In this brief note we highlight some risks for markets in 2022 and discuss current portfolio characteristics.
As we look forward to 2022 where is the vulnerability for equity markets?
Equities can get hurt from two areas. Share prices can fall because earnings decline – and they can also fall because the multiple that the market is willing to pay for those earnings declines. As we look ahead, we believe there is more risk for markets around the multiple than there is for earnings.
Despite an upturn in the virus this winter, the earnings outlook ought to remain solid because of the solid underpinnings for nominal GDP. The recent increase in the pool of global savings and to global net worth is so large, that the demand for durable goods and services ought to remain strong. US household net worth is up $23 trillion year on year, representing more than 20% annual growth. This growth rate in wealth has not been seen in 70 years.
US household net worth % change year on year
1952 – 2021
Whilst this is increase in wealth is good news for the global economy, it may present some risks to markets. The surge in liquidity is driving a surge in risk appetite within certain equities. Retail participation in equities is high with some evidence of speculative activity. Call option volumes have risen sharply this year. Below we show call option volume (in thousands of contracts) as a proportion of equity market volume (in millions of shares) in the US. The number itself is less important, more relevant is how the ratio has changed over time. The current level of activity is over 3 standard deviations above the post 2007 mean.
US Call Option Volume as % of Equity Market Volume
1 month rolling average
Retail trading euphoria is evident within the valuations of certain companies that have captured investor imagination. There is extreme polarity in the valuations of the auto sector. Below we show global auto valuations per expected car sold in 2021. Tesla’s valuation per car sold is 100x VW and 400x Renault.
$ Market Value Per Car Sold in FY 2021
Despite this wall of liquidity there is some tentative evidence that valuation is beginning to become more important for investors. Some of the most expensive assets are starting to underperform. Below we show two “ultra-growth” portfolios of companies – Ark Innovation and Goldman Sachs’ “Non Profitable Tech Basket”. Both were strong performers in 2020 but have underperformed the S&P 500 by around 25% year to date.
This underperformance does not in itself suggest valuation will become more important for returns, but it shows that there is weakness in the growth investing style in some areas. At turning points, the most aggressive or levered investors tend to suffer first, and so this bears watching.
The Most Expensive Stocks Are Starting to Underperform
For the stock market outlook as a whole – the message is nuanced. The market is split – some parts are historically expensive and some parts are historically cheap. We believe it is prudent to avoid those parts of the market where there is excessive optimism and excessive valuation. Over the last century high valuation has tended to lead to higher downside risk. Below we show downside volatility by PE quintile since 1950. The last decade has lulled investors into the idea that high price means high quality, and that high price will somehow protect downside. This has certainly been true since the financial crisis. But high price did not provide much protection from 1950 – 2007. We could see a return of high valuation leading to high downside risk. A value focus diminishes this risk.
Downside Volatility by PE Quintile
Equal Weighted 1950 – 2022
In the LF Lightman European Fund we see excessive valuation in Technology and Consumer Staples. We have zero exposure to these sectors. We see attractive valuations in Banks, Materials, Energy, Autos and some Industrials. In these favoured areas we also see strong balance sheets and attractive earnings growth.
Sector Weights: Fund vs Benchmark
Over the last 12 months the fund has returned approximately 24%. Encouragingly, despite the fund’s rising price, the PE ratio has declined over the period. The earnings growth of our holdings has been higher than the share price appreciation. The fund’s one year forward PE ratio is now 9.6.
LF Lightman European Fund Return
with Fund PE Ratio 2020 – 2021
One of the most striking improvements in our holdings over the last year is the reduction in debt. Many of our companies have largely eliminated their borrowings. The median net debt to ebitda is now just 0.2x. It is quite possible that the median portfolio holding will move to a net cash position in 2022.
LF Lightman European Net Debt to Ebitda Evolution 12 months rolling
This improvement in balance sheet strength is a function of high free cash flow. This in turn is enabling our holdings to increase cash returns. The mean dividend yield of our holdings has been steadily rising and is now 4.6%. The fund ought to provide a strong outlook for income in the coming years.
LF Lightman European Estimated Dividend Yield Evolution 12 months rolling
Looking back over the last 12 months, the major drivers of performance of the fund were from Financials and Materials. The portfolio’s underweights to Healthcare and Staples also helped. Two sectors have cost performance, Consumer Discretionary and IT. In both cases large cap stocks that we do not own have performed well. LVMH and ASML have delivered over 15% of the total benchmark return over the last year and we do not own either. If we include a third large cap growth stock – Novo Nordisk – and add it to ASML and LVMH – these three companies have provided over 20% of the index return over the last year. All three companies today trade at the highest valuations in their history – with valuations that we see as too high relative to their earnings delivery and risk profile. We expect to add alpha by not owning these companies in the coming year.
We continue to focus on owning companies with low valuations and strong balance sheets. Our companies also have rising dividends and decent earnings growth. We believe the fund’s current valuation offers an attractive entry point. Valuation will likely start to become a constraint for some equities in 2022. The LF Lightman European Fund ought to be well positioned in a world where valuation matters. We believe that the portfolio’s characteristics will enable it to perform well in absolute and relative terms in 2022.
Sources:
Federal Reserve, Bloomberg, Kenneth R. French Database, Compustat, the Center for Research in Security Prices, University of Chicago Booth School of Business, MSCI, Lightman’s own data – November 2021
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