Why valuation is the best risk-management tool
Owning undervalued assets is the key to protecting capital in volatile markets.
Many investors view valuation through an opportunity lens. They seek undervalued companies that can achieve higher valuations over time.
Less considered is valuation’s role as a defensive tool. Ultimately, the best form of portfolio risk management is owning undervalued assets with less downside.
That involves buying companies when they trade at bottom-quartile valuations, embracing volatility and being prepared to hold stocks through cycles.
Bottom-quartile valuations occur when market sentiment drives prices too low. Irrational selling can result in high-quality companies on single-digit Price Earnings (P/E) multiples and trading well below their asset value.
Consider Woodside Energy Group, an oil and gas producer. PM Capital initiated a position in Woodside in the first quarter of 2022. Like Shell PLC (another portfolio holding) Woodside’s share price lagged the oil-price recovery at the time.
We believed Woodside’s market valuation had become disconnected with company fundamentals due to ESG-related concerns about fossil fuel producers and a significant capital raise potentially required to fund the constructions of new gas fields and processing capacity.
After rallying for much of 2022, the price of Brent Crude fell as the global economy slowed. But Woodside’s share price rose as the chart below shows. This reinforces the importance of valuation as a risk-management tool: Woodside was able to rally when oil prices declined because it had traded on a low valuation and was misunderstood by the market.
Chart 1: Woodside Energy & Brent Crude Oil share price
Source: Factset & PM Capital
After identifying valuation anomalies, the next step is to embrace market volatility and buy quality companies when they are cheaper. Investment returns don’t occur in a straight line. Re-ratings of so-called value stocks are often two steps forward, one step back.
More than ever, PM Capital believes investors must embrace market volatility. Capitalising on excessive market fear is the key to delivering higher portfolio returns over time. Simply, you own undervalued companies and buy more of them when opportunities emerge during high volatility.
The third part of this approach is a willingness to hold undervalued stocks through industry cycles. This requires conviction, discipline and patience. It can take 7-10 years for a company to move from a bottom to top-quartile valuation, depending on the sector and industry cycle.
This is the power of long-term investing. You buy undervalued assets, add to positions as opportunities arise and let recoveries play out fully. Done well, this maximises investment returns and minimises investment risk.
Yet many investors struggle with this approach. Buying assets at bottom-quartile valuations usually means going against the prevailing market view. Buying more of that stock during high volatility can grip investors with fear. Patiently holding a stock for years can be even harder for those with a shorter-term focus.
Advisers can help their clients understand valuation’s role as a risk-management tool. As people live longer, they will need to hold a higher allocation of equities to maintain their purchasing power. They will also need strategies to manage that risk. None are more effective in the long run than owning undervalued assets.
This insight is issued by PM Capital Limited ABN 69 083 644 731 AFSL 230222 as responsible entity for the PM Capital Global Companies Fund (ARSN 092 434 618), the "Fund". It contains summary information only to provide an insight into how we make our investment decisions. This information does not constitute advice or a recommendation, and is subject to change without notice. It does not take into account the objectives, financial situation or needs of any investor which should be considered before investing. Investors should consider the Target Market Determinations and the current Product Disclosure Statement (which are available from us), and obtain their own financial advice, prior to making an investment. The PDS explains how the Fund's Net Asset Value are calculated. Past performance is not a reliable guide to future performance and the capital and income of any investment may go down as well as up.