After five years of crises-related monetary expansion, what financial assets remain under-priced?

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Anandh Sundar's picture

The topic implies that ever since the collapse of the USA subprime mortgage market, and the fall of other markets like dominos, the monetary expansion by developed markets central bank has lead to financial asset bubbles-hence the question of which assets remain ‘underpriced’. The fact of QE-I/II/III being self evident, I do not waste time on graphs/statistics to prove the fact of a bubble, but instead proceed directly to its impact.

A popular media narrative is that quantitative easing(the increased money supply in USA and EU) has lead to lower treasury yields(thereby pushing down the base borrowing rate for others), making it cheaper for governments to borrow as investors flock to safety or (worse) enter investments with much lower yields than paid earlier.

In a published insight, PIMCO opines that Based on our analysis, QE has not been the driving force behind rising equity prices in recent years. We found that since 2009, corporate profits have had a more direct relationship to stock prices. For clues on where the equity market is headed, we suggest investors focus on corporate earnings, dividends and cash flows and pay particular attention to valuations.[i]

They analyze the P/E of various indices and connect it to QE-I/II/III(assuming that lag is negligible). I agree with their rather counter intuitive insight(applying only to equities), because of evidence that a credit bubble(or rather, flight to safety to sovereign and corporate debt) is there. With increased liquidity making borrowing cheaper, it is interesting to note the absence of big ticket leveraged buyouts or even debt financed acquisitions. Instead, that money is entering commodities, creating bubble like conditions there. Also, monetary expansion is accompanied by increased directed lending/investment norms, either directly through moral suasion, or indirectly through global standards like Basel-III, mandating financial institutions to hold more of ‘safe’ government/sovereign backed debt. Hence, the ‘investment surplus’ free to enter more speculative avenues like equities, is further reduced.

Can a financial asset ever be mispriced? We should separate the financial asset(right to certain cash flows) from that of its underlying asset (corporate, country, commodity). Assets go through macroeconomic cycles especially commodities, countries may be ‘in’ or ‘out’ of favour and so on. So the underlying asset may be itself mispriced by investors, as distinct from those mispricing the asset class itself. But given the difficulty of separating the two reasons for mispricing, we proceed on a combined analysis of mispricing.

Also, what is mispricing? Does it mean the chance for outsized returns relative to the market? Or does it mean that a DCF valuation shows significant under-pricing? Given that DCF may be incorrect, I focus on ‘real reasons’ why a financial asset should be underpriced, and then give some examples of them. This is more a framework, than a recommendation.

The efficient market theory would indicate otherwise, but even microeconomic theory does not suggest that all markets are efficient. The conditions for an efficient market(perfect information, no transaction costs, ready buyers and sellers etc) are rarely met, making this an economic construct. For financial markets, the sheer turnover ratio would make it seem that it should be efficient. But behavioral finance studies indicate that investors are irrational, be they retail or institutional(the scale of capital merely magnifies the good or bad qualities of investors). Hence, we should look to the specific financial asset trading statistics, investment restrictions/constraints, behavioural finance and qualitative factors to assess the probability of the asset being mispriced. Specifically

1. Illiquidity :-(lesser free float hence lesser trades) may lead to non coverage in research universe and build vicious cycle of lower prices. Investment holding companies of Indian promoters(like Westlife Developments-the holding company of Indian McDonald franchisee Hardcastle Restaurents), midcaps/small caps are examples of underpricing. But conversely, good quality scrips/assets in short supply may be overpriced-or even negative yield as in some USA/EU sovereign debt.

2. Investment restrictions:-Many countries impose restrictions on participations of foreign investors in certain ‘sensitive’ sectors like media, defense, aviation etc, thus lowering the investor universe for financial assets in those sector, and therefore potential underpricing. Conversely, directed investment norms of financial institutions may increase the price of those investments, as also short selling restrictions/investors motivated by non financial considerations may also lead to continued asset overpricing. For example, David Einhorn recounted in his book about how no one paid attention to his pointing out Allied Capital fraud; no one listened to Harry Markopolus about the Ponzi scheme; Muddy Waters faced flak about their attack on Olam, which was bailed out by its major investor Singapore SWF Temasek.

3. Behavioral finance:-When investors behave irrationally or succumb to herd mentality, this effect manifests itself. For instance, the renowned NYU Stern professor and valuation expert Ashwath Damodaran calculates the ‘risk free rate’ for 120+ countries, where he attaches a ‘country risk premium’ to the ‘base rate’ of USA S&P 500 risk premium. This implicitly assumes that other countries are riskier than the USA and other AAA rated countries. While he cautions against applying that measure in isolation, due to ‘availability’ bias; bankers, auditors and valuation experts may simply adopt the same values to reduce their work, especially where data is not readily available, and therefore end up underpricing emerging markets.

4. Qualitative factors:- Management quality, corporate (mis)governance, geopolitical risk and so on, affect prices of assets. Equities are most sensitive, but even bonds(especially lower rated ones) may trade like equities. Corporate governance concerns are a reason why equity shares with differential voting rights(but similar economic rights) trade at different values from the normal class of equity shares. Another example is the recent collapse of NYSE listed Chinese stocks, where investors realized that the regulatory arbitrage achieved by appointing local Chinese promoters as the ‘operators’ of assets, failed when rights over cash flow/assets could not be exercised. Bottomline, governance matters.

About specific assets that are underpriced, PIMCO in its ‘Credit Supernova’ memo suggests that near zero real interest rates will adversely impact historic business models, and that investors should seek inflation protection by either purchasing inflation protected securities, or investing in real assets. iiWhile this implies that purchasing lower yield high rated fixed income securities would be riskier due to negative real returns, Howard Marks(the famous bond investor) states that even junk bonds are risky now because of the very low yields.

That would imply that purchasing growth equities, preferably those underlying real assets like commodity traders/farming or mining stocks is advisable. But here also, do a valuation check for underpricing. If you cannot identity a good reason why the financial asset is underpriced, then chances are your DCF valuation is incorrect. So once you identify a financial asset that seems underpriced, then check the legal/regulatory/governance framework to be reasonably sure that the promised cash flows will really accrue to you on time. Then only consider entering the investment.

I feel that since the circle of competence is different for each investor, as is the desired risk/return profile or appetite, the financial assets seeming underpriced would also be different. Investors can have common facts, but rarely common investment views. With that caveat, for 2013, financial assets seeming underpriced appear emerging markets bonds(those without default history-no LATAM issuers/Mexico!), agricultural commodities(given the exponential population rise in the decade) and consumption linked businesses(FMCG/retail) as also special situations(out of favour businesses like Indian infrastructure, USA energy stocks, PIIGS sectors.