Market Musings 240922: Start to hunt for deeply discounted quality

Market Musings 240922:

Start to hunt for deeply discounted quality

Where has the market been over-aggressive in its indiscriminate sell-off?

Summary:

1. Is a sense of financial market panic in the air?
2. Contrarian value to be found as the proverbial baby is thrown out with the bathwater
3. Be choosy, look for discounted quality growth companies
4. Value also in certain discounted Real Estate Investment Trusts for income seekers
5. Don’t be in a rush, markets are unlikely to rebound in a straight line.
6. Stocks that look good starting points for more research

Smells like panic is in the air

Another week, and yet more pain for long-suffering stock, credit and bond market investors.

In fact, some of the greatest pain was reserved not for the stock market, but rarely enough, the sovereign bond market.

In the wake of the ongoing strength of the US dollar, combined with the nervous bond market reaction to new UK Chancellor of the Exchequer Kwasi Kwarteng’s tax-cutting mini-budget, UK gilts suffered a real shellacking. The £VGOV Vanguard UK Gilt ETF is classified as a 4 out of 7 risk, and yet it has lost 28% over 2022 to date, far worse than e.g. the FTSE 100 stock index.

The VGOV UK Gilt ETF -28% over 2022 (so far)

Source: tradingview.com

Frankly, this week smelt a lot like investor panic, with even formerly resistant segments of the stock market such as the oil & gas sector taking as much of a bath as elsewhere.

Secondly, the US equity put/call ratio hit its highest level since March 2020 (the depths of the COVID lockdown-triggered market crash). Investors buy calls when they are bullish to get upside to the stock market. But conversely, they buy puts when they want to protect their stock portfolios or position for a falling stock market.

A high put/call ratio then indicates that investors are very bearish on the stock market, as they are buying many more puts than calls..

Most bearish US equity put/call ratio since March 2020

Source: tradingview.com

So markets are rapidly integrating the current/forthcoming recessions in Europe and elsewhere, as higher interest rates and high energy prices take their toll on economic growth.

Institutional investors have been heavy sellers of European stocks for pretty much all of 2022,

Investors have been heavy sellers of EU stocks all year

Source: @isabelnet, from Bank of America

But the contrarian in me smells an opportunity here for the patient, long-term investor. All of this poor economic news is already well-known, so no-one should be surprised at this stage.

I want instead to look for quality stocks and sectors that are the proverbial baby being thrown out with the bathwater, that present excellent contrarian investing opportunities. Yes, this type of investing requires strong nerves, I won’t deny, but also tends to produce good long-term results if you can weather the short-term price volatility.

Hunting for overreactions in quality segments/stocks

Where should we be looking for long-term bargains today?

There are a number of areas that I like to look at right now:

• Real Estate Investment Trusts (REITs) where borrowing is not too high and on the basis of hedged debt, i.e. the REIT is not exposed in the short-term to the sharp rise in interest rates. Also where rents tend to be indexed to inflation, so where one should see rental growth. There are a number of these higher-quality REITs trading today at substantial discounts to Net Asset Value, where not long ago they were trading at a premium to NAV.
  
• Look for quality (highly profitable, strong franchise, low/no debt) stocks in unloved sectors, where the strength of the business/brands/franchise, quality of management and long-term growth runway outweighs any short-term recession-related worries. Cheap stocks that fall into this category could include: fund and wealth management companies (hit by worries over falling stock and bond markets), quality consumer/retail stocks (worries over hit from economic recession), and selected specialist/niche quality industrial goods/services companies (ditto).
  
• Cheap UK companies that could make attractive bolt-on acquisitions for larger US or European competitors, given the low valuation of UK small- and mid-caps combined with the recent collapse in the GB Pound.
  
• Selected oil & gas and mining companies which have higher than sector average profitability, a history of growing production with further exploration potential, no debt and strong free cash flow and dividend generation. An area I still believe in for the long-term relates to the production of industrial metals necessary for batteries and electrification, including nickel, copper, tin and lithium. All of these metals are in very short supply today, have seen prices fall sharply on the back of global recession fears, but should see strong long-term demand growth on the back of heavier investment in energy transition to renewable and low-carbon energy.
  
• Companies that are counter-cyclical, i.e. that should do well at a time of economic difficulty - such as companies that deal with bankruptcies, companies in administration and pre-pack insolvencies.

Investment conclusion:

• Interesting REITs for further investigation: SUPR Supermarket Income REIT, EBOX Tritax Eurobox, LXI REIT, WHR Warehouse REIT
• Fund managers: POLR Polar Capital, LIO Liontrust, N91 Ninety-One
• Tech/Industrials: SPT Spirent, BOY Bodycote, SOM Somero Enterprise, MGNS Morgan Sindall
• Consumer/media-related: TRMR Tremor
• Retailers: HFD Halfords, PETS Pets at Home, DNLM Dunelm
• Gambling/spreadbetting: PLUS Plus500, 888 Holdings
• Commodities: SLP Sylvania Platinum, CAML Central Asia Metals, AEP Anglo-Eastern Plantations

Of course as ever please Do Your Own Research…

In addition, those looking for potentially undervalued small-cap quality growth stocks might find the following tweet thread from @QCompounding interesting, as it highlights 20 undervalued Quality Small-Cap stocks. This list includes the following 4 UK-listed stocks:

• SDI SDI plc
• TM17 Team 17
• GAW Games Workshop
• CER Cerillion

Perhaps a good starting point for more research…

Have a great week

Edmund