Moscow, Russia contrarian investing break away from the pack

Investment markets are always moving and finding the best opportunities requires a deep understanding of both risk and reward. This can be a relentless exercise, as the market pays no attention to your past and is always looking forward. There is no scope for complacency when attempting to express your “edge”.

With this in mind, we take the opportunity to explore the current landscape and outline five ideas that appear to offer superior risk-adjusted returns. As you will see, many of these pockets of opportunity are quite granular and often unloved.

UK multinational companies

UK investors are being forced to contemplate some incredibly difficult decisions. With Brexit considered to be a major fundamental risk, nervousness has taken hold and outflows are mounting. In this regard, speculation and volatility are a valuation-driven investor’s friends. Without them, contrarian opportunities cease to exist.

The first thing to acknowledge is that the UK economy is not the UK equity market. For example, approximately 70% of the FTSE 100’s earnings come from overseas, and one must appreciate that the fundamentals of corporate Britain has been reasonably resilient. If anything, earnings of the FTSE 100 have actually started to rebound through 2017 and early 2018 after steadily falling by as much as 20% in the five years prior. This is a long-term development that must be reinforced.

In contemplating the investment thesis, it is important to consider the opportunity set in both relative and absolute terms. We must recognise that fundamental uncertainty is ever-present, but often overhyped. At the same time, sentiment has clearly turned negative for the multinationals, and this negativity is being priced into the asset class – creating the cornerstone of a contrarian opportunity.

European energy companies

We all know the European political landscape is fragile, with periodic uncertainty creating emotional responses. We also know that the oil market has been through a lot of volatility in recent years, causing people to second-guess and implicate the energy sector as a result. When you put the two together, European energy is unlikely to reach the best-sellers list.

One way of viewing this, which is likely to align with the investing public, is to conclude it is too risky of a proposition, regardless of price. The other, which makes far more sense to us, is to obtain a structural understanding of the key drivers and assess how much bad news is already priced into the asset class.

When viewed this way, we find European energy to be an unloved asset that makes for a relatively attractive investment proposition.

Russian equities

If European energy is a concern to some, Russian equities must be outright disturbing to others. There is no hiding that Russian political anxiety has a pronounced impact on western thinking. Vladimir Putin’s latest moves add another sentimental blow to these developments, with concerns likely to remain and asset prices in the region likely to be influenced by the negative sentiment.

Yet, societal concerns aside, we see an opportunity to benefit from Russian anxiety. Specifically, we continue to look favourably on Russian equities, especially relative to many of the expensive developed market peers.

This verdict in favour of Russian equities may seem controversial, although really highlights the way collective behaviour creates valuation-driven opportunities. In the case of Russia, we have witnessed a gradual improvement in earnings, cash flows and dividends – all growing faster than western peers in nominal terms.

Over the very long term we would not be surprised if Russian risk remained elevated, although it could easily subside from current levels. This collective overreaction should therefore gradually subside too, meaning Russia could benefit from a tailwind of both stronger earnings and improving sentiment.  

European telecoms companies

Telecommunications is a sector that carries unique attributes and has significantly underperformed relative to the broader market. We find that European telecommunications have become increasingly attractive from a valuation perspective, although it is important to acknowledge that assets typically become cheap for a reason. In the case of European telecommunication companies, one must recognise that the fundamentals are currently very weak, with stagnant real revenue, compressed profit margins and return-on-equity at a 14-year low.

It is on this basis that the telecommunication sector makes for fascinating analysis. On the one hand, it is a troubled sector that faces several shorter-term risks including very high payout ratios and elevated debt levels. However, for longer-term investors that stand willing to look through shorter-term noise, there appears to be sufficient reward for risk on a relative basis.

AU Government bonds and credit

Much has been written about the potential forward paths for bond yield curves as central banks look to normalise from their emergency “loose monetary policy” settings.  What this means is that cash rates in the large developed countries – the US, UK, Europe and Japan – are likely to increase.  Coupled with the threat of normal inflation rather than potential deflation means that most expect bond yields to increase and sovereign bonds to look more attractive in future.

As this view has been perpetuated and accepted in most investors minds, then longer term bond yields have gone up by between 30 and 60 basis points since the start of 2018.  Amongst this coordinated action, two markets stand out as offering a long-term investor an attractive opportunity.  The US Treasury market has responded to increasing inflation expectations by rising the most aggressively whilst the Australian government bond market has demonstrated its lack of independence by rising in lock-step with its northern hemisphere counterparts. 

However applying rational independent thinking for a second, a local investor realises that the monetary cycle is very different in Australia to in the US.  Specifically, higher Australian wage inflation is nowhere to be seen, prospects of rate rises by the RBA are at the earliest a 2019 chance, and local employment growth keeps disappointing to the downside.  Quite different I am sure you would agree to the position in the US. 

As a result we believe Australian government bonds offer great relative value at 10 year maturity yields above 2.8% and continue to provide a safety buffer to lower corporate earnings growth in the Australian economy. Just what we expect from bond holdings in a diversified portfolio and quite different to the expectations from global government bonds. 

 

Andrew Lill is Chief Investment Officer, Australia, for Morningstar Investment Management.

 

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