Investors hoping for incredible returns from their equity portfolios were likely sorely disappointed by the second quarter's uninspiring results. Well they better get used to it. With stocks looking fully valued, corporate profitability already high, and seemingly unending economic uncertainty, equity returns don't look poised to repeat the impressive run of the last few years.
Right now, stocks look almost exactly fairly valued according to our stock research team. That means that on average, shares are trading for what we reckon they are worth. This isn't great news for value investors (like us) who are hunting for stocks that are trading for less than their intrinsic value. The hope in buying cheap shares is that over time the market will realise that those companies are worth more than they are trading for and that eventually the share price will converge with the fair value. This will give investors who got in at the ground floor a very nice return. If you think a firm is worth £1 and it is selling for £0.50, that is a pretty easy bet to make. You can potentially double your money as the stock price converges, and you get to participate in the organic growth of the company if its prospects improve over time.
Buying at a discount also gives investors a margin of safety if something goes wrong. You might think that a stock is worth £1, but what if it is actually only worth £0.80? If you bought at a deep enough discount, you'd still get a respectable return even if you were overly optimistic.
Is Any Value Left?
That discount and margin of safety are hard to find in the marketplace right now. And not only is the broad market fairly valued, so are the underlying sectors. With the exception of financial services and communications services (which look about 10% undervalued), there aren't any obvious pockets of value. Sure, there are some individual stocks that look cheap (35 stocks currently have a Morningstar Rating for stocks of 5 stars) but investors with broad market exposure are paying £1 for £1.
Conditions Not Ripe for Optimism
So at today's levels, investors shouldn't expect a huge run-up in prices just to catch up to current conditions. Instead returns are going to be dependent on how quickly firms can expand their cash flow and how much investors are willing to pay for that cash flow.
Rising earnings are hardly a fait accompli. Corporate profitability has already had an incredible run since the depths of the recession. The slashing of labour costs, restructurings, emerging-markets growth, and some other factors have helped boost earnings at a much faster rate than that of the broader economy. But as I discussed in April, these factors aren't sustainable, and finding new growth will be a challenge. Labour and other costs can only be cut so much before it is impossible to run a business.
And it shouldn't be a big secret to anyone who has been following the economic news during the last few months that the recovery has slowed down in the first half of 2011. Some of the slowdown may very well be from temporary factors such as the Japan earthquake and tsunami, and growth might return in the back half of the year. But even if there is some bounceback, the economy isn't going to be growing by leaps and bounds. Unemployment is still very high, housing remains shaky, and consumers are still in the painful process of paying off debt and cleaning up their personal balance sheets. These aren't the conditions that are going to suddenly create a surge in the intrinsic value of firms.
Another option for improved returns could be that investors would suddenly be willing to pay more for cash flows today out of hopes that earnings will increase at a faster rate in the future. Generally speaking, this would imply a boost to the market's outlook. Given that many of the economy's problems could take decades to truly sort out, I'm not optimistic on a sudden burst of optimism.
Margin of Safety Lacking
There are also a number of things that could go wrong and derail the stock market. Will Greek debt woes evolve into an international banking crisis? Will a failure to lift the debt ceiling send the U.S. into default? Could another spike in commodity prices sidetrack the recovery? There are also plenty of questions that we don't even know about yet. Often the next crisis is one that people aren't even considering right now. Investors demand that margin of safety to protect themselves against these unknown questions. But that safety is harder to find.
So what to do? This environment underscores the importance of good security selection. The days when all stocks were so cheap that you could make a decent return buying almost anything are long gone. Investors will need to build their own margin of safety by doing careful research and picking stocks that are trading at a reasonable discount to fair value.
Bearish markets editor Bearemy Glaser is the worry-prone alter-ego of markets editor Jeremy Glaser. Each week, Bearemy will share what's topping his list of concerns and invites you to share your own thoughts in the comments box below.
