Month: October 2010

The Case for Equities and How to Invest

“Quality is never an accident, it is always the result of intelligent effort” (Ruskin)

There appears to be at present a major discrepancy between quality and value – which reminds me of the Oscar Wilde quote that “a cynic knows the price of everything but the value of nothing”. As I highlighted in a prior post, What’s Driving the Markets and How Should I Invest?, investors have seemed to push up the price of lower quality companies, leaving an opportunity to invest in companies of higher value with upside potential of reversing its underperformance versus its index. I will now show how despite there being question marks over the value of the wider equity market versus its long-term average, against other asset classes the investment case looks strong – and there’s much cash waiting on the sidelines! Just remember – Quality, Quality, Quality!

Valuations may be unconvincing…

As you can see from the above chart it is arguable that relative to its long-run average, the equity market is fairly priced to slightly over-valued. To explain, using the same great blogger who sources the chart , the avid “Charter” of financial data, Doug Short: “The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. The total price of the market divided by the replacement cost of all its companies. The mean-adjusted chart above indicate that the market remains significantly overvalued by historical standards” — 41% to 52% (depending the version of calculation you choose).

… But risk premium is stretched…

US Cyc-Adj Earnings Yield (Non-Fin) vs. US Real Return on Cash (%). Source: Capital Economics

Despite my point on valuation, the above chart shows how little all the cash sitting on the sidelines is earning their investor and in stark contrast to the earnings yield some equities could be providing instead – a mighty enticing motivation to invest.

… the Case for Equity versus Bonds Strengthens…

Ok, so what about bonds? Surely that would be an equally enticing move? Perhaps better on a risk return basis? Actually no. The superior yield equities can offer versus bonds is well- exemplified in the chart below, from Jesse Felder in his contribution to Seeking Alpha, By One Measure Stocks Are Cheapest in Over Half a Century.

This highlights not only the motivation for a move from cash to equities, but also a switch from government bonds to equities. When discussing earnings yield it is interesting to remember Warren Buffett’s quote that: “earnings can be pliable as putty when a charlatan heads the company reporting them”, lending support to my focus on quality companies which includes the requirement of good management.

I showed in my previous post, How to Play the Bond Markets, how the case for bonds is no longer a “broad-based trade” and investment grade spreads are now 63% narrower than at their 2008/9 peak and now below 2002 levels.

… And it’s Not the Time for High Yield

Moving on to high yield, credit appears to have recovered much more than equities. The below chart (which will be uploaded tomorrow – an exciting insight from Merrill Lynch) shows that the last time high yield (called high grade (HG) in this graph) spreads were near 200 bps, the S&P 500 was between 1,400 and 1,500, vs. only 1,181 currently (20/10/10). (To keep this post short and snappy, I will explore this in more detail later)…

INVESTMENT INSIGHT – How to Invest

As previously expressed, this has been a low quality rally, driven by low quality, high beta names (exemplified in my chart showing US Consumer Discretionary which should be the most affected in a recession driving increases in the wider market) – Therefore active management remains key – sector and stock divergence

This is a ‘stock-pickers’ market. Invest in high quality companies (strong balance sheets, cash flow rich) which have the upside potential to re-rate to their intrinsic value and having underperformed during the periods of market over-exuberance.

How to play the Bond Markets

“Our lives are defined by opportunities, even the ones we miss” (F. Scott Fitzgerald)

I think the above title is apt for much of life, including the investment world, and the credit crisis was one such opportunity which served to make or break many mangers out there. A “broad-based” bet on parts of the fixed income asset class was enough to extract alpha. Now things are slightly trickier…

Investing is no longer a call on the asset class alone, but rather an emphasis on specifics is coming more into play.  Spreads have narrowed, from their historically wide levels (see chart below from an excellent fellow blogger the Calafia Beach Pundit, Scott Granis, the former Chief Economist at Western Asset Management and Seeking Alpha certified) but Corporates are focused on managing and strengthening their balance sheets. Differentiation in returns can be seen between sectors and between names. Thus, the key going forward is credit selection and a focus on quality.

I remain cautious on the high yield space, concerned with the possibility of the default rate coming in higher than expected and with lower levels of credit available to struggling companies, the recovery rate disappointing on the downside. This again highlights the importance of being name specific when investing. With spreads narrowing as far as the above chart shows, the risk / reward profile of this part of the asset class is not as attractive.

INVESTMENT INSIGHT: Be name specific, focused on high-quality companies with strong balance sheets

 


A Sustainable Recovery? “What’s driving the markets and how should I invest?”

The recovery is “neither strong nor balanced and runs the risk of not being sustained,” (Olivier Blanchard, the IMF’s chief economist)

INVESTMENT INSIGHT: Closely monitor the economy/markets – look to exploit overreaction on the downside, but with protection against future market pullbacks (E.g. via managers able to short / hedge exposures quickly).


Highlights

SENTIMENT DOMINATES: Markets driven by sentiment, cash on sidelines desperate to be invested

STIMULUS TO DECREASE: Earnings growth driven by cost cutting (a limited stimulus), to fall

INVEST WITH PROTECTION: Investing but with downside protection

 

Answer

The aggressive fiscal policies we have seen and the possible stabilisation or even turnaround in some data points have given fuel to the bullish. Nevertheless, with markets rallying so far from their lows, strongly driven by sentiment and perhaps ahead of fundamentals with investors focused on good news only, the possibility of a pullback is even higher. The market is moving from pricing in stabilisation to looking for a sustainable recovery, which is very risky. Further support for the possibility of a pullback comes from the fact that the rally which took the market to its current level, from March to year end last year, was arguably a low-quality, high beta and short-covering rally driven by discretionary consumer names which should be the most negatively affected in a recessionary environment (see charts below). Notice that since this point, the World Equity Index is flat, but the sector disparity has continued to widen. Nevertheless, I am also aware that there is plenty of cash on the sidelines and many managers judged against a benchmark cannot afford to miss out on another rally.

MSCI World Index +73% since 2009 low. Source: Bloomberg

During the 2009 equity market rally, the MSCI World Index (white) appreciated in value by ~70% from March low to year end. US Consumer Discretionary (orange) rallied ~90% whilst Consumer Staples (yellow) rose ~41%. Source: Bloomberg

What drove this rally? Markets rallied on better-than-expected corporate earnings but

  1. analyst estimates were so low that companies were bound to beat them;
  2. they were driven by cost cutting which companies cannot continue indefinitely;
  3. there has been talk of a “new normal” with growth in earnings reaching only 3% instead of the 5% we have been used to (Bill Gross)[1]

Bill Gross cites a move to a high persistent level of unemployment as support for his view. With lower income, higher savings, rising foreclosures and a credit restraining banking system, there still remains a strong case for the Bears to cling to. Across the “Pond”, the fragility of the UK market was highlighted when the BoE unexpectedly announcing massive expansion of quantitative easing program back in May of last year.[2] Many are now focusing on the possibility of a “double dip”, questioning how governments will be able to exit from their fiscal stimulus programs without dragging a muted recovery back into recession. This is before we discuss Europe which is widely believed to make a slower exit from the crisis.

US Unemployment Rate (%) at a heightened level. Source: Bloomberg

President Obama himself was given a stern warning from investment guru Warren Buffett about the severity of the situation. “He said, ‘We went through a wrenching recession. And so we have not fully recovered. We’re about 40, 50 percent back. But we’ve still got a long way to go’,” (Obama, July 2010)[3].

The situation remains unclear. At present there is enough data out there for Bulls to find reasons to be bullish as well as enough for Bears to find support for being bearish.

 

INVESTMENT INSIGHT: Until clarity returns, continue to closely monitor the situation to look for good entry points to exploit overreacting on the downside, but with the ability to protect from future market pullbacks (E.g. via managers able to short / hedge exposures quickly).

 

Demand for Debt limited, Outlook for Supply no better…. “How can I profit from this scenario?”

INVESTMENT INSIGHT: Invest in HIGH QUALITY companies – strong balance sheets – cash flow rich

“Despite various forms of support from the Bank of England and from Government, it is clear that the lending capacity of the banking system, in the UK and elsewhere, is impaired and will take some years yet to recover. Some banks need to continue de-risking and de-leveraging.” (Paul Fisher – Executive Director Markets and member of the Monetary Policy Committee – Bank of England)

 

As discussed, the outlook for the demand for debt is not looking rosy. Consumers, companies and governments are all focused on reducing the amount of borrowing on their “books”.  (See \”Isn\’t the consumer dead?..\”). On the other side of the equation, the supply of debt is also limited. Despite record stimulus packages, the amount of money that has reached the end user has remained muted.

In the US, commercial and industrial loans have fallen at an unprecedented rate.

 

Commercial and Industrial Loans at All Commercial Banks. Source: Board of Governors of the Federal Reserve System. Shaded areas indicate US recessions. 2010 research. stlouisfed.org

 

And in the UK, earlier this year, less banks stated they plan to increase supply of credit in June than March (BoE). Between Apr ‘11 and Jan ‘12 lenders are due to repay £185bn[1] raised under BoE special liquidity scheme. Furthermore, any banks that are able and willing to lend are being deterred with the threat of stricter global capital requirements looms as well as a tightening of credit scoring criteria.

INVESTMENT INSIGHT: Invest in high quality names, those with strong balance sheets, cash flow rich and therefore less likely to struggle needing to raise finance and instead more likely to have the capital to make value-adding acquisitions / increase market share

 

 

What is a “Structural limitation to growth”? How can I exploit it?

 

The ageing of the populations within, for example, the US and UK is a structural limitation to the growth of the economy. (See “isn’t the consumer dead?” for an insight into the amount of the country’s net wealth this part of the population account for and the degree to which they are ill-prepared financially for retirement).

 

Source: Office for National Statistics

 

Within the UK, the percentage of the population aged over 65 (retirement age) increased from 15% to 16% from 1984 to 2009, over the same time span going forward this is to increase from 16% to 23% by 2034. This is a substantial decrease in the percentage of the nation generating an income, spending and boosting the economy and instead increasing the proportion of the populace reliant on healthcare, a state pension and other costs to the government.

 

INVESTMENT INSIGHT: to exploit this long term secular trend, invest in specific healthcare companies, nursing homes etc. Be wary that they may underperform a raging bull market due to their “defensive” nature but as a long-term play they may “pay dividends” (excuse the pun!)

 

“Isn’t the consumer dead..?”

 

“American households have shifted their cash flows from illiquid real estate and consumer durables to paying down mortgages and consumer debt…It is this rapid rise in aversion to illiquid risk that explains a large part of the anaemic recovery in the US.” Greenspan

 

Highlights

DRIVER OF REVIVAL: The US consumer has historically been a crucial driver of economic renewal

PRECARIOUS POSITION: Many worried about employment, have under-saved for retirement

STIFFLED STIMULUS: The propensity to spend (and boost the economy) will be limited

 

 

Answer

The importance of the consumer and the concerns surrounding the structural headwinds they face are undeniable. Consumer spending accounts for approximately 70% of US GDP (although I’ve read an interesting piece by Darren Marron arguing this figure is actually nearer 60% when spending on imports are dealt with more appropriately[1] but nevertheless, this is still a significant percentage). The magnitude of the problem has been well described by John Maudlin who pointed out that versus the last recession, we have seen “double the asset deflation, triple the job loss, coupled with a collapse in credit.” It doesn’t look likely that the consumer will be bouncing straight back!

 

Conference Board Consumer Confidence Index down 57% since 2007. Source: Bloomberg

 

On the subject of unemployment, although it is universally monitored, what has been missed by many is what the rate does not take into account. Salaries have been cut and working hours reduced. This adds to the misery of many consumers. Furthermore, it is these people who are working part-time that will be hired back into full-time employment before companies reach out to the many unemployed. This must be assessed within the context of an expanding labour force where a substantial amount of new jobs are needed every month in the US.

 

Looking forward, another key limiting factor on the consumers’ propensity to spend is the move to save instead, as they look to fund their retirement / non-wage earning years. The “Baby Boom” generation is expected to account for nearly 60% of net US wealth by 2015, according to a study by McKinsey,[2] and their turnaround from spending to focus on saving will be magnified by the fact that they have historically under-saved. The aforementioned report identified that as low as only 25% are “financially prepared for retirement”, thus the decrease in the spending habits of the vast majority will be significant.  Inside Europe the story isn’t much brighter and the UK pension gap (the difference between the income needed to live a comfortable retirement and the actual income individuals can expect from their current pensions) has been heralded as the “biggest in Europe”[3] by national papers. The OECD sets an average pension at around 59% of the earnings built during a full working career, a stark comparison with the UK’s 31%[4]. With relatively small public pension, an individual will need to make extra savings to ensure their standard of living does not drop dramatically as they move into retirement. This is not an outlook that will encourage the spending that will boost or even support the economy. (For a deeper insight into the ageing populations of the developed world see What is a \”Structural limitation to growth\”? How can I exploit it?)

 

 

Savings Rate, US. Source: McKinsey Global Institute analysis

 

ECONOMIC IMPACT: This points to a muted recovery instead of a “V” shaped bounce-back.

INVESTMENT INSIGHT: Look at companies which aren’t as heavily reliant on the Developed Consumer but with an international reach and operations within Emerging Markets. To exploit the ageing of the “Baby Boomers” within Developed Markets, see What is a \”structural limitation to growth\”? How can I exploit it? and invest in companies positioned to benefit from an increased reliance on healthcare, nursing homes etc.

 

 

 

A “House View”

The search for yield is becoming an ever tougher quest for investors, especially the more cautious amongst us. Arguably, the easy money has already been made within the fixed income space; cash offers little as an investment vehicle and many question what the growth drivers will be behind many developed market economies and stock markets. Thus we are left asking, where should one invest?

We also need to question the type of environment we are investing in. Government action will be highly influential as it exits from its policy of Monetary Easing. Timing will be crucial but almost impossible to get right. Too early and we risk dipping back into recession and experiencing the destructive forces of deflation; too late and the threat of rampant inflation rears its head.  The consensus is that the government will favour the latter option as the lesser of two evils. Either way, any recovery the world sees may be a volatile one and clarity may remain elusive. Concerns over debt are still acute and here in the UK the Government predicts expenditure, revenues and debt are to get worse before getting better.

Thus I highlight the importance of an active management approach to investing, where the manager has the ability to react quickly to the changing environment and provide protection on the downside. Focus is also on being selective within each asset class. Although no longer a broad-based trade, opportunities remain within fixed income, with quality paramount and the focus on being name specific. Equities are looking more interesting. Nevertheless, with the potential for corrections in the markets in the near-term, investing with long / short managers, who have a proven track record of navigating the choppy markets of the last few years successfully and who are well-positioned to exploit opportunities both on the upside and downside, is attractive.

Emphasis is on being pro-active rather than reactive and continuing to monitor the changing economic and market environments closely.

INVESTMENT INSIGHT

ACTIVE MANAGEMENT

ALLOCATE TO EQUITIES

ANTICIPATE A MARKET PULLBACK (i.e. invest via long/short managers able to protect on the downside)