Recently, equity markets have been hard to interpret. On the headline, the S&P 500 looks fine, but the more you read online, the more it seems like under the hood there is a crisis. There is truth to both sides of this. The first nugget of confusion may come from the chart below, which shows the correlation between the S&P 500 and the S&P 500 Equal-Weighted Index. This tells us when the S&P 500 rises, how closely does the average company on the S&P 500 rise at the same time? Is the headline index an accurate representation of the individual company within the index.
Source: Bloomberg and Innova Asset Management
The level we’ve reached is less than 70%. This means the index is no longer a good representation of the average company performance in the largest 500 company US equity universe. This is partly due to the narrow rally of a handful of AI names recently, though it does also mean that stock-selection has become more important.
In light of these recent unusual behaviours, it’s a good idea to have a look at recent excess performances of particular styles, sectors and factors, to see what kind of opportunities may be emerging from such dispersed markets. This story is not just in the US either, whereby differing macroeconomic outcomes, debt levels and policy decisions are creating huge disparities across different countries’ equity markets.
So, let’s check out some unloved investible markets (via ASX Listed Equity ETFs) in recent times, why they’ve been unloved, and use it as a preliminary step for potential screening opportunities. Why are they potential opportunities? Because risk-premiums (the amount an investor is compensated for taking on risk) are directly related to price according to asset pricing theory and are seen in practice!
Universe
Source: Bloomberg, Morningstar, and Innova Asset Management
Using the Australian ETF universe from Morningstar, we utilise a simple measure being 5-year past return to screen for some “unloved assets”. We can see some outliers on the far right, which have massively outperformed the MSCI World ex-Australia ETF, also known as VGS, and the benchmark. Overall, 78% of the universe trailed VGS in the 5-years and the median excess return was -12%. Of course, the caveat is that VGS was powered by US mega-cap tech and AI, making it a tough benchmark in this regime.
We see a couple of regions such as India and China, as well as styles/sectors such as global REITs, Australian small caps and A-REITS as the most “unloved”. There are clear reasons for this:
- China (e.g. CETF): The property crisis, tighter regulation of big tech, weak consumer confidence/consumption, and deflation hit earnings. The valuation problem in China continued to persist given consistent unreliability of the Chinese stock market.
- India (e.g. NDIA): The economy grew strongly, but starting valuations were already high and earnings growth didn’t justify them. Foreign investors sold, and a weaker rupee cut returns for Australian investors. The Gulf war was the icing on top, given India’s huge dependence on oil imports and domestically focused economy.
- Global and Australian REITs (e.g. DJRE, MVA, VAP): Property is the most rate-sensitive part of the market. Interest rates went up sharply and stayed high, which lifted discount rates and funding costs and pushed down property valuations. There’s no relief yet, with the RBA still hiking this year and the Federal Reserve priced for another rise by December. This was made worse by Australian inflation being the highest in the developed world.
- Australian small caps (e.g. ISO): They are domestic, cyclical and exposed to higher funding costs. A fragile consumer, with sentiment near record lows have hurt them directly.
Are there any turnaround stories?
What we love to see in sectors, factors (styles) and country returns is high momentum and low valuations (or in this case we are using 5-year return as a naïve proxy for mean-reversion).
Hence, we can see a “trade-off” between momentum and mean-reversion below, whereby we look at the top 5 candidates for a “turnaround” from “cheap” levels. We screen for only ETFs with negative 5-year excess returns and then rank on average momentum z-score (12M, 6M and 3M Returns). We see that biotech, ASX 200 high dividend, global healthcare, global small caps and global minimum volatility have some attractive short-term expected return features. Clearly, CURE is the standout, with pretty significant positive momentum and still lagging VGS on a 5Y basis.
Whilst this is a good initial screen and historically, assets with such profile (high momentum and low 5Y return) have led to strong 1-3Y future returns, the efficacy for particular sectors may vary a lot. Whilst that kind of screen works well for countries, factors and sectors broadly, a further step to something like this would be to investigate if biotech and sectors similar to it have also had such predictive behaviour in the past. Another key important aspect to check is what drove the returns, was it single-stock driven or did the whole industry have a rally all together, as this may indicate very different outcomes.
Final Thoughts
Buying unloved assets, with momentum behind them is a good way to increase your expected returns on your profile. A simple valuation screen is often not enough however, given that value-traps exist, and hence a momentum overlay can be a solid way to avoid these. All Innova’s recent high conviction positions have come from dislocations as such, where asymmetric pay-off profiles are present due to low starting points and solid asset bases or businesses.
