Friday Morning Coffee Nr. 3: Out Hunting!

230318 Friday Morning Coffee

Friday Morning Coffee Nr. 3: Out Hunting!

As stock pickers, we prefer to focus our attention on understanding the businesses and valuation of the companies we are invested in or intend to invest in rather than paying too much attention on strategy pieces and economic reports. However, we are fully aware that the companies are not operating in a complete vacuum; hence their stock prices are affected by the overall environment of the financial markets and most importantly, the economic environment impacts the earnings power of the business we invest in.   Then, the challenge, when skimming through the tons of research we get from sell side, is to separate from the noise, the information that will be relevant to our investment process and portfolios… and once in a while, we have these AHA moments where the top down world meets our bottom-up approach. This is what happened recently, when I saw the below chart published by Morgan Stanley which compares the valuation of the defensive sectors (like Health Care, Food & Beverage and Telecommunications) to the overall European equity market.   The first element that pleased me in this chart was the fact that it was using the Shiller Price Earnings Ratio which is, from my point of view one of the most effective valuation methods as it adjusts the earnings over a business cycle. The second element that brought my attention was that it shows that, on this interesting metric, the defensive sectors in Europe are currently trading at a valuation discount towards the broader market unseen in 30 years!!   The chart also raises an interesting question: are defensive really cheap or are they just cheaper than an excessively expensive European stock market? We have argued several times before that we do not find the European market overly expensive neither when compared to its own history nor when compared to other developed markets like the US.   But what really struck me, as value stock picker, was the fact that this historical chart is confirming what we are seeing when screening the market in search for attractive investment ideas: after a period where cyclicals strongly outperformed driving up their valuations, defensives appeared to be attractively valued! Hence our idea generation process relies on 3 different types of screening and they are currently highlighting all defensive stocks as potential investment candidates.   This is why, as a convinced active stock picker, this graph woke up my hunting instincts! Potential targets have been identified, we must now conduct our in-depth fundamental analysis to determine which of them will be able to provide us with the undervalued earnings power we are looking for.