By Kevin Murphy.
In Uncertainty principle, we looked at how investors are seeking stability in an unstable world and often instinctively – though, in our view, mistakenly – choosing bonds over equities. This argument can be taken a step further with the suggestion this flawed logic is happening not just across but also within asset classes.
Thus, within equities, investors have been – and still are – seeking out the sectors of the market that are traditionally seen as providing greater stability. The areas of the market that pride themselves on stability, at least in the form of profits, are food, beverages and tobacco – with banks very much at the other end of the spectrum.
However, once again we come up against the problem of valuation. Measured on a relative price-to-book basis, food, beverages and tobacco are now the most expensive they have been at any time since 1973 – the earliest year for which such data is available – while banks are the cheapest.
In this instance, investors are swapping profit risk for valuation risk. With food, beverages and tobacco, the profit outlook is reasonable but the valuation risk is elevated. Many people will be hiding in these sectors in the belief they are more secure but the reality is that, while the stability of their profits may very well turn out to be as expected, the current valuations have the potential to harm returns.
In 2000, for example, GlaxoSmithKline was forecast to double its profits over the next 10 years and that is exactly what it did – however, the company’s shares fell by more than half over the same time because of the valuation multiple on which it began that period. Similarly, food, beverages and tobacco could have very stable profits for the next three or five years but that does not necessarily mean they will be stable investments.
Higher profit risks undeniably exist within the banking sector than in food, beverages and tobacco but the crucial point – as we discussed in more detail in The third dimension – is that profits are only one element of the three-part puzzle that is total return. In growing too comfortable about profits, people can end up forgetting about the other two ingredients – dividends and valuation.
To receive our free email newsletter sign up here.