Relative value is not enough

CIO Insights 2Q2005

Cash holdings continue at a relatively high level of 10–20% of the Fund’s assets. This is evidence of our somewhat suspicious stance with regard to the level of world equity prices. The principal problem we see is that interest rates in hard currency areas such as the US dollar, euro, yen and Swiss franc are too low. As a result, equity marketplaces of all types are being chased by cheap money, be it markets for minority shareholders (what people generally refer to as the “stock market”), private equity markets, M&A markets, and markets for companies in distress or reorganization.

For us, this means that there are not many true bargains around in the world of equities. To be sure, there are always relative bargains to be had, but those are not the kinds of bargains we are interested in. We never buy an asset merely because it is cheaper than a comparable one. We want to see something inexpensive on its stand-alone merit. In this sense, we continue to believe that currently most such absolute bargains appear in the industrial/”input” sector of the economy such as engineered products and related services. Here, incumbent players are most likely able to carve out a long-lasting, defensible market position characterized by high barriers to entry, high switching costs for buyers, little availability of substitutes and relatively low need for additional regulatory intervention. Most of these favourable attributes cannot be listed for broadly popular but fiercely competitive consumer/”output” industries such as finance, hightech, healthcare and consumer staples.

A second area where we continue to discover intriguing bargains are some lesser-known or out-of-favor companies based in emerging markets, as most international investors in those areas remain macro-rather than micro-driven. That is, money usually pours into large, well-known emerging markets stocks when economic and political trends are favourable and exit them as swiftly again when those factors appear to turn negative. This short-term thinking concentrates trading activity in the most liquid stocks and tends to leave certain smaller or unpopular companies neglected and undervalued. The favourite areas for us to uncover such “gems” remain India and Brazil, both countries where the enforcement of corporate law and financial transparency is on par with developed markets and where the industrial base is surprisingly broad and deep.

Sincerely,