Happy days are here again for equity investors

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published 14 August 2023

“Bull markets,” said legendary investor John Templeton, “are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.” The equity bull market started in October 2022 and is well under way, although it is further advanced in the US. Market sages are in denial, having warned of a recession that would dent stocks, but it has failed to appear. Ed Yardeni of Yardeni Research likens them to Vladimir and Estragon, the characters “waiting for Godot” in Samuel Beckett’s play. Godot never turns up.

The sceptics point to the narrow base of the bull market. The “MegaCap-8” of the US market (Apple, Amazon, Alphabet, Microsoft, Meta, Nvidia, Netflix and Tesla) fell by 41% in 2022, but have since rebounded by 64%, so their share of the S&P 500 index has risen from 19% to 27%. The S&P 500 has climbed by 17% this year, but only by 5.5% without the MegaCap-8.

The forward earnings multiple of the MegaCap-8 has risen to 31 times, still short of the 38 reached in 2020, but up from 21 at the start of the year. This has propelled the multiple of the whole US market from 15 at the October low to 19.6. But the multiple for the rest of the S&P 500 has risen only moderately to 16.7. The forward multiple of the mid-cap S&P 400 index is only 14.1. The small-cap S&P 600 is on just 13.7.

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The UK and Europe might benefit if there was a preference for “value” investing over “growth”. But Ron Tabbouche of RIT Capital argues that “the expansion of earnings multiples, driven by lower interest rates, accounted for most of the 12% annualised return of equities in the last ten years, with rising margins, helped by globalisation, also a significant factor”. Now, growth in revenues is needed “to drive returns”.

Higher interest rates and bond yields than have been seen in the past 15 years have held markets back, but won’t necessarily continue to do so. Equities performed well in the 1980s and 1990s against such a background as the high cost of debt constrained productivity-sapping government spending. Still, markets don’t go up in a straight line, and a setback is always possible. Almost inevitable is a change of gear in which the shares that led the market up initially take a breather and new leaders emerge. This makes now a good time to review a portfolio, taking some profits in the winners, selling the lame ducks and buying into some stocks left behind.

When it comes to new investments, it is tempting to buy a share that has fallen a long way as it’s easier to believe that a share price that has halved can double than to believe one that has doubled can double again. The latter is more common. As this year’s huge rebound of the MegaCap-8 demonstrates, if you don’t buy quality growth shares when they are temporarily out of favour, you probably never will. Cheap shares can wait.

Those who held on to these in defiance of the consensus that the sector had further to fall have good reason to feel smug. The shares still trade on double-digit discounts to net asset value (NAV), the bears are still in denial and their capitulation lies ahead. Still, it’s hard to believe that the MegaCap-8 will continue to outperform and there are plenty of attractive alternative investment opportunities. This suggests some profit-taking.

These defensive trusts performed well in 2022, but have disappointed this year. Managers remain bearish. Ruffer’s allocation to equities is at a record low of 14%. Capital Gearing has just 27% in risk assets, including alternatives and property. The trusts are structurally averse to equities, so they tend to be poor stockpickers. Bonds are no longer defensive, limiting the scope for diversifying risk. The shares trade on low discounts to NAV, so these are prime candidates for a sale.

RIT has also been a poor performer this year, yet the shares trade on a 20% discount. Exposure to quoted equities is only 34%, but 40% is in private equity. This was a minor drag on returns in the first half of 2023, but should now be positive. RIT’s managers are “keen not to sacrifice the upside” so they are not structurally bearish. Their stated view that “revenue growth and margins rather than multiple expansion will drive returns from now” implies that they are growth rather than value-orientated. The shares seem at least worth holding onto at the current price.

The shares have heavily derated this year and are now trading at discounts of between 5% (BBGI Global Infrastructure, LSE: BBGI) and 21% (HICL Infrastructure, LSE: HICL). 3i Group’s (LSE: III) shares are only down 3% over one year thanks to some good asset sales, but the others have lost roughly 20%. Investors have taken into account the effect of higher interest rates in pushing up the rate at which future cash-flows are discounted to present values (thereby reducing asset values), but taken no account of the benefit of higher inflation on those cash flows and hence dividends. This leaves the funds very attractively priced relative to inflation-linked gilts with a yield approximately 5% higher, making them a strong hold, especially if held in a Sipp or an Isa.

The same applies to these, although their exposure to market electricity prices has been an additional adverse factor. Over-enthusiasm about investment, especially by the government and opposition, has threatened lower long-term prices, but the discounts of the funds to net asset value is bringing their expansion plans to a halt. Vattenfall’s decision to suspend work on its North Sea site due to rising costs makes excess capacity look less likely, while demand for electricity will grow steadily. This makes the sector attractive longer term, with even the highest quality funds yielding roughly 6%.

It’s probably too late to bail out from a market that has reverted to underperformance this year. The market certainly looks cheap, but may deserve to remain so. There is very good value in small- and mid-cap funds and in those, such as Finsbury Growth & Income (LSE: FGT), investing in high-quality global businesses. The best returns are coming from the supposedly high-risk recovery shares most funds avoid: Rolls-Royce has more than doubled. But avoid stocks whose business models are broken, such as banks and general insurers.

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Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.

After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.