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Revisit value versus price


What is the value of an investment portfolio?  Expectations today are that one can log into a system and have a reasonably accurate snapshot of wealth, allowing for a few days or possibly monthly pricing differential for some asset classes.

That may create a misleading picture. As has been well publicised, industry super funds are grappling with the valuation of unlisted assets to create a fair playing field for those that want to withdraw capital versus those that elect to add to their fund. Reports suggest that a few have devalued the unlisted holdings by between 5-10 per cent.

Valuations rely on a wide range of metrics by convention and weighted to assumptions of future cash flows. Perhaps one of the flaws in providing investment advice is that the client is rarely shown an illustration of how various assets are valued.

  • For example, a simple operating model of a transparent industry and how markets may apply a multiple to enterprise value, cash flows, expected earnings or dividend yields. The most misleading would likely be a target price set by an investment bank given there is little accountability for this data.

    Then take a bond or corporate credit with duration, credit spreads and defaults in the mix. Change the input assumptions on any of these and consider the sensitivity to the assessed value. The arbitrary nature of pricing mechanisms is not a topic that most advisors would undertake given it is likely to confuse. Yet with any dislocation in financial markets, investor anxiety is heightened by an absence of understanding these machinations.

    As the months roll on, it will be of interest to see how unlisted assets are valued across the fund management industry. Comment from some private credit providers is that without any change to expected cash flow, the value has not moved.

    Yet it would be heroic to assume one could today realise such a portfolio without loss of capital given the widening spreads in investment grade. Another example might be a real estate asset with a long lease.  Assume the tenant is paying the lease and there is no reason to believe that will change. At an extreme, an argument could be made that given the fall in the bond rate, the asset is now worth more. That would be a brave move.

    The differential valuation between the pricing of listed equity and apparently price-insensitive private assets makes little sense. Imagine a comparison between a listed infrastructure company and a similarly structured unlisted entity. In principle, there should be no difference.

    Equity pricing should not be so dependent on sentiment, nor should unlisted assets be a world to itself in terms of methodology and frequency. Yet this is the reality and can play havoc with an investment portfolio.

    An alternative, albeit more complex solution, is to assume that valuations should be the basis of judging a portfolio regardless of the pricing mechanism.  This might mean basing listed equity on a range of well- known data points; long-run historic average P/E, CAPE ratio, price/book, dividend yield, price to cash flow, credit on historic spreads and default rates and unlisted assets on a cash flow stream discounted by a risk premium. Within all these the fundamentals of the investment matter more than the behaviour of markets.

    Consider a portfolio with 30 per cent Australian equity, 30 per cent global equity split two-third developed, one-thirds emerging markets, 30 per cent in credit and 10 per cent in unlisted assets. The ASX200 is not yet cheap, rather slightly above historic averages. Therefore, discount the stated valuation by say 5 per cent.

    Global equities are either at long term valuations (US) or cheap (Japan, UK/Europe and Asia) and therefore undervalued perhaps by a weighted average of 5 per cent. Conversely, credit spreads imply default rates that we have not experienced before. Credit, therefore, should be valued higher, perhaps by around 5%. Lastly, unlisted assets are case by case, for the sake of the argument assume the fair value is 5% lower. The total portfolio is slightly undervalued regardless of what happens in markets tomorrow.

    The reality is that we are currently in payback for extended equity valuations and tight risky credit spreads along with lightweight quality assessments. In hindsight, such portfolios were overpriced compared to their fair value.

    Investors may rather be made aware of such a possibility than hear opinions on so-called recovery to previous highs. Whatever methodology one uses, it is likely to be more helpful for investors to hear a grounded assessment than the hope of something magical.

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