Lower interest rates have led to higher valuations of many company shares as investors look for alternative ways to save, generate a return and have some fun. High valuations have also been driven by high levels of liquidity and strong demand from retail investors. The United States Government’s recently announced $1.9 trillion stimulus package and high levels of household savings will potentially add to retail investor demand.
Are share markets in a bubble? For the market as a whole we do not believe so because valuations, relative to current low yields, are around average. However, shares of some companies do show signs of being in bubble territory. Some company valuations have risen sharply due to investor demand and not necessarily due to their future earnings prospects. Bubbles are often driven by investors chasing past performance; buying what has gone up rather than looking at future profitability and importantly what is being implied by the current valuation. Although many highly valued companies will likely go on to generate strong profits, they may not generate strong returns for investors as the profit growth is more than factored into their current valuations.
So, what should investors do? Investing in areas of the market with strong momentum can generate strong returns particularly in the short-term as more investors pile in and chase return. It can be hard to ignore the prospects of easy gains being enjoyed by others. However, as valuations rise so do the risks of falls. As active investors, we believe it is important to ignore the noise and focus on the fundamentals, including future profit growth and valuation.
We do not avoid holding highly valued companies but instead make sure this is justified by the expected return relative to the risk we are taking. Valuing companies is not easy and accordingly we often generate a valuation range with a pessimistic bear market value and an optimistic bull market value. As companies approach this bull market value (or if their fundamentals change) we look to reduce our holdings and replace with companies which have better return prospects.
In conclusion, we believe that share markets in aggregate are not in a bubble but there are areas of the market that warrant caution. We believe that the current environment provides an attractive opportunity for active investment managers to pick the future winners and avoid those who are over inflated and full of hot air.