Interactive Investor

Why banks are cheapest since tech bubble

11th April 2016 13:28

Lee Wild from interactive investor

There's been a flight to so-called "quality" stocks amid all the market pessimism and volatility, but those shares now look expensive. Instead, investors wanting "cheap" shares should look at either end of the risk spectrum, argues one analyst.

"Stocks deemed potentially structurally challenged, i.e. 'value', trade at a high discount. Stocks with the fastest growth rates in Europe also appear mispriced. What looks expensive to us is 'quality', and surprisingly, energy & mining," writes Barclays analyst Dennis Jose.

"The discount on value stocks is still as high as when we last highlighted them [in February] and remains supportive of outperformance on a 12-month view. The catalyst needed is an increase in bond yields."

While the automotive sector - underrepresented in the UK - looks attractive on a combination of valuation and earnings momentum, according to Barclays, financials have been discounted heavily recently, too.

Indeed, bank shares are as cheap as they've been cheaper relative to the market in 16 years, since the peak of the tech bubble. Jose thinks the market is already pricing in a recession, but argues that the experience of Swedish and Danish lenders suggests the impact negative deposit rates would have on profits "may not be as severe as feared".

Insurers have taken a pounding, too, but Jose points out that the sector now features heavily in Barclays' top value picks that demonstrate better earnings momentum than the market.

However, after almost a decade of underperformance, there are at least signs of life in the value sector. They've outperformed expensive stocks by 1% since January, and Jose believes valuations imply that this could mark the beginning of a longer-lasting rotation.

In the past, when price/earnings (PE) multiples of the cheapest stocks have been at such a discount to the dearest stocks, 'value' outperforms on a 12-month view. For it to happen this time, though, the 10-year US bond yield must rise.

Of course, there are always so-called value traps - companies that have consistently traded on low multiples, often for very good reason - but Barclays has a method for avoiding them: "We find that combining value with earnings momentum significantly reduces the proportion of value traps and substantially increases performance."

Barclays also thinks the energy and mining sector has done enough. After a recent rally, the broker reckons oil will have to hit $60 a barrel again to bring the PE back to the longer-term average. Earnings per share (EPS) would have to be upgraded by about 40%. "A move higher in oil to c. $60 is already in the price, in our view."

A similar situation occurred in 1999, when the sector underperformed the market by 24% until it fell back to the historic average.

And there's a similar mispricing among the high-risk growth stars. "Investors appear to be paying a similar multiple for the fastest growing stocks in Europe when compared to those stocks with more mediocre growth prospects," points out Jose.

"It appears to us that risk aversion has manifested itself in not just how stocks deemed structurally challenged (i.e. value) are priced, but also in how the risk associated with the fastest growing stocks is priced. Investors currently appear wary of paying up for growth."

However, in the middle ground, investors are paying a huge premium to buy stocks with low risk. Indeed, the non-cyclical consumer staples sector is trading on a PE multiple last seen near the Tech bubble highs - one of the biggest valuation bubbles in equity market history.

This all has implications for Barclays' 'recommended' portfolio.

German carmaker Daimler is replaced by French rival Peugeot, and media conglomerate Lagardere makes way for Ray-Ban sunglasses owner Luxottica. Downgrading its weighting in energy means Royal Dutch Shell loses out to airline Ryanair. Unilever also exits to let Danish drugs company Novo Nordisk in.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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