Many investment managers abide by a valuation discipline in one way or another. It has historically been a strong driver of longer-term future investment returns as well as being economically intuitive and simple to comprehend. Buying “expensive” assets (i.e., assets priced well above their long-term norms, based on fundamentals) has tended to lead to weaker future returns, especially in the context of equity market indices (sectors, countries, factors). If you can pay less for them, i.e. they’re cheaper, you should get a better result.

This use of “Valuation Indicator” or “Valuation Model” as part of this discipline is also common as a measure of the market’s ‘price’. They can be specifically used to try and predict the “multiple re-rating” component of future returns. A “multiple” refers to a valuation ratio such as the Price-to-Earnings (P/E) ratio, and “re-rating” describes the market moving that ratio up or down over time (usually to a perceived ‘correct’ level, independent of the underlying company/sector/index earnings or future earnings. But what do we mean by that?

You can break the total return of an equity index down to roughly 3 things[1]:

1. Earnings Growth: how much company profits increase over time.
2. Multiple Expansion/Contraction: whether investors are willing to pay more or less for each dollar of earnings.
3. Dividends (plus share buybacks): the cash income paid out by companies or used to buy back their shares.

For context, here is the return attribution of US markets over the past 10yrs:

Source: Bloomberg and Innova Asset Management

Generally, valuation models such as the Price-to-Earnings (P/E) ratio are trying to understand the direction of point 2 from above (multiple expansion/contraction) as a result of the current starting point. When the starting point of this valuation ratio is high, it generally reverts back to some longer-term average (perceived as the ‘correct’ long term price, as we alluded to above), whereas the future path of points1 and 3 are more unpredictable. For (1 – earning growth – we can expect over the longer term for earnings to revert back to a longer-term trend as well[2], and for (3), dividends, using historical dividends generally can be a decent proxy. However, in recent years, for the US market earnings and dividends haven’t necessarily played out exactly as one would expect. Earnings and margins have continued to trend upwards without any real reversion back to trend[3], and dividends have trended downwards for decades.

What drives valuation ratios?

Generally, valuation ratios on country equity indices, over roughly 1 to 5 years, are driven by interest rates/discount rates, macroeconomic volatility, liquidity and sentiment. Valuation ratios can stay at extremes for quite some time (anyone remember Japan in the late 1980’s???), which is why you’ll hear a lot of people say they cannot be used to time markets. We agree with this, but it doesn’t mean one should be complacent with their asset allocation in times of extreme exuberance, and solely be momentum driven (or in harsher, layperson terms, “following the herd”).

Timing

While we are buying cheap assets, the goal isn’t to know why they will re-rate — because no one truly does, and that’s not the point. In stock-specific investing, analysts often believe they understand the mispricing, thinking a company is undervalued relative to its intrinsic worth. But in broader asset allocation — especially across regions — the drivers are rarely clear and typically hinge on shifts in sentiment

Recent examples illustrate this: Korea’s market surged after an unexpected pro-capitalist government change, while Germany’s value stocks (defence) re-rated following a sudden €600 billion defence stimulus. In both cases, few anticipated the catalysts — yet low starting valuations magnified the upside.

The broader point is this: a valuation discipline isn’t a bet on timing or catalysts, but on asymmetry. As with our comment above, trying to predict the exact catalyst of anything is missing the point. Investing this way means the trigger is irrelevant, because you have greater leeway (when compared to more expensive assets) when things inevitably go bad; but just as importantly, they increase the odds of you making money, increase the amount you can potentially make and reduce the odds of losing money – asymmetry. They key is in the balance ACROSS all the assets available and combining them in a way to increase the likelihood of a superior outcome no matter what happens in the short and medium term.

Cheap assets provide room for positive surprises to spark powerful re-ratings when sentiment turns. The charts above show how these abrupt re-ratings can translate into strong equity returns as valuation and momentum reinforce each other. It’s typically in the later stages of an ongoing upwards market — when less-informed and non-professional investors pile in — that risk rises, and it becomes time to consider trimming positions. This often also coincides with maximum aggressiveness and highest short term recent returns, so is also very hard to do!

Importantly, when the above assets were bought by Innova at depressed levels, no one was talking about them — they were unloved, and often for good reason. Yet by confirming they permanently or irreparably impaired —they contained sectors or companies with genuine earnings power and structural relevance  — investors could confidently buy at a lower relative price (even ‘cheap’) and wait for the asymmetric upside when the catalyst inevitably appears.

Risk, not just Return

We highlighted in a precious article, that equity indices at extreme valuations aren’t just a good predictor of long-term returns, but highlighted the heightened short-term risk when these were super expensive – such as being in the top 5% of historical ranges. Avoiding regions with stretched valuation ratios is therefore important for 2 inputs within the portfolio construction process, expected return and EVEN MORE importantly, expected and potential risk.

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[1] Over short term time horizons such as 6 months to 2 years, valuation expansion or contraction could be further explained by momentum; a temporary earnings upset could lead to a fall in prices along with those earnings, however at an index level it could be argued the market should “look through” this etc.

[2] Earnings can’t continue to grow at an increasing rate forever, or else whatever you’ve invested in will quickly compound to be bigger than the whole world economy, and would BE 100% of the whole world economy!

[3] As above in the 2^nd footnote, this clearly can’t continue forever!