The role of equities is changing in scheme's portfolios. Goodhart Partners' Alan Barlett, Hymans Robertson's Andy Green, JLT's Kieran Harkin, KPMG's Jon Exley and M&G's Aled Smith discuss where value in the asset class can be found.
Aled Smith: We are seeing something quite important happening. That is that equities, in their recovery, are now going into what we would describe as a secular bull market, which should last multiple years. And that is after a period of a very long bull market in bonds.
There is an initial recovery phase and very strong returns. But the point about equities is they compound you value at 5 or 6 per cent real, and they might be fair value today but the point is the psychology is starting from me not owning them. It is more about the crowd seeing that their neighbour has made money and wanting to be part of it; it is hard to differentiate too much between the markets.
Equities everywhere are a good investment for savers for the next five or six years until we get into overexuberance and crowding, and we are now here at a table talking about 40 per cent ownership of equities.
Kieran Harkin: An area we have seen value in, in the past 12 to 18 months, is frontier markets. On a portfolio construction level, frontier markets actually have a lot of benefits that can be added to a developed markets portfolio; it can also be added to an emerging markets equities portfolio. It is not, in portfolio construction terms, just an extension of the emerging markets story. Some of the volatility we have seen in emerging markets has not been experienced in frontier markets.
That is not to say there are no challenges in the market. There are illiquidity and capacity issues. Some of the trends we have seen in emerging markets are likely to play out slightly further down the road, but certainly there is value there for investors, particularly pension schemes.
Andy Green: The key question here, particularly for the developed markets, is the extent to which markets are just supported by interest rates being as low as they are.
With 10-year bond rates at 2.5 per cent, equities look pretty decent value. If rates increase faster than is priced already, how much pressure does that put on equity market valuations? If we suddenly see interest rates rising and investors see yield opportunities in cash and gilt markets of 4 or 5 per cent, to what extent will we see money move away from equities? To me that is why – even out to five years – there has got to be quite a lot of uncertainty about predicting the returns that come from equities.
Jon Exley: But added to the effect of quantitative easing on valuations, it seems to me that equity markets have become so much harder to value in terms of index price to earnings multiples etc. I know it is an oversimplification, but in the old days you had a steelworks and some plant and machinery, but now a lot of company value is intellectual property.
There are so many examples of companies that have been stellar performers one year and then the next minute an app or new innovation takes it out and the company is worth practically nothing. You can see why price to earnings ratios might be lower than they used to be just because unless you have a really strong brand, the barriers to entry seem so much lower for new competitors than they used to be and the lifespan of a successful company potentially so much shorter.
Green: There is another challenge here: earnings recovered in the first couple of years after the credit crisis but after that, frankly earnings are not delivering the growth that is expected but the dividends keep on coming through as companies are sitting on cash rather than it being reinvested.
There are a lot of share buybacks, which essentially results in higher gearing of the companies. To the extent that the same pool of investors just pops that money straight back into equities and there has not been the level of IPOs going on, this simply affects the market price. You need new companies to come into the market to genuinely increase the underlying equity of the market, otherwise all you are doing is just pushing the price up as you allow those companies to gear.
Exley: It is a bit like the glass half empty thing, that you can either look at companies generating lots of cash and think they are great companies or you can say they have got nothing to invest in. Is it not a concern that actually there are no new investments for them to really put this cash to work? To get the growth we need they have to employ it in projects that generate a higher return rather than just giving the cash back.
Alan Bartlett: The market is endogenous though; you could argue companies will not want to do anything with their cash because it might increase the variability of their operating performance. This means they will not hit the screen for the low-volatility investment manager and they will not get the premium multiple on their earnings that come today from being perceived to be a sort of bond proxy low-volatility equity. One of the interesting things is equity markets directly reflect demand, and the pension fund industry in aggregate will change the corporate sector over time if it demands different things from it.
