The speed and extent of this year’s equity bull market has arguably made it trickier to position for the longer-term economic recovery. Martin Steward asks portfolio managers about the courses they are setting
You’d be forgiven for thinking that 2009 must have been a great year to be an equity portfolio manager. And it was - if you bought all the trash you could lay your hands on as you got out of bed on Monday, 9 March. But if you pick stocks with a long-term view based on bottom-up fundamentals, your performance this year might suggest that you’ve missed the wood for the trees.
From top-down to bottom-up?
“Since oil peaked, the macro influence on returns has been dramatic, and that makes things difficult for bottom-up fund managers,” laments Chris Herrera, lead portfolio manager at Nicholas Applegate Capital Management. “If you look at the traditional stable-growth companies that have been underperforming, there is a striking correlation between that and the negative movement in the dollar, for example.”
Plenty agree, and most are now calling time for a return to bottom-up drivers. If you haven’t been exposed to the right sectors this year “you’ve had a pretty dreadful time of it”, says Nick Hamilton, head of equity products at Invesco Perpetual. “Brokers tell us that participants buying financials and materials often did so without a strong fundamental conviction,” he says. “We’re resigned that here may be one last big squeeze into these stocks - but that doesn’t make them the ones to own longer term.” For the last two years “it didn’t matter which stock you owned but which sector you owned,” says RCM’s Europe CIO, Neil Dwane. “But since July, in many areas, the performance of the stock is again the most significant driver.”
Not everyone buys this top-down to bottom-up narrative. “People always say that,” says Andy Headley, portfolio manager and head of research at Veritas Asset Management, a bottom-up stockpicker working with a thematic top-down framework. “Isn’t it always a stockpickers’ market? Utilities have been awful this year - but we know at least one, in Brazil, which doubled.” Even Herrera notes that some of his best-performing stocks have been from the year’s worst-performing sector - healthcare - thanks to a strategy that shunned traditional big pharma in favour of positions in companies like ophthalmology specialist Alcon Laboratories.
Furthermore, it is not clear that the top-down factors have gone away yet. As Dwane concedes, there is “a dislocation between what the market is doing and what’s happening in the real economy”, and with rates likely to be held low to protect the recovery “there could continue to be a mismatch between the market and the economy”. With a great deal of money still looking enviously on from the sidelines, a great deal sitting nervously on double-digit gains since March, and central banks grappling with exit strategies, the stage may well be set for some sizeable moves by that risk capital. Morgan Stanley’s UK equity strategist Graham Secker puts a 30% probability on the FTSE100 re-testing the lows of March 2009, while Credit Suisse’s global equity strategist Andrew Garthwaite suggests that “the macro environment will decide 2010, and investors in sovereign debt will probably decide the fate of risk assets”.
From trashy value to quality growth?
It seems more certain that growth will make up some ground against value. The S&P500 at 18-times earnings (and about 15-times 2010 earnings) no longer looks cheap. Getting to those levels from the despair of February has seen huge outperformance from basic valuation (P/E, P/B) and quality metrics (low return on equity, high beta).
“It will be more likely to see continued performance through improvement of earnings rather than the market going to 20-times P/E,” says Herrera, whose growth-tilt has seen him suffer since March. “Over the last few months we have seen earnings momentum, for example, starting a slight pick-up.”
Investors usually start to pay a premium for growth as economic recovery sets in and the ability to grow earnings faster than peers stands out as the rising tide floats all boats. But a further, counter-intuitive case could be made for serious growth outperformance based on the current very low visibility into forward earnings. Those earnings usually grow as consumers rediscover their appetite to spend. “That cycle just isn’t being seen this time around,” says Hamilton. Schroders’ head of global equities, Virginie Maissoneuve, agrees: “Earnings look much healthier and companies have cut costs - but what happens after April? We need to see final demand coming back. We can’t predict that and neither can the companies themselves.” That could translate into a big premium for top-lines tough enough to withstand a long grind-down in broader demand: “This year has seen lower visibility on earnings than at any stage in many investors’ careers,” says Laurence Taylor, a portfolio specialist at T Rowe Price. “We’ve focused on whether a company is going to be around in a year’s time, and then second, in a low or zero-growth environment, what is the company and its assets worth, does it have a right to exist?”
That existential question leads us to the Altman Z-Score, a combination of five ratios used to measure a company’s risk of bankruptcy. According to multi-asset boutique Armstrong Investment Management, the bottom quartile of the S&P500 by Z-Score has doubled in value since March (even as their Z-Scores failed to improve), while the top quartile is up, in line with the broad market at 40-50%. “We think there’s a play on these high-quality stocks,” says managing partner Patrick Armstrong, “almost a return to a Nifty Fifty-type environment.”
There is a consensus for robust pricing power, strong balance sheets and the potential to put cash to work improving operations or acquiring new assets. The primary bond markets have thrown money at the right companies through 2009, and will be more than happy to see it put to work in the right ways. Taylor points to Roche’s acquisition of Genetech, which “will be earnings-accretive pretty quickly and very complementary to their business”. These companies are also the most likely to maintain dividends, and given that the broad S&P500 dividend declined by 21% in 2009 and that Standard & Poor’s estimates that only 6% of that will be clawed back in 2010, it should pay to maximise that exposure. “The companies that lagged the market this year are the ones paying 6-9% dividends that have been tested through such a tough economy,” says Invesco Perpetual’s Hamilton.
Pro-quality doesn’t translate easily into traditional long-defensives short-cyclicals: tech is universally loved for its quasi-monopolistic market shares and self-funding capacity for R&D. Few are betting against consumer staples but political uncertainty may continue to weigh on healthcare and investors remain wary of over-leveraged utilities.
At Veritas, a 2006 theme called ‘Resilience’, designed to identify companies with strong balance sheets and stable demand to weather a credit crunch, is evolving into ‘Strong Survivors’. The change is subtle, bringing beaten-up but market-leading cyclicals - like Kingspan Insulation, whose main market is new homes in the UK and Ireland - into the frame. “The first question is, Will Kingspan survive?” says Headley. “We waited until they’d completed a big debt refinancing before taking a position. The next question is, What will they do in 2012-13?” He bought a stock that had peaked at €22.00 in May 2007 when it hit €4.00, and saw it bottom-out at €2.00 before starting its recovery.
Many others go for this “chicken cyclical” tilt. Hamilton likes industrial services for their exposure to economic recovery anchored by stable earnings streams; RCM global equities CIO Lucy Macdonald reports a move towards healthcare, consumer staples and tech, but will retain neutral risk in energy and materials “while China continues to grow”; Maissoneuve at Schroders gratefully picked up stocks like Rio Tinto, BMW and Nokia at rock-bottom prices and is prepared to hold them based on long-term views on emerging-market industrialisation, energy efficiency and demographic change, as well as her favourable impression of management.
Indeed, these market inflexion points often make it difficult to figure out whether managers are buying individual stocks as value or growth. As Ignis Asset Management’s value-investing director of specialist funds, James Smith, puts it, “some traditional growth sectors are appearing as value on our internal screens due to the divergence in performance this year”. Similarly, Gary Motyl, global equities CIO at value manager Franklin Templeton, says that it has been a while since his firm had such a big exposure to tech, and healthcare and telecoms are also in-favour - “not traditional value stocks, but stocks which under our five-year analysis look extremely undervalued”. Perhaps the key question is for manager selectors: if we do get a pro or even ultra-growth market, will value managers be able to let their profits run to their full potential?
From developed to emerging markets?
Most global equity managers appear neutrally-weighted between the US and Europe: some argue that pro-cyclical Europe edges it during a recovery; the more conservative prefer the US’s hulking conglomerates. But most of the risk is being taken in emerging markets.
The macreconomic argument doesn’t need to be rehearsed again here: unlike quality and growth, this is hardly a new story. As Armageddon faded in the rear-view mirror, investors stampeded back in - the MSCI EM index has outpaced the MSCI World Index by 30 percentage points this year. If anywhere will deliver the economic growth to support those valuations, it will be emerging markets, but, how much more juice is in the tank?
Rekha Sharma, global strategist at JPMorgan Asset Management, describes “a nervous long”, valuations “a bit stretched”, and the commodities and Asia growth stories as “both a benefit and a risk”. Franklin Templeton’s Motyl concedes that “we are not generating many new buy ideas”. On the other hand Carmignac Gestion recently estimated that emerging market companies are still discounted at an average of 20% compared with developed market indices; while Asia-Pacific equities specialist Jason Pidcock at Newton anticipates a wave of cross-border M&A to feed the markets in a repeat of “the mid-1980s boom”.
“A lot of big thematics roll off the tongue so easily,” warns Hamilton. “If you’re not being asked to pay too much for it, you clearly want it - but if you’re being asked to discount 20-30% growth way out into the future it’s more difficult.”
If you believe that you are being asked to pay too much, it might pay to look for exposure via developed market companies with a high proportion of revenues sourced from the emerging world. This might be an argument for European exporters; or perhaps even Japan. (We will explore this idea in more depth in our February issue).
So, for the next couple of years, global equity managers recommend bottom-up quality (but don’t be surprised if you get punished or rewarded from the top-down in the short-term); growth (at a reasonable price, with a risk that excess liquidity or the resilient consumer might keep value in the game); and emerging markets (as long as you don’t get sucked into paying too much for them). Unsurprisingly, most are now building more balanced portfolios: we are moving from an either/or market to one where diversification begins to pay off once again.