Investment Insights

Equities Symposium: A global view of equities

Irrespective of how we measure beginnings and endings, the current equity cycle has been the most exceptional run. Is this a siren song luring investors into the market, or should it serve as a warning? At the recent Schroders Equity Symposium in Sydney and Melbourne, attended by more than 200 advisers, we explored three views from across the equity landscape, including: the benefits of investing against the masses, how human behaviour shapes investing and Trump’s impact on global stock prices.

28/11/2018

Andrew Fleming

Andrew Fleming

Deputy Head of Australian Equities

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

Tom Wilson

Tom Wilson

Head of Emerging Market Equities

Andrew Fleming, Deputy Head of Australian Equities

No matter what way you look at the Australian market, the extremities are high — and if you break the market down into 13 sectors, you can compare the multiples against their own history.

Across the board, only four of the 13 sectors are trading within their average historical ratio. All the rest are at one or other of the extremes, with IT the clear example of extreme valuations — there has been about six months on the ASX in the past decade where multiples in this sector have reached the levels where they’ve been for the past couple of months.

The overall market is not too bad, but most sectors that are popular are at eye-watering revenue multiples. The reason people are piling in is because of ‘growth’ — the word that hides the sins of irrational exuberance. But are investors really getting growth?

By looking at three areas of growth— EPS, dividends and rerating —  you glean some interesting insights. In particular, it is rerating that is inflating their market capitalisation while earnings have remained stagnant. In Technology and Healthcare, earnings growth has actually been negative.

This is all a carry trade on emotion that blinds the investor from fundamental analysis. When you buy those high multiples, you are buying a narrative of growth that is unsustainable in the longer term.

When you break down the analysis of the “good” global tech companies (those with sales growth and a good reinvestment strategy), it becomes apparent that our local tech market darlings are overvalued.  To illustrate this point, you can go to the US and buy companies with five times sales across the board. In Australia, if you looked at a company with EV/Sales of more than 20 times, and you said that it could drop by 75% in a year, people would say it’s an incredibly harsh prediction — but all we’re doing is benchmarking them against the FAANG stocks and that’s what they’re trading at. Suddenly, it’s not that silly.

There’s a lot of market cap in these companies. This has been built up over the past couple of years, and while some of are down 25% in the past six weeks, they are still up 200%.

It comes down to working out where a dollar today is worth less than one in the future.  When comparing two stocks to work out where the value of a dollar would be, and where it is likely to be in the future, we compared two Australian stocks — RIO and CSL, as they both had similar enterprise value at the time (or how much it would cost you to buy them at market value and wipe out their debt).

The multiples are worlds apart. For RIO, you are paying a price-to-earnings multiple of about six times with 15% cash-on-cash returns. Even if commodity prices were to fall by half, you’re still looking at about a 10% return.

For CSL, you’re paying a multiple of more than 30 times, with 3% cash-on-cash return. You need an incredibly high and sustained period of growth for those figures to make sense.

And here’s the problem. If you’re an investor in Australian listed healthcare stocks that are earning a lot of their profits from the US markets, you’re going to need to be aware of President Trump’s plan to look at category B drugs available on Medicare and benchmark pricing to global norms.

Why is this a concern? Pharmaceutical prices in Australia and the UK have dropped compared to consumer prices, but in the US, prescription drug prices have eclipsed consumer price growth. If you’re invested in healthcare, then the US is the market you look to for growth. Anything to impact that can have serious consequences, particularly as buying at a high P/E multiple means you’re depending on high growth, in perpetuity.

Given the uncertainties in the markets, the disruption to the banks, unreasonably high multiples, and the way in which growth is actually delivered on the book; it’s more important than ever to have a deep understanding of the stocks being considered, and how they may fare over the medium to long term. We believe finding true value has never been as meaningful to ensure future growth.

Tom Wilson, Head of Global Emerging Markets

We’re not really running with the bulls in the emerging markets space — we’re being trampled by them. So, what does the next 12 to 24 months look like?

Clearly it’s been a tough year for investors, however, emerging markets have continued to deliver on earnings, but experienced a starker derating of P/E’s, which are at the lower end of the historic range. Emerging markets look cheap in aggregate, when compared to developed markets.

As sentiment deteriorated and valuation multiples have come off, there were outflows from EM equities in 2013 to 2015, and was followed by flat flows in 2016.  This set up a very big inflow in 2017, which supported the market rally.

From our standpoint, the US dollar looks quite expensive. With US economic momentum likely to slow, there is some potential for US currency stabilisation and a degree of depreciation as we move through the next 12 months.

This is a big deal for emerging markets — given we’ve seen an appreciating US dollar over the recent period, which tightens EM financial conditions. As the funding currency for emerging markets, US appreciation puts pressure on EM currencies and inflation, incentivising central banks to tighten monetary policy.

While some countries are more vulnerable than others, such as Argentina and Turkey, it does have broad implications across EM. If the dollar depreciates, even marginally, it will provide relief for EM and a positive catalyst.

Our base case is further escalation in trade tariffs between China and the US of 25%, which will likely take place in January 2019. We’re a little bit more cautious on escalation thereafter. There is a remaining $270bn of exports to the US, but they’re more consumption-orientated, and the impact from an inflationary standpoint would be more visible for consumers.

Trade escalation clearly impacts Chinese growth, and to a certain extent Asian growth. This is unhelpful for China as growth was already slowing due to a negative credit impulse and a focus on addressing systemic financial risk.  In addition, infrastructure investing has cooled and an anti-corruption program has caused local government to be cautious about investment fund allocation.

The key issue is what scale of stimulus is implemented to stem declining growth.

China’s current account surplus has been moving from surplus to deficit, and this is a major monetary policy issue. Historically, they’ve been able to manage domestic rates and the currency simultaneously. While they have high savings rates and stringent capital controls, external funders want an attractive return for transferring cash into another jurisdiction.

We believe you will see sustained currency depreciation, which increases volatility risks.

And where do we invest?

We run a disperse risk group, that includes a lot of countries and contains 100 stocks in the book. Our largest country allocation is Korea, which is trade exposed, but the Korean market already prices in a heavy degree of stress.

Brazil is a standalone and interesting market. It’s just had an election and while you can have some concerns about Jair Bolsonaro’s social policy, on the economic side, he’s doing exactly what the market would want him to do. He has a very credible economic adviser; the priority looks to be to get social security reform and pension reform done, which is very supportive of the yield curve for corporate confidence.

Given that our base case is for dollar stabilisation through next year, and maybe potential for modest depreciation, that would provide a little relief but there are clearly still risks.  Therefore, EM may remain volatile or out of favour on a six to nine month window but the cheaper valuations are attractive on a long term horizon.

Nick Kirrage, Global Recovery Fund

In some respects, when you talk about value investing, the best way to talk about it is to talk about its better looking, more popular sibling — growth investing.

Growth companies are a bit like growth investing — they’ve got immediately obvious strengths, they’ve grown very quickly, and it’s really very hard to imagine how that would ever change.

Value investing is significantly less cool, their attractions aren’t as immediately obvious, and you have to look a lot harder to work out what it is you want from investing in those businesses. But here’s the thing: over the long term, value investments more than hold their own. In fact, on a calendar year basis over the long term they do slightly better. Both these two styles have their days in the sun, and I think if you were the average investor you would say, ‘I’ll just have a bit of both’. Diversification is the most sensible way to spread and manage risk, and it sounds sensible.

Except absolutely nobody is doing that today.

Today, 90% of all global equity fund managers have a majority bias towards growth, and only 10% have a majority bias to a value investment strategy. We have never before been as concentrated, and while in most aspects of our lives we diversify, in this one aspect we are absolutely convinced it’s all in growth.

Having said that value works over time, why does value work? In the value investor case, it’s the psychology that underlies the style. Being invested in the market sometimes feels like being on a rollercoaster with highs, lows, and troughs.

Value has had 10 of the worst years in its history — it has been an absolute desert, and it has been value investing’s worst run since 1939. We have almost never had a downturn that is as long or as deep in value terms as it is today. Expensive markets have been getting more expensive; the dollar market’s going through the roof. It’s been relentless, over and over and over.

There have been good periods for value, like 2016, which actually serves to show how alone we are in doing this. In 2016 we were one of only 15% of global equity fund managers that outperformed. 85% of other people are in growth investments, and the one-year growth did badly, everyone underperformed. Everyone is growth tilted.

Why am I excited about our performance, which has been bad? Because it augurs well for the future.

We have been managing recovery of deep value money for a very long period at Schroders. Our flagship UK deep value fund was started in 1970 and has one of the best track records in the entire UK market. We’ve used this data to try and ask questions about what today’s underperformance might mean in terms of any future rebounds in value.

When that fund underperforms for one year, it outperforms for the five subsequent years. The worse it gets and the braver you are, the stronger the rebounds are.

This is the nature of life. The choices that are the most rewarding are always the difficult ones. Everything of value in your life is something that you’ve had to work for. For me, this makes me feel positive about the future, despite the headwinds.

As with the perspective on Australian equities, understanding what the long-term value of a company is guides us to where the future profits will lie. After the longest weak period for value investing in almost 80 years, we believe it’s about to turn — and history shows that when it does, it does so at magnitude. In order to reap the most rewards, you have to invest at the right time, in the right companies, when they’re not in the spotlight. That’s the ultimate key to value investing.


 

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