Investing In a Challenging Environment

December 30, 2020

Equity valuations (P/S, P/E, P/B, P/CF, etc.) are high relative to historical averages, with some measures at the 99th – 100th historical percentile. Some areas of the market such as recent IPOs, SPACs, and certain high-growth sectors may be approaching overvaluation or even represent potential asset price bubbles. A portion of this move towards higher valuations is natural and expected because of interest rates moving to or near 0%. A portion of the move is the expectation of a recovery continuing into 2021 with consumers regaining confidence (vaccines) and meaningfully increasing spending. However, a portion of the move seems to be driven by speculation and leverage, some of this coming from new retail investors. Private Equity funds are rushing to monetize their investments via IPOs, indicating they too believe current market valuations are rich.

 

In the short-term there is no firm link between asset prices and the underlying value of future earnings or dividends. Prices can disconnect from fundamentals and there is no rule or limit as to the magnitude of over/under-valuation nor clarity as to when price and fair value will reconverge. However, in the medium-to-long -term, the market tends to reward a disciplined approach towards valuation. Whether growth is sustainable, over what period, and whether the business can translate that growth into cashflow will determine returns. Not all areas of the equity market are dangerous at present and we strive to identify quality businesses at reasonable prices.

 

Despite current valuations at the broad market level, we continue to expect positive future results for equities in our diversified portfolios and recommend that most investors should continue to hold the asset class. Market corrections (dips of 10% or more) happen about once a year/year and a half.  They are not fun, but they are necessary and provide shareholders with an equity premium over cash and bonds. We would not be surprised to see a correction in the next two quarters, especially following one of the strongest growth periods (since March) on record. Some areas of the market that have outperformed in 2020 and command the highest valuations may very well experience a larger magnitude correction.

 

In general, periodic rebalancing and diversification across asset classes and sectors are useful ways to mitigate risk in a challenging environment. For new investment, it may be appropriate to use dollar-cost-averaging over several months rather than a lump sum (see the article “putting cash to work” for more detail). Despite low yields, cash and fixed-income holdings may be appropriate for some investors to provide a safe anchor for portfolios and to take advantage of any potential pullback.

We hope you are having a great holiday season. Looking forward to a great new year!

Exencial Investment Team

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