US Equities: Squeezing the last drops
US corporate margins have expanded impressively since the crisis. Joseph Mariathasan asks where the next wave of growth is going to come from
As Apple leads the way in showing the world what US companies can achieve, investors grapple with the issue of whether the rest of the US economy’s recovery from the financial crash is sustainable, and whether the US banks are now in any position to support the US corporate sector.
Can US corporate profits continue the upward momentum they have shown since 2009? US unemployment figures suggest that much of this improvement in profits has come at the expense of labour. Balance sheets groaning under the weight of cash piles suggest that the much of the rest has come at the expense of capital projects, but there is a limit as to how much earnings can be increased by cutting costs.
“A lot of the profit recovery during the last three years was driven by margin recovery, as there has been a margin rally from March 2009,” explains Paul Chew, head of investments at Brown Advisory. “US companies have seen margins recover despite sales that are below the prior peak. Companies have done more with less and have been hesitant to hire employees.”
Meanwhile the US banks seem to be in much better shape than their European brethren after de-gearing seriously through equity issuance in 2010. But how important is this in an environment where non-financial corporates appear to have plenty of cash to work with, even without bank financing?
Europe, like the US, has to deal with huge debt overhangs, anaemic growth prospects but also has the burden of supporting the struggling periphery of the euro-zone. The US, by comparison, is looking much healthier and US equity managers are very optimistic.
“Every time I want to feel concerned, I look at what is happening on an individual company basis and what I am paying - and I feel better,” says Chew.
Joseph Carson, US economist at AllianceBernstein, recently released a note entitled ‘Has the “Real” US Economic Recovery Just Begun?’ As that title suggests, his view is that the US is in the early stages of a durable growth recovery.
Michael Hood, market strategist at JP Morgan Asset Management, suggested in a recent note that the US may even be experiencing a revival in manufacturing. The worry for investors is that, as Carson’s note implies, although the US has technically been out of recession since mid-2009, the economic recovery so far has been atypical.
Clearly, investing in US equities is also a play on the global economy. “Global GDP growth is what US companies have access to,” argues Richard Pzena, CIO of value investor Pzena Investment Management. “Just because they are US-based and US-listed does not mean they are constrained by US GDP growth. They are very adept at moving to where there is growth in the world.”
Chew points out that 50% of the sales of S&P500 companies are outside the US, and a lot of global consumer brands are focusing on emerging consumers. However, these figures can understate the exposure to the US domestic economy. Qualcomm, for example, sells 80% of its products outside the US - but these are electronic chips that are incorporated into devices that are themselves sold in large quantities to consumers back home.
Sure enough, around 70% of the US economy is driven by consumer consumption - but the US economy lost a lot of jobs during the downturn. So while the growth in US GDP has been accounted for by exports and business investment, the consumer-oriented sectors that traditionally lead the early stage of a recovery, such as staples and residential property investment, have underperformed.
“Margins are pretty good already,” says Chew. “We cannot expect them to rise, so earnings figures are driven by top-line sales. Creating jobs increases consumer consumption.” In other words, prospects for the US corporate sector are highly dependent on the outlook for employment.
The real estate and construction industries were among the worst affected by the financial crash, and with a housing market full of foreclosures, prospects are still uncertain. Chew does see hiring by smaller companies in areas such as technology.
“At the beginning of Q4 2011, companies found that they could not squeeze more out of employees without hiring workers. Now we are seeing an improvement in the jobs figures,” he says. However, the March preliminary payroll report was disappointing, showing a smaller-than-expected gain. But Chew adds a note of caution about extrapolating these figures.
“Over the past two years, in spring and summer the jobs data saw a downturn,” he observes. “There is a seasonal adjustment factor which can skew figures, as the government is trying to smooth out the numbers hired for summer employment. There are a lot of construction workers hired over the summer, and if that industry is not hiring then the figures may show a seasonal over-adjustment. So you cannot place too much reliance on the jobs figures and they may create some noise around the employment recovery.”
Carson argues that the broader trends in the six months to mid April offer much more convincing evidence about the recovery of US labour markets. In his view, enough progress has been made in both employment gains and traditional domestic engines to provide an important lift to recovery.
Hood argues that higher labour costs abroad, particularly in China, may boost domestic manufacturing. It would also reflect the end of the secular increase in corporate profit margins, which he attributes at least in part to companies moving to take advantage of cheap labour costs outside the US.
This would fit with Chew’s argument that the profit picture in the US is now tracking top line growth rather than margin expansion - and his investment strategy, which favours companies that can deliver that top-line growth rather than looking for more ways to expand margins. The same strategy seems to be driving M&A and buyout activity. The time for acquiring businesses to make efficiency cuts has passed, and the focus, particularly from trade buyers, is on buying in growth.
But while employment seems to be recovering, albeit slowly, growth also depends on investment - which is not. The debt-to-equity ratio for the S&P500 is just 1.3 times today, having hit 2.2 times in 2007, and there is no sign of a reversal in deleveraging.
“US corporates are nervous about investing and very uncertain about the future,” says Pzena, who, as a value investor, is far from concerned by this trend. “They don’t want to start new initiatives such as R&D, new product development or new plants. Why build a new plant if you don’t need to? When they run out of capacity they will spend. If I can get 20% current earnings yield, why do I need growth? If companies never had growth from now to eternity I would be a happy man. When companies are in a position to spend money to generate growth, the evidence suggests that it’s time to exit. During capital spending cycles, you should be heading for the hills.”
This has consequences for one sector that makes up a big proportion of the US equity market: banks. While they have de-leveraged impressively over the past couple of years and stand ready to finance US industry, there is no sign that US industry wants to take their money.
Again, that means some value managers spot opportunities - including Pzena. “We are in one of the interesting points where financial companies have faced their problems but are not being valued as if they have,” he argues. “You can buy virtually any US financial company at under book value - and some, such as Bank of America, at under half book value.”
Pzena sees the sector as solid value, with 10-11% ROE and strong business franchises. “A bank like Citibank is a collection of strong business franchises,” he says. “I see queues of people in New York at their ATMs - I carry a Citibank credit card in my wallet. People won’t switch their electronic bill payments to another provider because it would just be too much hassle.”
But ROE at 10% is a far cry from the heady days of 2004-05, when 25% was the norm. “In the 1800s, the ROE of banks was 9%,” says Eric Veiel, lead portfolio manager of the T Rowe Price Financial Services fund. “It has gone up and down over the past 150 years, and going forward it may be a little better than the 1800s, at 11-12%.”
Chew is not enthusiastic, either. “We are underweight banks because while they have done a very good job in shoring up their balance sheets, they face challenges in their long-term growth prospects.”
But prospects for extraordinary returns from M&A in the sector do not look attractive. Historically, M&A has been driven by big banks acquiring smaller banks to expand their footprints. But today a large player like Bank of America already has such a presence that it is unlikely to get approvals for more takeovers.
“If you don’t have big companies doing acquisitions, the prices go down,” says Chew. “When you look at a full cycle, the banking industry has shifted from growth. It won’t produce as high a ROE as in the past and the top-line growth won’t be as high as in the past. The banking industry has moved from being growth to being value stocks.”
Still, there are some who think there is still some margin expansion to be squeezed out - and that today’s high levels of corporate profits can mislead investors about the potential for further efficiency gains through technology.
“A burst of technological change in the coming years could serve as an offset to the sluggish rate of labour force growth,” suggests Hood.
“A driving force for a lot of technology expenditure is related to increasing productivity. To do more with less means spending more on technology,” agrees Chew.
Technology companies have been responsible for a lot of US growth - with Apple the pre-eminent example. “A 5% company with a growth rate of 50% means 2.5% of earnings growth in the S&P500 comes from that company alone,” says Chew. “Technology is 20% of the index but a bigger percentage of our Growth fund.”
He sees Apple as both a growth and a value company - its stock price has appreciated more slowly than its earnings, leaving it cheaper than it was a year ago. “Our assumptions on Apple do not require it to have another product introduction for the next three years,” he says. “There are still huge areas for sales. China Mobile has 625 million subscribers and does not yet sell iPhones. We still believe smart phones will see increasing market share at the expense of traditional phones. This will expand the market for Apple and this is attractive when you have a company that can maintain or grow its market share in a growing market.”
Clearly, both the software and hardware environment is seeing rapid change. Companies can struggle to find successful strategies in the face of new competitors and threats, as the traditional PC manufacturers that are under high attack from Apple and mobile telephony are finding. Microsoft would now be seen more as a value stock than growth, for example. For investors, understanding how much technology stock prices have been discounted to reflect competitive threats is really the key issue now.
“We are interested in Microsoft as a technology stock in our Value fund,” says Chew. “We are paying 11.5 times [earnings] for a great core business with amazingly high profit margins. Today we are not paying for the other areas of their business if they do become valuable. It is not priced as though they will succeed.”
Similarly, the fund holds Dell on 7.5 times earnings, but not Hewlett Packard. “The stock is cheap,” Chew confirms. “But they are not as aggressive in developing a credible plan for addressing the challenges. They have a lot of things under attack. PCs are under attack from iPads and tablets - they put a ceiling on prices when tablets sell at $400 and notebooks at $800.”
By contrast, Pzena has a much more positive view of the stock - it is his largest global holding - pointing to its “almost 20% current free cashflow yield”. His rationale also points to the cost-cutting dynamics in the economy, rather than speculation about consumer-led growth. Enterprise computing companies with long relationships with clients are not easily overcome.
“HP is the number-one or number-two player in three-quarters of critical technologies,” he says. “If IT grows this 5-6% per year globally, HP will still see some growth. I can see them growing at least 2-3% a year. Margins are quite good. If they simply maintained margins and grew at 2% per year, they would be earning around $6 per share in five years, assuming excess cash flow is used to retire debt and repurchase stock.”
There are good reasons to be optimistic about US corporates. Future growth may be driven more by rising domestic employment stimulating demand, but innovative US technology companies are still at the fore in improving productivity.
The US banking sector may be of less relevance to the corporate sector, but the new banking model that is being created may mean a return to old-style banking, and for value investors at least, that may be no bad thing.