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It’s easy to get caught up in market narratives. When news flow is good and sentiment positive, investors tend to buy popular securities at any price, paying lip service to valuation and risk.
When news is bad and share prices fall, fear of loss makes investors retreat – from real risks, but also those that may be unfounded or overstated.
While it is important to avoid getting swept up in prevailing hype or gloom, it is equally important not to ignore the narrative altogether.
“Some of the best investment opportunities can arise from strong negative narratives,” says Philipp Wörz, fund manager at PSG Asset Management. “In fact, they are a necessary pre-condition to finding quality companies at cheap valuations.”
‘The death of the PC’
Consider Microsoft – a company whose products many of us use daily. In 2012, Microsoft’s share price had effectively been flat for a decade, trading in a range of $20 to $30. Over that period, earnings per share had continued to compound by over 10%.
The popular narrative back then was that technological advancements like mobile, cloud computing and the move away from upfront software licences would significantly impair Microsoft’s business model.
“This view was overly simplistic, given the company’s considerable moat in enterprise computing and the fact that its consumer segment only accounted for a small part of the overall business,” Wörz says.
At the time, it had $50bn in cash on its balance sheet and was generating roughly $24bn of free cash flow.
But a winding down of the business had already been discounted in the share price, making it available at a compelling price-to-earnings ratio (P/E) of less than 10 times.
Fast forward five years: Microsoft has transitioned into the Cloud and subscription services, and doubts about its continued relevance are long forgotten.
Now, at a share price of $76, it trades at a P/E of well over 20 times.
A current narrative: ‘Death by retail’
A strong prevailing narrative is the predicted demise of brick-and-mortar retailers (particularly in the US), due to the growing dominance of Amazon and other online players.
As such, share prices in the sector have come under significant pressure. While the narrative may generally hold true, its broad application across the retail sector has created the potential for significant mispricings.
Within the retail space, niche, vertically integrated brand owners such as US-listed L Brands are attractive. L Brands has a direct-to-consumer business model and is the market leader in the US lingerie market, with well-known brands Victoria’s Secret and Pink.
It is also the owner of the highly successful US fragrance and skincare business, Bath & Body Works.
“Concerns about the company’s recent slowdown in trading can largely be attributed to discontinued product lines, while its international business is expected to gain significant traction over the next three to five years.”
L Brands’ share price traded at an all-time high of just under $100 less than two years ago but dropped as low as $35 in August 2017.
“This offered a great opportunity to acquire a high-quality and relevant business in an unloved part of the market, at a cheap valuation and large discount to our estimate of intrinsic value.”
As fertile a hunting ground as negative narratives may be, investors should be careful to avoid companies that are out of favour for good reason.
Quality and valuation are equally important considerations, both when prices may be inflated and when they may be justifiably low.
