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Ariel Investments' John Rogers: August Monthly Commentary

September 26, 2012 | About:

Holly LaFon

277 followers
In our meetings with clients, prospects, consultants, and investing peers, the theme that continues to come up again and again is the dramatic shift in risk tolerance over the last several years. After the tumult of the 2008-2009 financial crisis and amidst the uncertainty of the European debt crisis, it is clear that investors have become far more risk-averse than they were a few years back. The most obvious signs are the massive rush of billions into bonds despite their historically anemic yields and the new world order of “risk on/risk off” days. We were asked recently if we could quantify the statement: more stable stocks have become much more expensive than they used to be. We are happy to weigh in, and think it is absolutely true people are paying a much higher price for perceived safety than they have in the recent past. In our view, they are likely trading one risk for another and are creating opportunities for dedicated contrarians like ourselves.

The most dramatic example of the newfound ardor for comparative stability comes from what many practitioners call “beta.” In financial lingo (specifically in the capital asset pricing model and modern portfolio theory), beta refers to the correlated volatility of a security versus the market’s volatility. If that sounds complex, think of it simply as a ratio of how much an asset is likely to shift when the benchmark moves.1 To study this phenomenon, we separated the stocks in the S&P 500 Index into quintiles by beta, from highest to lowest, and looked at their current valuations versus their 5-year average valuations. The results are striking.

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In our meetings with clients, prospects, consultants, and investing peers, the theme that continues to come up again and again is the dramatic shift in risk tolerance over the last several years. After the tumult of the 2008-2009 financial crisis and amidst the uncertainty of the European debt crisis, it is clear that investors have become far more risk-averse than they were a few years back. The most obvious signs are the massive rush of billions into bonds despite their historically anemic yields and the new world order of “risk on/risk off” days. We were asked recently if we could quantify the statement: more stable stocks have become much more expensive than they used to be. We are happy to weigh in, and think it is absolutely true people are paying a much higher price for perceived safety than they have in the recent past. In our view, they are likely trading one risk for another and are creating opportunities for dedicated contrarians like ourselves.

The most dramatic example of the newfound ardor for comparative stability comes from what many practitioners call “beta.” In financial lingo (specifically in the capital asset pricing model and modern portfolio theory), beta refers to the correlated volatility of a security versus the market’s volatility. If that sounds complex, think of it simply as a ratio of how much an asset is likely to shift when the benchmark moves.1 To study this phenomenon, we separated the stocks in the S&P 500 Index into quintiles by beta, from highest to lowest, and looked at their current valuations versus their 5-year average valuations. The results are striking.

Another sign of this change in risk tolerance is the provocative shift in the valuations of the various sectors in the S&P 500 Index. While not every area in the table below shows a dramatic example of the phenomenon, in aggregate the picture is clear:

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*Sector classifications are provided by Morningstar.

Based on its valuation premium relative to history and the other sectors, communication services jumps out. With massive 5.0% average yields, these companies now trade at an average of 33.4x earnings, a big premium to their already lofty five-year average of 24.4x. You can also see a telling flip in the cost of the consumer sectors. Consumer defensive companies, which grow fairly slowly and have limited branding power, have traditionally sold at a 4% discount to the faster-growing franchises in the consumer cyclical area (a P/E of 17.0x versus 17.7x). Now, however, they trade at a significant 19% premium (a P/E of 20.0x against 16.8x)! Meanwhile, two key areas associated with stability and good defense in the downturn, health care stocks and utility companies, now cost 17% and 15% more per dollar of earnings, respectively, than they have over the last five years. On the other hand, two areas that tend to prosper when the economy grows, industrials and financial services, trade at significant 18% and 10% discounts to their usual P/E ratios, respectively.

So, what does this mean for you and for us? Looking backward, it informs the recent behavior of the market and the makeup of our portfolios. That is, as the crowd has piled into the stocks it associates with stability, those areas have performed well and gotten expensive. As committed contrarians and value investors, we have necessarily leaned away from this expensive fare. We have embraced out-of-favor, cheap stocks representing ownership in businesses built to thrive long-term. In some cases, we think these stocks have been more volatile than their underlying businesses, which we are willing to accept given the bargains available to us. Looking forward, we believe reversion to the mean will occur. That is, broadly speaking, we think low volatility stocks, securities with juicy yields and the “bunker” sectors should fall from their currently elevated prices. Meanwhile, the cheaper, out-of-favor areas where betas have been higher and profit growth is generally greater are likely to also revert to higher price-tags. Obviously we cannot guess when or why this will happen, but the more the valuation disparities increase, the more confident we become. Ultimately our portfolios are not shaped to fit a dismal new normal, but a “normal normal,” and we shall continue to think independently and remain patient until it arrives.

The opinions expressed are current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. Analyses and predictions are based on assumptions that may or may not occur, and different assumptions could result in materially different results.

The price-to-earnings ratio (P/E) is a valuation ratio of a company’s share price to its per-share earnings. The S&P 500® Index is the most widely accepted barometer of the market. It includes 500 blue chip, large cap stocks, which together represent about 75% of the total U.S. equities market.



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