While the stock market “Santa rally” seems to be continuing, US market valuations are now looking stretched.
That’s not the case for value stocks, though, which have underperformed for several years as investors have either fled for “safe” but expensive defensives, or gambled on highly valued growth stocks.
Value is now trading at its biggest discount to growth stocks since the 1999-2000 dot-com boom, and we all know how that turned out. That could mean that there is now a significant opportunity in value stocks.
Time to head abroad
Where should investors be looking for value? With US markets now sitting on high valuations, it’s worth rebalancing portfolios towards foreign stocks. To get an idea of the potential, the 75% of the global economy that’s not the US makes up only half the world’s market capitalization. In other words, it’s too cheap. The US is now trading at a 60% premium over European, Asian, and other emerging markets.
Some emerging markets are now benefiting from better commodity prices. Brazil and Russia are lowly valued, but their economies are now being helped by a resurgent oil price. China also looks cheap as long as you don’t believe the economy will see a hard landing. Investing using a mutual fund or ETF is easy, but make sure you check out the manager’s investment style before putting your money down.
Laying your sector bets
Sector wise, it’s fairly easy to see what to avoid. Real estate, consumer staples, and utilities are all quite richly valued considering they are rarely high growth areas. Real estate and utilities could also suffer from their status as bond proxies if bond prices fall as the Fed hikes interest rates.
Much more attractive for the value investor and particularly the contrarian are resources stocks, many of which have seen their attraction as income stocks blown out of the water as they cut their dividends when times were tough. Valuations right now are low, and earnings should benefit from cost cuts as well as rebounding prices. In most metals and oil, several years of capital investment constraint have helped rebalance the supply and demand equation, and producers are still trading on cheap multiples.
Banks could also be a value trade. The sector has been affected by negative sentiment since the credit crunch, but rising interest rates should help banks achieve higher margins. While challenger banks have made the headlines, the fact is, few customers have moved their business – the”moat” that Warren Buffett typically looks for is still effective.
Biotech and tech sectors might also be interesting; though valuations remain high, biotech stocks took a big knock last year and haven’t completely recovered. (Again, specialist funds provide an entree to the sector for those who don’t have the expertise to do their own research on the technology involved.)
The best things come in small packages
The biggest stocks on the market have benefited from investors’ desire for safety, leaving small caps behind over the past few years. Value investors are most likely to find undervalued stocks at the smaller end of the market. That means a lot of patient digging if you’re investing directly in equities rather than using funds, but your research could be well rewarded if you find the right stocks.
Keep costs down to get the best returns
It’s no good being a value investor and making a great return if your cost of investment is too high. While it isn’t, and shouldn’t be, your most important investment criterion, a high cost of investment can affect the performance of your portfolio over the long term and you need to keep an eye on fund management houses and brokers to ensure you’re getting a good deal. Trade ETFs using a firm like CMC Markets rather than your bank, and compare online brokers annually to make sure you’re still getting a good deal.
Keeping costs under control could be particularly important in 2017, as returns on investment may be lower than they have been for a while. If that’s the case, you really want to make sure as many cents on the dollar as possible are coming to you, rather than being taken out in high commissions or management fees.