How to navigate extreme valuations

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A respected academic metric popularised by well-known economist Robert Shiller points to valuations for the US stock market being higher only once, during the dot.com boom and bust. Joining Kyle to explain what history suggests will potentially happen next is Ben Whitmore, manager of the TM Brickwood Global Value and TM Brickwood UK Value funds. Whitmore also provides his views on whether the AI theme has become overheated, explains how he approaches finding businesses on a discount while seeking to avoid value traps, and names some US and UK shares he’s viewing as opportunities. 

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On The Money, a weekly show that aims to provide food for thought for investors.

The focus of this episode is on whether investors should be concerned about the high valuations attached to the US stock market versus its history. We’re also going to be discussing concentration risk with a narrow set of companies heavily influencing US stock market returns in recent years.

My guest is also going to be highlighting where he’s seeing value opportunities in a market that on one valuation measure has only been this expensive once before, which was during the tech boom and bust. 

My guest today is Ben Whitmore, a value investor who manages the TM Brickwood Global Value R GBP Acc (BTKVZL1) fund and the TM Brickwood UK Value R GBP Acc (BRCCMP1) fund.

Ben, thank you for coming on today.

Ben Whitmore, manager of the TM Brickwood Global Value and TM Brickwood UK Value funds: Thanks very much indeed. Thanks for having me.

Kyle Caldwell: So, Ben, before we delve into the topic, could you provide a brief overview of your approach as a value investor, and explain how you judge a potential value opportunity and avoid those potential value traps?

Ben Whitmore: Yeah. Well, that’s a very good starting point. I co-manage the global value fund with Dermot Murphy, and we believe - and this is based off the academic evidence - that the starting valuation that you pay for a security is one of the key determinants to future returns, and low starting valuations paradoxically lead to high subsequent returns. 

That is what we believe in, and to try and then put that into practice, we screen the market using a couple of screens which have a long history of evidence of working. 

The first one is the CAPE screen, which is where we look at the cyclically adjusted price earnings as favoured by Ben Graham back in the 1930s.

We look at the 10-year average and look for companies that are lowly valued on that average, and then we also use the Greenblatt screen that’s got a long history of working and which was invented by Joel Greenblatt.

This is where you rank by valuation, EBIT/EV a bit, you rank by return on assets as a measure of quality, and then you choose the companies which are highest up the combined rank.

So, the best combination of low valuation and high returns, if you like. So, we put those two screens to work, and that for us is, if you like, the key to our philosophy: low valuation leads to higher subsequent returns.

Kyle Caldwell: And it’s those screens that help you avoid potential value traps?

Ben Whitmore: Well, the screens push us in the direction to go and look at companies, and we then sift through those companies looking in some detail at the history of the company, the financial history. We’re wanting to check that profits turn into cash. We’re wanting to check that the company can survive an unanticipated setback on the balance sheet. 

Companies with low valuations have got issues. It might be an economic downturn. It might be some poor capital allocation, or it might be something else going on in the industry. Maybe the issue you’re talking about is that something’s changed in the industry such that the profits won’t recover, and that it might be a value trap.

So, I think just specifically on that one question is we’re really asking ourselves, will the sales and profits be higher in five years’ time? Is that debated? Is that a big debate?

And then second, of course, the other thing to help us against protect against value traps is that we’re running a portfolio, so we’ve got about 50 holdings. Our starting position size is normally about 2%, and so we will always have securities that don’t work out how we hope, but the portfolio is a very good way of dampening that.

And of course, [with] our stock selection, we’re also focusing very much on how much money the clients will make if we’re right, and how much we’ll lose if we’re wrong. So, we’re always looking for shares where there’s like a strong asymmetry, so that the upside is like a multiple of the downside. So, all those things we’re putting in place to try and limit the impact of, if you like, shares that don’t perform as we expected.

But I think it wouldn’t be fair of me to say we can completely avoid them. We will absolutely come across them, but the way the process and portfolio construction is designed is to try and minimise the impact for securities that go wrong.

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Kyle Caldwell: Two areas where I think there’s a lot of debate at the moment about whether they are an opportunity or a potential value trap are the companies that were caught up in the software related sell-off early this year, and also consumer names, particularly Diageo (LSE:DGE). Where do you sit on the debate for those companies?

Ben Whitmore: Yeah. So, I think there are two areas you’re talking about, one is the software companies. There’s a great worry that AI will lead to software being able to be produced way more cheaply, and I think disrupt the existing software companies. 

For us, we’re always thinking about disruption, but we also want a low starting valuation so that it can cope with that disruption. 

One area we have made a purchase recently in for the Global Value fund is Accenture  Class A (NYSE:ACN). Now, it’s not a software name, but it’s sort of like the pre-eminent IT services company in the world. It’s very lowly valued because there’s also a sort of follow-on worry that the services of integrating software of large-scale IT transformations will be able to be done at a much lower price or some negative effect. 

But what we think there is that the IT transformation will be needed under AI and this very low starting valuation with a very strong balance sheet [means] that you have some protection of your wrong. And if it turns out that it’s not as disruptive as people think now, then you could make a lot of money. 

On your second name, the consumer area, I think that there are concerns more broadly, food, drink, company names, where people are worried about the effect of weight-loss drugs. And if we specifically think about Diageo, the spirits company, I think there are several other factors going on there.

One is the shares got very highly valued, and during Covid, there was a bit of, if you like, over-consumption, and that’s now being met with, in particular, a US consumer that is under quite a lot of pressure economically and so has been trading down in the spirits category. I think Diageo have publicly said that they’re more exposed to premium spirits rather than lower-priced spirits, so it’s hit them a bit harder.

But I think more broadly, when we look at alcohol, alcohol consumption has been declining for probably at least 50 or 60 years in the West. So, moderation has been in practice for a long, long time. So, I think if we assume that continues. 

Spirits have been taking share from beer and wine. If that continues, I don’t think it’s like a terrible backdrop for Diageo, and I think what we’re more interested in at Diageo is (a), we bought the shares when the starting valuation was very low, and, secondly, there’s a big operational turnaround there in terms of more discipline on categories, cost-cutting, restoring the strength of the balance sheet, and all those areas.

So, I think there are some moderating effects to alcohol consumption definitely, but I think within that, this is a very lowly valued security with quite a lot of necessary improvement in the operational cadence of the business as well.

Kyle Caldwell: Let’s now move across the pond to the US. In terms of valuations, as mentioned in the introduction, the market has been more expensive only once, and that was at the very peak of the dot.com bubble in 1999/2000. Could you explain what valuation metric that is based on, that the US has only ever been more expensive once?

Ben Whitmore: Yeah. The one you’re quoting is the dataset that’s maintained by someone called Professor Robert Shiller. He’s a very, very well-known economist at Yale University who popularised this valuation approach to the stock market, but he also popularised the valuation approach to American housing. 

If we touch on this one, he goes back to, I think, 1870 US data, and he collects the earnings for the US stock market, and then he divides them by 10 to give an average for the last 10 years and divides that into the value of the US stock market. So, you get what’s called the CAPE valuation, that’s the cyclically adjusted price earnings ratio.

He’s tracked that over time and as you so correctly say, it got over 30 in 1929 and then in 1999, it had, I think, 19 months where it was higher than it was today. So, that was over 43 times and today, we’re about 41.5 times.

So, what that shows is that the US stock market on that measure is very highly valued, and that is not a predictor of a crash or anything. It just says that if history is a guide, subsequent returns are going to be very muted. And if you’re at this valuation, history says that your returns are going to be very, very muted, like maybe 1-2% per annum.

Now, some people say, that’s just one method of looking at valuation. But even if you look at composite methods, so quite a lot of people use a composite of eight factors, P, price to book, price to sales, Q ratio, CAPE yield, all sorts of ones. 

If you look at that, the market today in the US is at levels last seen in 1966, 1929, 1999. I think all people would agree that if you use a variety of metrics, it’s at very high levels as judged by history.

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Kyle Caldwell: And added to that is the increased levels of concentration risk. So, seven companies dubbed the Magnificent Seven account for around a third of the S&P 500 index, and those seven companies are also approaching around a quarter of the MSCI World index. How much of a concern is both concentration risk and the high level of valuations for the US market for investors?

Ben Whitmore: Yeah. I think the best place to start with a lot of things, as you might have picked up already, is history. If we go back over history, you can see previous concentration levels, and if we go back to the technology, media, and telecom sector in the late 1990s, as you touched on, that reached about 40% of the index. 

Japan, when Japan had its bubble in the late 1980s, as a stock market was about 40% of the world index, and if you go back prior to that, railroads, they’re all around the level of 30% to 40%. So, I guess that’s like a flashing indicator to say history says this level of concentration is very, very high.

And if you mix that with high valuations, personally that for us is not appealing, and that’s why we fish elsewhere. We’re in the low valuation with a spread of investments across a vast array of industries. We just think that fundamentally is much more diversified and much lower risk.

Kyle Caldwell: And ultimately, I think whether the US market’s in a bubble or not, or whether we’re going to [receive] lower future retains going forwards, that ultimately depends on the performance of a small number of companies, those Magnificent Seven stocks.

The big question mark is whether the scale of capital expenditure on AI advancements is going to lead to the future earnings growth and profits that investors are expecting down the line.

We’ve also seen some share prices re-rate in Asia Pacific emerging markets for the likes of Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM), Samsung Electronics Co Ltd DR (LSE:SMSN), and SK hynix Inc ADR (NASDAQ:SKHY). What are your thoughts on the valuations for these companies? Are they too high? Are they justified? Somewhere in the middle?

Ben Whitmore: Yes. So, you’re absolutely right. The question the stock market is grappling with is the scale of AI investment more broadly as a percentage of GDP hasn’t been witnessed before, so it has exceeded cars and railways and all the other things that have transformed people’s lives. The scale of the investment is exceptionally high in relation to history.

And, as you say, what is going be the return on that investment is an extremely important question. Now, we don’t know the answer to that, and what we tend to focus on much more is, like, what is implied by the share price? 

So, you touched on some of the DRAM [memory] makers, the people making memory for AI, like Samsung or SK Hynix. There, while the price/earnings (P/E) look quite low on today’s profits, that industry historically has been brutally cyclical, very capital intensive. So, we would be nervous there because they’re implying a level of returns that have never been seen before.

Now, it may well be the case that returns are higher than the past, but it still looks like it’s pricing in some very, very generous returns indeed. So, I think what we’re trying to concentrate on are companies where there’s very low valuation, where the balance sheet’s good, cash generation’s good, and the reasons why they’re out of favour are temporary, and where we can construct a portfolio which is spread across a lot of industries. 

So, the companies you’ve talked about, the Magnificent Seven, or I saw the other day that’s called the Magnificent 10 now because you need to add in three of the big semiconductor companies, but however you call it, we just think that the valuations are high on CAPE yields, and therefore, for us, it’s just not appealing to invest in.

Now, we don’t know the answers really to the returns on AI investment, but what we do know is that on average, low valuation is where we want to concentrate, not high valuation.

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Kyle Caldwell: What would it take for those growth stocks to enter your universe and for you to potentially buy them? We do see over time certain growth stocks become value stocks. Remember Facebook [now Meta Platforms Inc Class A (NASDAQ:META)] turned into a value stock, I think it was in 2022?

Ben Whitmore: Yeah. I think broadly all companies change over time from maybe growth stocks to average stocks to value stocks depending on how capital enters the industry, and what happens to society and changes.

For us, it’s just having the discipline of assessing companies on their merits when the valuations are low enough. So, if we think about our Global Value fund at the moment, we express the CAPE yield as a yield, so it’s about 12% in the fund at the moment. Those companies you’re talking about, they’re all on CAPE yields of sub 1.5%, so they’re just not attractive for us. We’re looking for companies that broadly are around the sort of 10%-plus CAPE yield where we can find really good value, and where we think the businesses are of reasonable quality, balance sheets are strong, cash is good, and that’s where we’re really concentrating.

So, for us to look at some of those shares, the valuations would just have to be a lot lower.

Kyle Caldwell: And could you now talk through some stock examples in the US that are meeting your value criteria?

Ben Whitmore: Yeah. So, one I mentioned earlier was Accenture. The US healthcare system more broadly is quite lowly valued at the moment. So, we’ve got, a holding here in a company called Zimmer Biomet Holdings Inc (NYSE:ZBH). They’re the largest providers of replacement knees and hips in the world. They’re very lowly valued. There are concerns over how they’re changing their US sales force, and more broadly, that area of the US stock market is quite lowly valued at the moment. 

We’ve got a company in the life sciences area called Avantor Inc (NYSE:AVTR) in America. That’s very lowly valued because it hasn’t been run very well, and post-Covid when a lot of labs were trying to come up with new products, there’s been a slowdown on that. And then the US administration has cut back funding to quite a lot of research areas in America.

So, that’s very lowly valued, and both those companies are what I call pretty high quality. They’re either number one or number two in their industry globally. And so, that’s where we see tremendous value on offer in America despite, if you like, the headline valuation of the market being very high.

Kyle Caldwell: The fund, however, does have a much lower weighting to the US versus the index and also to many of your global equity fund peers. You have just over 22% in the US at the time of this recording. Could you highlight the range of opportunities you’re seeing elsewhere in terms of other countries?

Ben Whitmore: Just before I do that, a really important starting point is that we don’t use the benchmark to construct the portfolio. 

So, America, as you said, is 60-65% of the benchmark. We’re not trying to deploy, say, 60% or 65% of the fund just because the benchmark has got that in. 

We’re looking fundamentally at, say, 50 companies as we have at the moment, spread across a range of industries, a range of geographies, and we think fundamentally that that makes for a much more diversified, more attractive portfolio.

Now clearly, if you’re doing something very, very different to the index, the fund returns in the short term will vary much more significantly, but we think by adopting that approach that over the medium or longer term, we’ve got a much better chance of compounding the clients’ savings in a much better fashion.

So, where we can invest is where the opportunity is. At the moment, as you say, we’ve got just over 20% in America. We’ve got about 18% to 20% in the UK where we see some very attractive names. UK house builders are at valuation levels not seen since the Great Financial Crisis. That’s not seen across the world.

We also see some very attractive names in Europe, where we can deploy capital and buy some very attractive franchises on very low valuations. So, we have a holding in a company called Edenred SE (EURONEXT:EDEN). That’s the largest provider in the world of employee benefits, and we move around the world, really, looking for low valuation, and importantly, try and construct a portfolio with a spread of names across industries, across geographies, so that we’re not taking a particularly big bet on any one area. 

A spread of investments, we think, is a very good way of diversifying your risk and providing the most attractive returns going forward.

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Kyle Caldwell: In regards to UK house builders, is it the house builders that you own, or is it companies that are supplying that industry?

Ben Whitmore: In the UK fund, we own both the house builders and the companies supplying the house-building industry. 

In the global fund, we own Bellway (LSE:BWY), the UK house builder, and the reason we do is that when we look across the globe, there aren’t that many companies that trade on half the tangible assets in their balance sheet, which the UK house builders, and in particular, Bellway do. So, that’s why it can get into a global portfolio where you’re considering a whole range of potential investments.

Kyle Caldwell: Ben, thank you very much for your time today and for all your insights.

Ben Whitmore: Thanks very much indeed for having me.

Kyle Caldwell: So, that’s it for our latest episode of On The Money. We love to hear from listeners, and the best way to get in touch is by emailing us at: otm@ii.co.uk. For more information regarding investments, do check out the interactive investor website, ii.co.uk, and I’ll hopefully see you again next Thursday.