How to identify mispriced opportunities in the market

Note: This interview was recorded on 22 October 2024.

Uncertainty in markets may feel painful to investors, but they can also be a source of opportunity. Periods of uncertainty can open up mispriced opportunities, particularly when fundamental value is a critical component of your investment philosophy.

For Western Asset Management's Anthony Kirkham, identifying those opportunities is about deep analysis.

“We’ve developed different models to highlight when we believe markets or securities are mispriced, or sectors are mispriced, and that makes our job a bit easier in terms of finding those, but you’ve got to evaluate those as well,” he says.

When it comes to mispricing in the bond market specifically, he finds large participants in the market will have a focus area and their buying behaviour can then move securities or sectors out of line, opening mispriced opportunities.

“My example there would be if you think about a Japanese insurance company, it tends to look a bit more long-term – 10-year focused, and if they’re investing a reasonable amount of capital into a market, then you can see that 10-year part of the curve can get mispriced,” Kirkham says.

In this episode of The Pitch, Kirkham discusses his investment philosophy and approach to mispricing. He also shares the opportunities he is seeing in certain sectors and what is driving that mispricing.

Edited transcript

How has your investment philosophy changed over your career and how does it align with Western Asset Management?

The good thing is I’ve actually been at Western Asset and its predecessor for over 25 years. So, my investment philosophy probably started out very similar to what Western Asset had as its base. It’s an investment philosophy that Western has had for over 50 years, so they see it as time-tested, and I would say it makes a lot of sense for what we do with fixed income.

It does have the components to it that really work in terms of investment philosophy, when you think about markets and trying to add value for your clients. Starting out with that long-term fundamental value is a really key starting point for our philosophy. Obviously looking at and valuing for mispriced securities is a really key component of that and looking long term is key and makes sense within a fund management firm like ours.

With that though, and it's the other side to our investment philosophy, is that you're not always going to be right. We'd love to be, but the reality is not going to happen, and so therefore we must have multiple and diversified strategies as a part of our positioning.

And, thinking about how all your different positions are leaning, understanding that they could be leaning the same way in different economic environments is really key to that investment philosophy. Therefore, we really try to make sure that we do have them diversified so that if we do get our view wrong, it doesn't mean that our performance is going to be totally impacted as a result. So that's really the key component of it.

You mentioned systematically identifying mispricing. What does this mean in practice and how do you go about it?

As a fundamental firm, we do have deep teams in terms of analysis. In fact, if you look at our analytical team, it is one of the largest buy-side teams in the market. They generally are career analysts, so they're not trying to become PMs, they're career analysts looking at markets and looking at different sectors and obviously down to individual securities. And it's the same for the portfolio management team. We are thinking about those opportunities and trying to put them together in a way that, as I said, is somewhat diversified.

We do have a number of tools that we use as well. We’ve developed different models just to really highlight when we believe markets or securities are mispriced or sectors are mispriced, and that makes our job a bit easy in terms of finding those, but then you've got to evaluate those as well. And so that's where you really do rely on those deep teams to look at those sectors, look at the industries, and then obviously look at the individual names to have an understanding of where that valuation might be.

What factors are behind these mispricings and what's your view on them at the moment?

Particularly in the Australian bond market, which typically would just be made up of investors similar to ourselves or insurance companies, our market grew a lot because government debt grew. It meant that you actually were open to the world to invest in it, and so therefore you've got a lot of different investors coming to our market for different reasons.

We have found that those participants will be looking at different parts of the yield curve or different sectors within it. And because they're generally large players, they can certainly move securities out of line or move sectors out of line. 

We've definitely seen that over the years, and so therefore, finding where that is or that sector or that security is mispriced is on that basis that they're looking at it from a different objective.

My example there would be if you think about a Japanese insurance company, it tends to look a bit more long-term – 10-year focused, and if they’re investing a reasonable amount of capital into a market, then you can see that 10-year part of the curve can get mispriced. If they're chasing semi-governments or SSAS or even corporates at different parts of the yield curve, then they do get somewhat mispriced. So, it's about capturing those within the tools that we have to see where that valuation is out of line and therefore lean into those or lean out of them if it looks expensive.

Where are you seeing mispricing today?

It's probably a bit more sector-based.

We've certainly seen some within, say, REITs is a good example, pretty much post-2022, where the yields rose valuations on REITs globally really got out of line because some of them were too levered. 

Work habits changed obviously, particularly on the office side, which probably drove some of that change in those valuations. Therefore, REITs globally saw a widening in spreads. But in Australia, when you look at our REIT sector relative to, say, the US, it's much more lower levered. So, you have that.

Generally, you'll find within those pools of assets, there are different levels of quality. Too often, our Prime A grade buildings are sitting inside those REITs, so they're larger corporations, better regulated, and therefore as a result of being Prime and A grade, even as people's habits around the office change, people were actually still wanting to obviously lease that space in Prime and A grade buildings because they were the best buildings, they were located in the best spots and therefore they actually performed reasonably well.

I think the other component of that is that a lot of our routes also are diversified in nature as well. They're not just offices. You've got the retailers component, you've got industrials as part of that, and all of those have actually done reasonably well in this environment. Therefore, the pricing of them got pushed wider as a result of what was happening offshore.

But for us, we could say, “Hey, these shouldn't be going wider. These are actually good performing assets”, and so you'd lean into that sector and we've seen those actual contracts in. So yeah, there was definitely a bit of that and we're still a bit overweight those to be honest, because there's probably a little bit more to go in some of that within some of those REITs.

Learn more

Anthony's fund is designed to be an active core fixed income allocation with a mandate to provide both defensive exposure and disciplined alpha generation. Learn more via the fund profile below, or visit the Franklin Templeton website for more information.

Managed Fund

Western Asset Australian Bond Fund

Australian Fixed Income

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