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25.01.2016

Giselle Roux: Why smart investors look for themes, not bargains

The voracity of the 2008 downward spiral in equity values and subsequent response by central banks have left many pundits scrambling over the unique nature of the current investment cycle. There is little debate that the nature of monetary intervention was unprecedented, yet equity performance has been passably normal.

So where are we now?

Looking back, the 1990s was a period of stellar three-year rolling returns, interrupted only briefly by the unexpectedly sharp interest rate rise in 1994 and the Asian banking crisis in 1989.

In turn, this phase seeded the dotcom bubble, which came crashing down in 2000, exacerbated by accounting scandals and the consequences of the events that followed September 11, 2001.

Eventually, low interest rates, a rebound in Asia as China joined the World Trade Organisation and strong US consumer spending brought about a sharp recovery.

The most recent cycle is probably familiar to most investors. The highly variable pattern in annual returns, however, inevitably attracts more comment than the longer-term trends.

There is a good degree of similarity in what lies beneath each of these patterns. Excess credit and irrational valuations are common features. In the current phase we have monetary easing, a form of credit expansion.

Regardless of the nature of this market, most consider we are now in the mature phase of a bull market and cautionary comments about the risk of a large pullback have emerged. Yet the trigger and timing are far from evident.

Some possible causes are unlikely. The risks of central banks raising interest rates too rapidly seems improbable, given the Fed’s path to date, easing conditions still prevalent in the eurozone and Japan, and China now heading into monetary expansion.

Household leverage is manageable, perhaps outside Australia and a few other countries. Labour markets are improving in many parts of the world, with the bonus from lower oil prices.

Global economic GDP forecasts are being edged downward, but the suggestion of a recession has, at least for the moment, little basis. The reality is that excess capacity in many sectors and lower credit expansion than before is going to mean economic growth will be soft for some time.

Just as Greece did not matter as much as the headlines would have suggested in 2015, the Chinese sharemarket cannot be a culprit. While unpleasant in terms of sentiment, the breadth of impact is small. That is not to dismiss China as a source of risk; its economic management and recent unsteady depreciation of the renminbi is hugely important.

On the other side of the ledger, the consequences of widening spreads in corporate credit and possible defaults could stir an unexpected outflow of funds.

Different times

Credit markets are often considered the canary in the mine, and equity markets are will not escape unstable debt assets.

One of the frustrating aspects of recent times is that many US corporations have used credit for buybacks and tax-engineered mergers, rather than building their revenues for the longer haul. This may leave the growth in cash flow wanting when rates do rise.

Structurally, investment markets are different now. The combination of much larger index fund holdings and lower liquidity in some segments, particularly debt markets, could result in a messy trading pattern unrelated to any event or data.

There are unquestionably many other positive or negative influences observers will suggest. The reality is, for all the expertise in financial markets, specific forecasts are of little value. At best one can make a considered judgment on possible outcomes.

When faced with rattled markets and negative returns, home bias often returns. The apparent comfort of familiarity with the companies and dividend payouts can appear as more secure. Yet such a move would in practice add to investor risk.

The over concentration in a few sectors and narrow local equity market has not gone away. There is a perverse willingness to tolerate unrealised capital losses in domestic stocks, while looking to sell down global investments when they falter.

The decision should rather be a strategic decision of how much of a portfolio is in equities, and the appropriate split between local and global, taken outside of current market conditions.

Most private investors are likely to hold Australian equities directly and there is a strong tendency to hold onto big-cap stocks regardless of changing fundamentals.

Conversely, with managed investment funds the predominant global asset, these are constantly adapting to conditions.

With some judgment, many global funds have in recent years elected to not hold any meaningful position in energy or resources companies while selecting information technology, healthcare and consumer brands instead.

Now to valuation. In the ASX 200, stocks with credible, proven growth have been increasingly rerated, and globally that is also the case. This makes it now a much tougher assignment, as overstaying one’s welcome in highly valued companies is a persistent source of loss at some point.

We are therefore seeing fund managers shift their emphasis to other parts of the market – US banks, selected European stocks and Japan, for example. No one is pretending there is a preponderance of bargains given the movement in indexes in the past three years. This year is likely to be a reminder that revenue growth is essential for longer-term profit improvement.

Buybacks, dividends, mergers and acquisitions are not bad, but these alone can’t sustain corporations to do what equities are intended to achieve; capital growth with only excess free cash flow returned to investors.

If one can eke out a 5 per cent to 7 per cent a year investment gain over a three-year period, this would be a decent outcome at roughly double the rate of inflation. The best chance of achieving this is through a meaningful allocation to global equities. Modest compound profit over time is a more likely outcome than a jackpot achieved by racing into markets and out again.

Source: AFR

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