A contrarian's view on a return to volatility
Asia's favourite equity markets are still overvalued, lacking in transparency and ripe for catastrophic collapse. That's good news for some.
The recent turmoil in global equity markets may have spooked millions of investors around the world but it hasn't come as bad news to everyone. Contrarians like Stephen Diggle, a hedge fund manager with Artradis, have been betting on a return to volatility for the past few years.
When volatility started hitting all-time lows in 2005 analysts explained the phenomenon by arguing that a combination of financial derivatives, structured products and hedge funds had created a new paradigm in which risk was almost perfectly recycled through the financial markets. It was a nice idea, but Diggle and his colleagues didn't buy it. Literally. Today, while consensus theorists are struggling to explain what went wrong, Artradis is having its best month ever.
It will be a long time before volatility settles down, says Diggle, because of the amount of leverage still in the system. In the meantime, there may still be some money to be made. Speaking at an RBS event in Kota Kinabalu on Friday, Diggle gave delegates his views on Asian equities, which was not exactly music to the ears of those investors who still believe there is some value left in the market.
Perhaps unsurprisingly for a contrarian, Diggle took his first swipe at the region's most popular market. "Every hedge fund manager I know loves Korea because it's a very low PE market. We hate Korea," he said during a presentation that he had prepared even before the markets started to go haywire. "We also hate Hong Kong. And we hate India more than either of them."
Artradis's view is based in large part on the valuations on offer in those markets, but Diggle also treats dividend payouts as an important indicator of transparency and good corporate governance. "An auditors report is an opinion," says Diggle. "But a cheque in the post is a fact."
Price-earnings (PE) ratios in Korea may be attractive, but the companies don't pay dividends and that worries Diggle. If the companies are making so much money, where is it all going? In fact, PEs aren't even that low û trading at about a 60% premium to the 10-year average according to consensus forecasts. Even worse, Korean stocks are actually only paying a tiny premium over the risk-free rate or return. Put simply, even if you believe the accounts, investors aren't getting paid anything to buy Korean equities.
Holding Hong Kong or China stocks is an even less-attractive proposition, says Diggle. The Chinese market is trading at twice its 10-year average PE and investors could get better returns investing in safe bonds.
"The numbers speak for themselves," he says. "At some stage this market is going to have to catastrophically crash. The only justification for investing money in China is as a momentum trade."
India does not fare much better in Diggle's analysis. PEs there are up more than a quarter on the 10-year average and investors are being asked to pay five times book value. At the same time, safe investments in India can yield as much as 10%, which means stocks need to perform well-above expectations just to beat the risk-free rate.
Compare this to Europe, where the top 30 stocks are trading a quarter lower than their 10-year average PE and paying a 0.7% premium to safe bonds. Even the S&P 500 numbers look sustainable, if not particularly attractive.
So which markets does Diggle like? Taiwan is his favourite pick for now û bonds are paying very little while stocks are paying close to 6%, which gives investors a strong incentive to stay in the market. Indeed, dividend income alone makes Taiwanese stocks look more attractive than bonds. "It's illogical to sell," says Diggle. "Even if the market looks bumpy we believe drawdowns will be stable."
Japan is among Diggle's buys as a pure contrarian play. "Everyone hates Japan," he says. "As everyone's taking their money out we're buying calls on Japan."
That said, the valuations also look reasonable. PEs are trading at a one-quarter discount to the 10-year average and the equity premium over bonds is almost 3%.
Diggle favours Thailand for similar reasons. "We think, 'what the hell?'," he says. "It's been so low for so long û sentiment is as bad as 1997 û there is a chance for an improvement in sentiment, and it's not too expensive."
If Diggle's strategy seems cavalier it is because the rewards of being right just once are so great. "Right now we've got long calls in places we like and long puts in the markets we don't like," he says. "I don't have to be right on all of these. We make money if we're right on just 15% of these calls because they pay off exponentially."
When volatility started hitting all-time lows in 2005 analysts explained the phenomenon by arguing that a combination of financial derivatives, structured products and hedge funds had created a new paradigm in which risk was almost perfectly recycled through the financial markets. It was a nice idea, but Diggle and his colleagues didn't buy it. Literally. Today, while consensus theorists are struggling to explain what went wrong, Artradis is having its best month ever.
It will be a long time before volatility settles down, says Diggle, because of the amount of leverage still in the system. In the meantime, there may still be some money to be made. Speaking at an RBS event in Kota Kinabalu on Friday, Diggle gave delegates his views on Asian equities, which was not exactly music to the ears of those investors who still believe there is some value left in the market.
Perhaps unsurprisingly for a contrarian, Diggle took his first swipe at the region's most popular market. "Every hedge fund manager I know loves Korea because it's a very low PE market. We hate Korea," he said during a presentation that he had prepared even before the markets started to go haywire. "We also hate Hong Kong. And we hate India more than either of them."
Artradis's view is based in large part on the valuations on offer in those markets, but Diggle also treats dividend payouts as an important indicator of transparency and good corporate governance. "An auditors report is an opinion," says Diggle. "But a cheque in the post is a fact."
Price-earnings (PE) ratios in Korea may be attractive, but the companies don't pay dividends and that worries Diggle. If the companies are making so much money, where is it all going? In fact, PEs aren't even that low û trading at about a 60% premium to the 10-year average according to consensus forecasts. Even worse, Korean stocks are actually only paying a tiny premium over the risk-free rate or return. Put simply, even if you believe the accounts, investors aren't getting paid anything to buy Korean equities.
Holding Hong Kong or China stocks is an even less-attractive proposition, says Diggle. The Chinese market is trading at twice its 10-year average PE and investors could get better returns investing in safe bonds.
"The numbers speak for themselves," he says. "At some stage this market is going to have to catastrophically crash. The only justification for investing money in China is as a momentum trade."
India does not fare much better in Diggle's analysis. PEs there are up more than a quarter on the 10-year average and investors are being asked to pay five times book value. At the same time, safe investments in India can yield as much as 10%, which means stocks need to perform well-above expectations just to beat the risk-free rate.
Compare this to Europe, where the top 30 stocks are trading a quarter lower than their 10-year average PE and paying a 0.7% premium to safe bonds. Even the S&P 500 numbers look sustainable, if not particularly attractive.
So which markets does Diggle like? Taiwan is his favourite pick for now û bonds are paying very little while stocks are paying close to 6%, which gives investors a strong incentive to stay in the market. Indeed, dividend income alone makes Taiwanese stocks look more attractive than bonds. "It's illogical to sell," says Diggle. "Even if the market looks bumpy we believe drawdowns will be stable."
Japan is among Diggle's buys as a pure contrarian play. "Everyone hates Japan," he says. "As everyone's taking their money out we're buying calls on Japan."
That said, the valuations also look reasonable. PEs are trading at a one-quarter discount to the 10-year average and the equity premium over bonds is almost 3%.
Diggle favours Thailand for similar reasons. "We think, 'what the hell?'," he says. "It's been so low for so long û sentiment is as bad as 1997 û there is a chance for an improvement in sentiment, and it's not too expensive."
If Diggle's strategy seems cavalier it is because the rewards of being right just once are so great. "Right now we've got long calls in places we like and long puts in the markets we don't like," he says. "I don't have to be right on all of these. We make money if we're right on just 15% of these calls because they pay off exponentially."
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