in expected returns as a result of Covid-19 continues to present compelling value opportunities across unloved geographies and sectors

While parts of the global equity market have once again become very expensive over the last few months, we continue to find attractive opportunities for investment. We have taken advantage of this dispersion in expected returns to reduce the ESG Portfolios’ exposure to some assets that are now looking less attractive and added assets that have recently become attractive following the decline in prices during the COVID-19 crisis. The former includes Japan and Healthcare companies that have served investors well over the year to date, delivering small gains for investors while the main UK equity index remains near 20% below the level it started the year.


Additionally, our global healthcare equity exposure has proved to be an excellent diversifier in 2020. Healthcare stocks have been one of the main beneficiaries of the COVID-19 crisis and as a result, valuations today are rich, especially in the healthcare equipment and healthcare technology sectors. Our valuation and fundamental research continues to direct us to a handful of sector and country themes. World Energy is a high conviction position that we have decided to increase. Even subjecting the sector to extremely conservative earnings and cashflow forecasts, we believe the sector will deliver attractive long-term returns for our investors.


On the other hand, as we look at US technology stocks, we see there is a great deal of optimism about the future backed into the prices of these companies. While this optimism may prove to be justified any disappointments that cause investors to be less optimistic could result in a significant fall in share prices. It is for this reason that we prefer companies that are dogged by pessimism such as energy stocks. So much bad news is already priced in that the future offers plenty of opportunities for pleasant surprises that could lead to sharp rises in the share prices.


Key Points for investors to consider:


Given the confusions caused by rapidly changing economic and market conditions, it is worth highlighting a few key points:


As we have now passed the fifth anniversary of the launch of the Sustainable Development Goals (SDGs) in September, it would be too optimistic to think that ESG is the investors’ “philosopher’s stone”, able to automatically give them the power to find good businesses with the potential to thrive in the future. Investing does not have shortcuts and a holistic view comprehensive of market dynamics, company competitive position and balance sheet strength remain necessary. In addition, sectors with perceived low ESG risk, such as the Tech sector and alternative energy, are not immune from ESG risks. From this, we understand that a low ESG risk company should not automatically be considered well placed for the future just because of its good current ESG scores.


Additionally, the level of Quantitative easing (QE) in the system globally has taken on another level, meaning the amount of capital available is skewing valuations further. So while it is difficult to identify the exact impact of QE, it does appear clear that very low interest rates have encouraged investors to take more risk, increasing the price of a broad range of asset classes. This has typically reduced expected long-term returns, or the value available to investors.


However, the method of identifying value has changed very little over the last century. The key difference between valuing a company now and in the past is that companies tend to have fewer ‘physical’ assets and more intellectual property. Consequently, the price to book value, the most basic of all valuation metrics appears to be a less powerful indicator of value than in the past.


Highlight of Our Convictions:


  Asset Class Overall Conviction* Key Long-Term Drivers
EQUITIES U.K. Medium to High Investor sentiment remains low and high energy exposure creates a contrarian opportunity. The reward for risk continues to appeal.
  United States Low to Medium Valuations are not as compelling as international markets. The technology giants are priced for perfection, which is a concern for us. 
  Emerging Markets Medium Risk remains, but prices typically reflect these risks. Again, we find the opportunity set to be diverse, with South Korea standing out.
FIXED INCOME High Yield Credit Medium Yields have moved markedly (driven by wider spreads during CODIV-19). Our view is moderating but still attractive.
  U.K. Corporate Bonds Low to Medium Yields are unattractive in an absolute sense, but they look healthy relative to gilts. We are wary of long duration and downgrade risks.
  U.K. Government Bonds Low U.K. gilts have abnormally long duration risk and near-zero yields. This makes them very sensitive to inflation risk and offers poor return prospects.


Source: Morningstar Investment Management, conviction levels confirmed at 15 August 2020.

*Overall conviction is a long-term judgement built on a five-point scale from “Low” to “High”. Typically judged on a 10-year horizon, a “Low” means that reward-for-risk is likely to be subdued, whereas a “High” means reward-for-risk is appealing. This incorporates our four pillars of conviction including 1) absolute valuations, 2) relative valuations, 3) fundamental risk and 4) a contrarian scorecard.


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