Investor appetite for certainty on near-term profits and strong balance sheets could be forcing some stocks to outperform “irrespective of their underlying intrinsic valuations”, portfolio managers have warned.
Technology and software firms are among the companies which are able to have a greater degree of certainty despite lockdown conditions, and investors have favoured them in the equity market recovery since mid-March.
This is evident in the strong returns of the tech-heavy Nasdaq 100 index, which is up 12.8% year-to-date, according to FE fundinfo. By comparison, the S&P 100 has returned just 3.9% over the same period while the MSCI World is down by 1.6%.
Managing director of strategic public equity at Gresham House Richard Staveley explained that during a typical market crisis investors become prone to "loss aversion" over opportunity seeking and, as a result, "drives capital to businesses with more ‘certainty' over their near-term profits, irrespective of their underlying intrinsic valuation".
He added that growing concerns about corporate debt levels have also meant the market has punished highly-indebted companies while rewarding those with strong balance sheets, but this has also been "irrespective of whether these companies were already valued highly relative to history or the rest of the market".
Staveley said: "We see extremely full if not over-valuation in lots of technology, software companies and consumer staples. This has created one of the widest periods of dispersion between cheap and expensive stocks ever."
He also compared the performance of companies with "perceived or actual recurring revenues" to the "massive revaluation of bonds", and warned, "buying these securities now is akin to buying negatively yielding or almost non-yielding government debt and will likely produce similar medium-term returns".
Staveley added: "The opportunity is in those companies with near term uncertainty but which will re-establish highly cash-generative businesses over the medium-term."
Jeremy Hewlett, UK equities fund manager at Mirabaud Asset Management, noted that the current situation is historically unique in terms of the relative attractiveness of risk-taking, with risk-free returns "lower than at any previous time in history, being effectively 0% in real terms and around one-tenth the collapsed levels reached in the Global Financial Crisis".
He added: "In this context, companies with the promised certainty of real growth can be expected to have exceptionally low-risk premia (i.e. unusually high valuations and prices).
"In short, investors need to weigh up whether 40x P/E is the new 20x and whether risk-free rates nailed to the floor are the manifestation of only a most anaemic recovery in economic activity and of moribund trading for challenged businesses, so that ~5x P/E is the new 10x?"
Growth and value
Portfolio specialist in the equity division at T. Rowe Price Laurence Taylor said that investors having "doubled down" on the past ten years of growth stocks' outperformance of value since markets have recovered, meaning "we now sit amid a truly unprecedented cycle for growth stocks" - both in terms of length and "incredibly strong fundamentals".
However, if unprecedented spending by governments and central banks was to have an inflationary impact on the economy, "then a value cycle could finally be spurred on", he explained.
Taylor said: "While the sheer strength of growth versus value may create a catalyst for this balance to adjust in the near term, we still struggle to see how a value complex can attain longer-term superiority in this prevailing environment without changes on the inflation front.
"With interest rates practically at zero for many countries, and no inflationary impulses likely to emerge in the short term, we find it difficult to support a durable style reversion."
Beware old maps
However, portfolio specialist at Jennison Associates of PGIM Raj Shant cautioned against "reversion to mean" models whereby valuations ought to suggest "valuation dispersions are too wide right now".
He explained investors should "stop and consider how much the way you live is changing - the way you work, shop, play, watch entertainment and communicate".
"The markets are simply reflecting these changes", Shant said.
He added: "It is very dangerous to use old maps when you move into new terrain. As tempting as it may seem to buy very cheap banks, oil companies or old-school retailers, it is hard to see how they are going to make a decent return on your capital in the coming years - some may not even be able to return your capital."
Similarly, manager of the Aviva Investors Global Equity Endurance fund Giles Parkinson is sceptical of comparisons between the valuation of today's tech giants and what was seen during the dotcom crash.
He explained "At least at the headline level, the multiples of these companies show this isn't the dotcom crisis.
"These trends are so much more real now, and they're really real in terms of the cash flow and profits these companies are producing.
"It is almost the first recession in history, where a quarter of the S&P's free cash flow actually revised higher because of what's happened."