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Overvalued equity markets reveal pockets of opportunity

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MEDIA RELEASE: The economic response to the pandemic has caused the equity market in Australia to become inflated, at the same time fundamentals are lacking in many valuations, but real opportunities remain in some sectors, according to Martin Conlon, Schroders’ head of Australian equities.

“All of this liquidity is starting to drive up prices, housing markets have boomed everywhere, and stock markets have gone crazy, not exactly what you think would happen when we have just come out of a pandemic with decimated economies,” he said.

“A lot of areas of the stock market have degenerated into gambling now. We are passing the parcel rather than looking at the fundamental value of a company and how much money it can realistically make. You can see that everywhere, and loss-making companies, story companies, are the ones doing by far the best. So, there are plenty of danger signs that would suggest that we are absolutely in a bubble market now,” he said.

Nick Kirrage, co-head of the Schroder Global Value Team shared Mr Conlon’s sentiment from a global perspective.

“Valuations are at an extraordinary level. In the US – which represents two-thirds of the global stock market – it has been a particularly phenomenal leap, and it has been led by a half dozen absolutely iconic, massive, software businesses.

“But there is a disconnect with investors’ return expectations. A recent study by Natixis revealed investors believe they will get a nearly 17 per cent per annum return over the mid to long-term, which is more than twice the long-term average return of global equities, ever, and that is starting from high valuations.

“There seems to be the view from the average investor of ‘we just went through a global pandemic, and that didn’t de-rail anything, so markets are not risky’.

“This very ‘risk happy’ appetite is a dangerous thing. Asset classes are not free lunches, and investors have to ground themselves in fundamentals.”

Meanwhile, alternatives investment director, Claire Smith said that the small to mid-cap segment of the private equity market was not exposed to risks in the same way as listed equity markets.

“On the private equity side of things, we are a bit shielded because the tax effect never really trickles down. We play in the smaller end of the market and we’re just not seeing as big price increases as in listed markets or the large buyout market.

When asked about opportunities, Mr Conlon said the intersection of infrastructure and health is likely to provide good opportunities for investors.

“There are selective opportunities in healthcare. The private hospital sector in particular offers opportunity. Although costs of building are going up, you can buy in place hospitals for reasonably attractive prices,” said Mr Conlon.

Claire Smith and Nick Kirrage echoed the opportunities in healthcare.

“50% of what we do is in the sort of healthcare and tech space, and we particularly like the intersection of those two segments, so a software company that’s dedicated to medical practices, that’s a pretty interesting opportunity for us,” said Ms Smith.

“One of the things we can all agree is that healthcare will probably grow over the long term,” said Mr Kirrage.

Mr Conlon also identified the energy transition as a crucial inflection point for investors.

“Energy is the building block for everything we do and use, so if that price rises, then most other prices are likely to rise.

“Financial capital has moved quickly to abandon fossil fuels as a source of energy production. This alters the valuation of companies producing fossil fuels, however, we are still very early in the journey to replace existing energy sources and despite technology improvements, capital requirements are vast. Paradoxically, capital has flowed into ESG and sustainable investing, deserting companies currently involved in materials and energy production, yet Martin Conlon said that some of the biggest emitters could help improve sustainability.

“The issues of mining companies, emissions-intensive companies, which are bearing the brunt of the pain, are actually some of the companies making the biggest difference because they are the biggest emitters, and they are the ones investing the most to improve the situation,” said Mr Conlon.

Nick Kirrage reported that the Global Value Team has added more energy into their portfolio.

“We added to the energy sector earlier this year in February. It’s now somewhere between 12 to 14% of our funds.

“We do see energy companies as part of transition.”

Looking at global opportunities, both Nick Kirrage and Claire Smith pointed to opportunities in Asia.

“We continue to think Japan has some interesting ideas. We’ve got three or four different sectors we think are very cheap.

“One of the themes of the last two to three years is businesses have very quickly moved to sort themselves out and they now have better balance sheets and we’ve seen a big move in debt from corporates, and consumers to governments,” said Mr Kirrage.

“China is the second biggest private equity market behind the US, too big to be ignored. We follow the ‘Made in China 2025’ thematic, following sectors such as digitalisation, medical devices, aeronautical exploration. We really want to back those thematics so that we’re in line with the government’s vision,” said Ms Smith.

Mr Conlon points to the opportunities that will arise now that the concept of ESG and sustainability is broadening.

“In recent years discussion around sustainability and ESG has largely just focused on climate change and emissions, and it is encouraging that the debate is now broader.

“We are applying the sustainability lens more broadly which I think is great. For instance, the banking sector acts like a tax on wealth inequality, savings go up, debt goes up, banks take a margin in-between, so the more wealth inequity there is, the better the banks do,”

“These things tell you that there is a sustainability issue at the heart of just about every company. We’ve just got to find them and solve them.” says Mr Conlon.

Mr Kirrage also pointed to the role that an increased ESG awareness will play in portfolio construction.

“Funds management has a massive role to play over the next 20 to 30 years to try and improve things,” said Mr Kirrage.

“But simply demonising businesses up front because of their ESG credentials, and not wanting those businesses in your portfolio is slightly reductive. The focus should not be on the current position, but how companies are planning make the transition to sustainability happen.”

Ms Smith also said that private equity portfolios can be bolstered by ESG and sustainability investing, providing a solid investment opportunity.

“We launched a fund in the US which focuses on quality jobs, which looks at companies that have good employment practices, that have good relationships with their staff, because we think that those companies will succeed. We also have a fund in the pipeline that will focus on the ‘circular economy’, so companies that participate in reusing and recycling to reduce the environmental impact of production” said Ms Smith.

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