Markets are at all-time highs

Global equity indices are trading close to their all-time highs. Twenty-eight of the 47 countries included in the MSCI All Country World Index (ACWI) achieved 52-week highs early in August this year. The 11% p.a. US dollar return produced by the ACWI over the past five years is comfortably ahead of the 8.5% p.a. achieved since its inception in 1987.

Following this strong run, investors may be bracing for a cautionary message, in which we argue that the outlook is now poor and that future returns are likely to be underwhelming. This was indeed our view at the end of 2012, after a similar period of strong market returns.

However, we are very optimistic about the opportunity set we are seeing in markets today. This view is reflected in today’s full (~75%) equity allocation in Coronation Balanced Plus compared to the ~55% allocation we held in December 2012.

SO WHY ARE WE SEEING OPPORTUNITY NOTWITHSTANDING RECORD-HIGH MARKETS?

Market returns around the world have become increasingly concentrated and narrow, driven by a few large companies that have been mega winners. As a result of this concentration, benchmarks are less representative of the broader market.

The following chart (Figure 1) shows just how narrow global equity market returns have been over the last four calendar years, for a relatively small group of stocks outperforming the broader market.

The consequence of a narrow market is that as narrative, attention, and capital converge on what is working, 'Everything Else' is neglected, presenting an opportunity to those who are prepared to look beyond the momentum and instead focus on the price you pay for an asset.

Capital has flowed aggressively into the obvious AI winners: the frontier AI labs and the picks-and-shovels businesses supplying the chips, hardware, and infrastructure that underpin AI development.

At the same time, the sell-off on the other side of market momentum has been equally aggressive and even less discriminating. Businesses in the digital economy that could potentially be disrupted by AI have been marked down sharply, often with little regard for their individual fundamentals. The market has been shooting first and asking questions later.

That disconnect is where we are finding opportunity, and it shows up across three distinct pockets of the market. The first is businesses widely perceived as AI losers, which we believe will use the technology to strengthen rather than surrender their competitive positions. The second is high-quality compounders (in other words, businesses with durable earnings power and strong franchises) that the market has moved on from because they are not part of the AI narrative, even though very little about their underlying prospects has changed. The third category includes businesses that are actively reinvesting to become AI-fit, where the market penalises near-term costs without giving credit for the long-term competitive advantage that investment is building.

WHAT DOES IT MEAN FOR INVESTORS?

The best way to demonstrate the extent of the opportunity set is to look at what our global equity portfolio is currently priced to deliver. Our research process estimates a fair value for every business we own, which measures what we believe each company is worth based on its earnings power, competitive position, and long-term prospects. The gap between today's price and that estimate is defined as upside to fair value. Across our global equity portfolio, that figure is currently around 90% (see Figure 2). We have rarely seen this level in the portfolio's history, and typically only after markets have experienced significant drawdowns, not while the headline indices are still trading at all-time highs.

Historically, there has been a strong positive correlation between upside and future returns. If our assessment of what these businesses are worth turns out to be broadly correct, future returns should be significantly above average.

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