How I'm avoiding stockmarket value traps

An absolute view on valuation is an interesting question in these times of unprecedentedly low interest rates.

Bonds are a recurring theme at the moment for good reason; when the equity market responds vigorously to an event such as the 10-year bund yield turning positive, one knows we're in an unusual situation.

When we make valuation judgments on a company's stock, we are looking at the firm on its own and compared to other businesses. We judge relative valuations after taking underlying financial leverage into account. So, as far as possible, we are not judging valuations of equities relative to bond yields.

Equities offer clear daylight between their own valuations and those of bondsGiven the aggressive monetary stimulus we are seeing, there is the potential to distort equity valuation judgments by lowering discount rates.

We believe that examining absolute valuation is particularly important at present to guard against valuation risk.

Equities offer clear daylight between their own valuations and those of bonds (the equity risk premium, in abstract financial parlance), but caution is required.

To drag prospective returns down relative to the zero available from some sovereign debt would not acceptably compensate investors for the real-world risks always faced by businesses.

Weighing the risk premium

This appears to be a point that market participants agree on as well. It has let the market equity risk premium widen to near historic highs, i.e. future returns from equities have not followed bonds into the abyss.

What that means is there is sufficient absolute value around to enable us to put together a portfolio with enough potential return to warrant continued long-term investment.

Certainly, some stocks have undoubtedly benefited from being dragged up in price by low bond yields, but we are still uncovering compelling opportunities.

Long-term ownership allows us to get to know investee firms well, in bad times and goodTo come back to the risks presented by the long list of global worries, in a way these are positive for the equity investor.

If market actors are worried about prospects for sales in emerging markets for Diageo, new drugs for GlaxoSmithKline, oilfield equipment for Smiths Group or soap in Nigeria for PZ Cussons, it helps keep a lid on valuations and enables us to continue to invest for the long term.

A helpful side effect of long-term ownership is that we can strike up a constructive dialogue with our investee firms, and get to know them very well through bad times as well as good.

Within the universe of businesses that we examine, we can tilt towards better value and away from less attractive market prices, which puts the Evenlode portfolio as a whole into the "cheap" camp in our estimation.

On a long-term view, this estimation translates to the potential for high-single digit total returns per annum.

But it's important to remember in the execution of our process that the valuation of a business is one consideration amongst many. In particular, not all businesses are of equal quality, even within our slimmed-down universe of stocks.

Navigating the stormy seas ahead

Our top two holdings, for instance, Diageo (alcoholic beverages) and Unilever (consumer goods), are in our view priced to deliver attractive long-term returns. However, there are stocks with higher forward cash returns in our investable universe.

So why do two businesses that we accept have a lower return potential than others feature at the top of the portfolio? It reflects the confidence we have in their repeat-purchase revenues, strong brand portfolios, diversified business models and healthy, stable cash flows.

All these factors equip them well to cope with any particular bump in the road and to continue to deliver a growing dividend stream to the fund through thick and thin.

Uncertainty, not least from the referendum, is a significant headwind to current tradingConversely, we estimate higher forward cash returns for other companies, such as UK-focused firms Halfords (retail) and Mitie (support services).

Both of these firms feature in the Evenlode Income portfolio.

We assess that they are strong in their niches, and they tick all the boxes from our quantitative assessment of quality. But they operate in reasonably competitive spaces, and are less diversified than other firms we might invest in.

So to prudently manage the fundamental risk that is the flip side of the valuation opportunity, we hold relatively small positions in the fund.

Mitie's recent profit warning is a real-life example of these fundamental risks coming to bear as uncertainty, not least from the referendum, presents a significant headwind to current trading.

Ben Peters is co-manager of Evenlode Income, one of Money Observer's Rated Funds.

This article was originally published by our sister magazine Money Observer here

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.