Taking the market’s pulse

Christoph Ohm
Christoph Ohm
Portfolio Manager

Christoph Ohm

Portfolio Manager

Christoph joined OP in August 2015. He previously worked as an analyst at Marlborough Partners, providing financing advice to private equity firms. Before that, he worked in the valuation team at Duff & Phelps. He graduated from Aston Business School and Free University of Berlin, and is a CFA Charterholder. He co-manages the international portfolios, and contributes to the overall investment selection.

Christoph Ohm

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A core tenet of our investment philosophy at Oldfield Partners is that starting valuations drive future returns. Low valuations reflect low expectations, and it is precisely this pessimism that creates opportunity. The reverse is equally true: high valuations embed high expectations, leaving little room for error and much room for disappointment.

So where do valuations stand today? One of our favourite measures for taking the pulse of the market is the cyclically adjusted price-to-earnings ratio (“CAPE”). Unlike the traditional price-to-earnings ratio, CAPE uses average earnings generated over the preceding ten years and adjusts them for inflation. This averaging makes CAPE less susceptible to cyclical peaks and troughs in earnings. The CAPE of the US market is now at 42 times, compared to a 30-year average of 29 times.

What this high level of CAPE means for investors is best illustrated by the chart below. Each dot represents a starting CAPE for the US market, and it shows the subsequent 10-year annualised real return. The message is clear: The US market has never generated a positive real return over the subsequent decade when it traded at such valuation levels. The dataset covers over 140 years of history, and it clearly shows that valuations and returns are two sides of the same coin. If anything, we believe the chart may overstate the return potential of the US market today. US corporate profits amount to 12% of GDP, more than 60% above the long-run average[1]. Corporate taxes are at near record lows and several of the large technology companies are generating 40-55% net margins. At some point, either competition or the taxman will erode these monopoly-like levels of profitability.

[1] Corporate after-tax profit as percentage of GDP. Average since 1947. Source: U.S. Bureau of Economic Analysis via FRED

The good news for investors is that the US is an exception. As the chart below illustrates, many international markets are trading at moderate valuation levels.

At Oldfield Partners we continue to find pockets of value in the US through our bottom-up, research-driven approach, but we believe any equity investor in the market should be highly selective. The strategies we manage are dominated by equities outside the US given their relative and absolute attractiveness. All our strategies trade on price-to-earnings multiples of below twelve times.

 

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