Investors need to shift their focus to companies that offer both quality and value in today's stock market, in which equities prices are showing signs of overvaluation, according to a new report on global equities from Manulife Asset Management Ltd. published on Tuesday.
"There are opportunities out there despite the valuation-rich environment," writes Paul Boyne, senior managing director and lead portfolio manager of Manulife's global equities strategy team and author of Understanding Value in a Valuation Rich Environment.
Quality companies, Boyne writes, are those with proven track records of achieving rates of return on invested capital that are greater than the cost of capital; solid balance sheets with manageable levels of debt and sustainable cash flows; and strong management teams that understand their core businesses and stay disciplined.
"Getting a company's valuation right is only half of the equation," Boyne says. "It's just as important to have a considered view on the quality of a company."
With price/earnings multiples for most global indices well above their historical averages, the report suggests that the market today favours active management and a critical approach to stock picking.
"We currently see opportunities in the financial [services] sector, although we continue to have a very cautious view of the European banking sector," Boyne writes. "We also continue to favour sustainable quality franchises within consumer staples. It should also come as no surprise that we are underweight the most expensive markets and have maintained a negative view of the utilities sector."
Investor sentiment at the moment remains high, the report suggests, despite the warning signals being sent from various valuation measures.
"Equity valuation is closer to the stretched side of the equation, having been lifted by the wave of optimism that has taken hold since last November," Boyne writes.
Corporate debt levels also appear to be "elevated," a trend that the report believes "warrants monitoring." And the capital that corporations have raised appears to be used more for buybacks and dividends rather than reinvestments into businesses.
"There is optimism [in the market] that share prices will continue to appreciate," Boyne writes. "However, there is underlying evidence suggesting that the contrary could happen — a perspective that's consistent with our views."
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