Decision Drivers: Stock Prices Versus GDP

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¿Cuál es la relación entre el PIB y la subida de las bolsas?
CC-BY-SA-2.0, FlickrPhoto: Alonis. Decision Drivers: Stock Prices Versus GDP

Does the prospect of a rapidly growing economy mean that a country’s equity market will follow a similar upward path? Or conversely, will a country’s weak economic prospects weigh on its equity market returns? Not necessarily, though many investors tend to see gross domestic product (GDP) as an indicator of the direction of stock prices. It’s a common misperception. But in reality, there is little correlation between the two. And that’s an important point, because understanding the true drivers of stock prices can help investors uncover opportunities, avoid pitfalls and set more realistic return expectations.

Why the misperception?

In their search for return, particularly as the markets grow more complex, investors often anchor their analysis to the wrong data point. In this case, they believe economic activity has some predictive value in forecasting the direction of stock prices.

But taking a closer look at the components of GDP tells us more about consumer, business and government spending and very little about individual company valuations or the forces behind them.

What’s important to recognize is that two-thirds of GDP is based on consumer spending. Since that’s generally true of most economies, GDP is essentially just a proxy for population growth and consumer spending. Equity prices, on the other hand, are a discounting mechanism of a company’s value, which is its steady state value (the value of the enterprise) plus its future cash flows. Historically, we’ve seen very little correlation between the two, as we see in the chart below.

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What does that mean in terms of setting expectations for equity returns? First, GDP doesn’t have to be growing at what most would consider a normal rate in order for investors to find adequate returns in the stock market, nor does a booming economy translate into higher stock returns.

What drives stock prices?

So if GDP doesn’t shed much light on stock prices, where should investors look for signals? In a word, profits (or earnings). If you think about the simplest formula for equity valuation, it’s price/earnings. Investors utilize trailing P/E ratios, which reflect historical earnings versus today’s stock price, or forecasted P/Es, which compare 12-month consensus earnings expectations to today’s price. Either way, most importantly, earnings, or profits, typically carry a lot of weight in driving stock prices.

Over time, the equity-market multiple has been roughly 15 times earnings. Outside extreme valuation periods, or bubbles, such as in the late 1990s, when the S&P 500 Index multiple reached an all-time high of approximately 26 times earnings, what matters most among the components of stock prices is their profits.

Considering profits and prices

Here is some historical evidence. When we look back at companies that have made money (red line in the chart) versus those that haven’t (yellow line in the chart), we see those with profits outperforming those that lose money, which isn’t surprising. But the magnitude of outperformance is significant. Over the past 20 years companies that were profitable were up more than 650% (cumulative), while unprofitable ones were down 23%.

 

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The ability to see the potential for future profitability (or lack thereof) ahead of what the market has discounted is an active manager’s most critical skill. An important part of that is to understand where a company’s product or service is in its life cycle (see Exhibit 3 below), as this can help estimate future cash flows. Will a company be a price taker, because there is little competition and high demand, or a price giver, because its value proposition is no longer unique?

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Focus on fundamentals, stay disciplined

The point is that investors need to think carefully about the data points they use to make decisions. The importance of differentiating between what is noise and what are meaningful fundamental signals has probably never been greater. That’s a challenge for many, because while technology has made information readily accessible, it also tempts investors to act on false triggers. Today’s world of instant information gives investors the opportunity to exercise an age old behavioral bias: buying at maximum enthusiasm and selling at maximum pain, which often leads to punitive outcomes. Understanding the value of individual companies over the long term isn’t about the current level of federal funds, the growth rate of the economy or the upcoming US presidential election. Rather, fundamentals drive cash flow, cash flow drives profits, and profits drive stock prices.

Robert M. Almeida is Investment Officer at MFS.

 

Tesla’s Giant Awakens

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Tesla's Giant Awakens

On 4 January 2017 Tesla began producing its next generation lithium-ion battery cells at its enormous Gigafactory. Located in the Nevada desert, the factory will have the largest footprint of any building in the world when it is completed in 2020. To mark the commencement of production, Tesla hosted an on-site investor event where it reiterated its 2018 target of producing 35 gigawatt-hours (GWh) of battery cells and 50GWh of battery packs, enabling it to meet its 2018 production goal of 500,000 all-electric vehicles. At the event, Tesla also highlighted the productivity gains that it and its partner Panasonic have been able to achieve by using advanced engineering techniques and factory automation technology.

A zero carbon factory

The factory has been designed as a giant machine and its capacity is now expected to be three times greater than the original plan. Reflecting this, Tesla also announced a 2020 target of 150GWh of battery pack production, enough to support the production of 1.5 million vehicles. This level of battery production will have a material impact on reducing global demand for fossil fuels and therefore carbon emissions. The factory itself will also be zero carbon, thanks to its roof being entirely covered by solar panels, and an onsite battery reprocessing facility will allow battery cells to be recycled.

In addition to producing next generation batteries with higher energy density, the Gigafactory will result in material reductions to the cost of batteries. In many parts of the world, thanks to lower running and maintenance costs, electric cars are already competitive with gasoline cars on a total cost of ownership basis. With a 30% decline in battery costs they will become competitive on a list price basis.

Not just cars: storage solutions and solar tiles

It is not just about cars, however, with Tesla’s ambitions going far beyond manufacturing vehicles. The company’s mission is “to accelerate the world’s transition to sustainable energy”. We think many people overlook the fact that Tesla expects 50% of the Gigafactory output to go towards battery packs for stationary storage applications in residential, commercial, and utility end markets. Affordable batteries enable much greater penetration of renewable energy since the problem of the intermittency of wind and solar power is solved.

The partnership with Panasonic also extends to the manufacturing of solar cells incorporated into roofing tiles to create a solar product that will go on sale later this year.

We are fast approaching the inflection point where the cost of clean technologies is competitive with fossil technologies on an unsubsidised basis and the transition to a low carbon economy will be driven by market forces. Tesla is at the heart of this transition. It is attacking multiple industries – from fossil fuel production to power generation and transportation – and we believe it will be one of the great global growth stocks of the next decade. We think Tesla’s earnings could approach US$20 per share by 2020, which by our estimates implies the stock is currently trading on a 2020 price-earnings ratio of roughly 12x. And this is just the beginning: we expect more Gigafactories to be built and that Tesla will keep on growing.

Signal-to-Noise Ratio

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Signal-to-Noise Ratio

Finding—and sticking to—the facts will be especially crucial for investors in the months ahead.

With the inauguration at our backs, it’s a good time to consider how, at a basic level, investors can make their way in the current frenetic landscape. One particularly apt term that comes to mind in the current context is the “signal-to-noise ratio.”

According to Wikipedia, “signal-to-noise” is “a measure used in science and engineering that compares the level of a desired signal to the level of background noise. It is defined as the ratio of signal power to noise power.” We have operated in and will continue to operate in an environment where the signal has been extremely low. It is therefore very difficult to figure out what the true signal is.

Not long ago, I heard a common refrain in my travels: “I can’t wait for the election to be over.” I agreed with the sentiment, and the notion was that all the crazy stuff we were seeing would die down and things would go back to normal.

At this point, I think it’s clear we’re not going back to whatever normal was. To the contrary, the level of partisan rancor concerning the issues of the day remains very high. Moreover, during the election we saw plenty of news that was light on facts and heavy on viewpoint, and that continues. Throw into the mix a new president who thinks out loud in real time and the reality of operating in a very low signal-to-noise ratio world for the foreseeable future is something an investor must confront. I’m afraid these are just realities of the new environment.
Employing a Filter

What can investors do? First, focus on important facts and employ a process for ignoring the noise.

Part of the challenge is that when you look at what the incoming administration has proposed, it’s a very ambitious agenda, focused on substantial reforms—to the tax code, the government’s role in health care, and immigration, among other things. These are truly complex issues. This is evident in all the reporting, noise and rhetoric around the tax code, specifically concerning the border tax adjustment proposal. It has dominated the financial news over much of the past week and is very hard to explain succinctly, so commentators latch onto scary, often misleading headlines. Sorting the facts from the noise is going to take real concentration moving forward.

For us, some of the most important facts are as follows: Of all the objectives in the new administration’s agenda, none is likely to have more impact on markets and the valuation of individual stocks and bonds than reforming the tax code. Given that, we are focused on the process of change, which is crafting legislation and who is working on it. It involves understanding the perspective of the authors and others who might have a meaningful influence, and the timeline to passage and implementation. It’s not clear how much transparency there will be, but I think a starting point for analysis has to be a document that’s been around for seven months: the House Republicans’ budget proposal. The question is, how much will remain by the time we get to the finish line.

Bring the Perspective of a Great Analyst

Second, process all news and information the way a great stock or bond analyst does when analyzing a company. I am fortunate to work with a lot of them here at Neuberger Berman, and they share a common approach. Data, facts and experience all trump opinion. But in markets, of course, opinion does matter. When assessing the viewpoint of a CEO, CFO or sell-side analyst, understanding the messenger’s track record, credibility and biases is paramount. The simple conclusion is that if you can’t check these boxes on a messenger, reject the message.

This decidedly does not mean seeking only viewpoints that mesh with your own—quite the contrary. I am a regular reader of Paul Krugman’s column precisely because he looks at economic and political issues from a viewpoint very different from my own. He expresses his views in a consistent and articulate fashion through time; I know where he is coming from.

Bring Historical Context

Finally, big issues of the day are usually just a point in time that are impossible to understand without a sense of the broad arc of history.

In the aftermath of the financial crisis, Carmen Reinhart and Kenneth Rogoff wrote a well-timed and insightful book called This Time Is Different: Eight Centuries of Financial Folly, which put in perspective the world-changing events we’d just experienced, and everyone in our business either read or should have read their observations.

Similarly, looming tensions with China on trade haven’t just emerged in the last couple years. Nineteen years ago, False Dawn: The Delusions of Global Capitalism, by Thatcherism architect John Gray, predicted that China’s form of capitalism would eventually collide with that of the West.

As for Russia, Putin’s adventures in Ukraine and Crimea are the culmination of more than 100 years of struggle with the West. I’d strongly recommend The Great Game: The Struggle for Empire in Central Asia, by Peter Hopkirk, written in 1992, to understand the dynamics at play.

Looking for that kind of perspective on whatever developments emerge could help investors find the relevant signals and avoid getting caught up in the noise that is sure to resonate throughout 2017.

Neuberger Berman’s CIO insight by Brad Tank

Making Sense of Misalignment

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El desajuste entre el horizonte temporal de los propietarios y los gestores de activos, un riesgo a tener muy en cuenta
CC-BY-SA-2.0, FlickrPhoto: Quinn Dombrowski. Making Sense of Misalignment

When the Centre for International Finance and Regulation (CIFR) says that “investment horizon reflects an interconnected web of influences,”1 chief among them is the relationship between asset owner (principal) and asset manager (agent). It’s a relationship where we see growing friction, largely based on the misalignment between asset owner time horizons and the delegation of investment decisions to asset managers. We touched on this misalignment in my last post, but now it’s time to be more clear about one of the root causes.

Both asset managers and asset owners play a part in this misalignment — and one of the most significant areas of confusion is the lack of clarity around full market cycles. While most active managers will state that their objective is to outperform over a full market cycle, they need to be more emphatic with asset owners up front about how much time that really entails and why they need it, especially if they state they have a long-term philosophy. They must also be clear about the fact that this is what investors are paying them to do. Asset owners need their own sense of clarity around the length of a full market cycle, because, as CIFR research acknowledges, “there is no common definition of long-term horizon that is accepted or clear.” Asset owners also need to recognize the importance of giving their active managers a full market cycle, and whether or not their own time tolerance will allow them to make that commitment.

So let’s start with clarity on the definition of a full market cycle. We see that as peak to peak or trough to trough. What history has shown us is that, on average, a full market cycle is at least 7 to 10 years, depending on the extent of any drawdowns in the market, i.e., 15% or 20%. According to our recent investor sentiment survey, and as shown in the exhibit below, more than half the institutional investors we spoke with around the globe know this. But their time tolerance does not line up. As you see in the exhibit, at least 70% of the investors we surveyed would only tolerate underperformance for three years or less.

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What results from this misalignment of time horizons between investors and those managing their money is principal/agent friction. And that has potentially significant costs to institutional investors, particularly those who might be pressured to hire and fire active managers at the wrong time because their boards are focused on chasing short-term performance. In fact, as we see in the third bar of the chart, many boards are placing demands on their internal investment staff to deliver alpha in less time than the investment staff gives external managers to perform.

The trouble is, we may also be underestimating how much this misalignment is driving institutional investors into pro-cyclicality, i.e., a herd mentality. In a paper on countercyclical investing, Bradley Jones at the International Monetary Fund (IMF) points out that investors often hire active managers just after a period of outperformance, only to experience a period of subsequent underperformance based on where they are in the market cycle.3 Or after doing a tremendous amount of due diligence to hire active managers, institutional investors might be forced to replace underperforming managers, only to leave alpha on the table as these fired managers often outperform in subsequent periods. As Goyal and Wahal point out in their widely read Journal of Finance article, these hire and fire decisions can damage investor returns over time.

To avoid rotating managers at the point where active skill might matter most, institutional investors need more support to impress upon their boards the importance of a full market cycle. That is particularly critical during periods of underperformance, when an active manager’s countercyclical view can help manage future risks or find good entry points to invest. Yet today, underperformance for any period has become unacceptable. That is likely because institutional investors, who have to take on so much more risk today, may naturally react by overmeasuring short-term performance to gain a sense of control and satisfy their external constituents.

Accepting periods of underperformance, however — even three years or more — could be the price of admission for allowing active skill to work effectively. We know this is a real pain point for investors. But as Mark Baumgartner points out in his paper on shortfall risk, periodic underperformance does not necessarily reflect a lack of skill. He notes that even “Warren Buffett’s Berkshire Hathaway lagged the S&P 500 in more than one-third of rolling three-year periods in the 25 years since 1987,” which, he says, is “something to keep in mind when trying to gauge manager skill over shorter time periods.”5

Getting out of this trap starts with the clarity I’ve outlined — clarity around full market cycles, around investor time tolerance and around the need to evaluate performance over longer time periods. In fact, that clarity around time is not only the start to solving misalignment, it’s the basis of good governance. When we get right to the heart of good governance for asset owners, it really is about the time tolerance built into the partnerships they have with their asset managers, as well as within their own delegation chain. That good governance is what restores and maintains alignment and builds trust that can be maintained even through the most difficult investment periods.

We know this involves a tradeoff. Asset owners, as principals, take on more agency risk when they commit to asset managers long term. So in my next post, I’ll talk about how to manage that agency risk and get comfortable with commitment.

Carol Geremia is President of MFS Institutional Advisors.

And What About Best Execution in Spain?

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¿Y qué hay del Best Execution en España?
Pixabay CC0 Public DomainPhoto: Bluesnap. And What About Best Execution in Spain?

Now that the equity market reform is behind us, the Spanish industry can refocus on other things. One of the topics that seems to take much momentum is the question of Best Execution. Not that it will create business but not addressing it could have dramatic consequences.

Last time ESMA looked into it (2015/494 Peer Review Report: Best Execution under MiFID), Spain was saved from receiving bad notes because with the very high concentration of the activity on the primary exchange (the analysis was conducted in 2013. By then the primary exchange concentrated over 80% of the market), there were no real concerns about best execution. The picture has significantly changed now with between 30 and 40% of the volume that moved away from the primary exchange to the alternative venues, so called MTFs. We need to consider a range here as there seems to be no number all stakeholders agree on, but even if we don’t agree on the numbers, the trend is very clear. Also comparing with the other European markets, Spain was exceptionally resisting the trend. This is now over and one might wonder whether Spain will not actually become the European market where the primary exchange will lose the largest market share (comparing with data provided by LiquidMetrix). Time will tell but this might happen in a not too distant future. The percentage today is only made of flows coming from international brokers. Spanish institutions are still mostly concentrated on the primary exchange. But many now seriously look at the alternative trading venues, understanding that this is an unstoppable trend that will have to be addressed.

And better earlier than later! The information that recently came out in the press that CNMV is investigating how Spanish brokers address the Best Execution requirements dictated by MiFID raises many concerns. Is the Best Execution principle being applied in Spain as it should be? Today, the concentration argument mentioned above does not apply anymore.

Beside the regulatory angle which is obviously the one Spanish financial institutions and asset managers should be the most concerned about, there is also a commercial argument which should not be underestimated. There is a clear first mover advantage and no one will want to be the last one to adapt to this new reality. There has been news recently in the press of first Spanish institutions moving in that direction and positioning themselves commercially on that ground of Best Execution capabilities, using Smart Order Routing technology to direct orders in the best interest of the investor.

The problem is that adapting quickly to this new reality is very challenging. Offering best execution over different trading venues requires some technology and more precisely a Smart Order Router (SOR). Developing one from scratch is probably the least realistic option. Buying one still represents the challenge of implementing it and feeding it with the right data to work properly. Here this is not so much about the cost of buying a license but more about implementation, maintenance and upgrading to industry or regulatory changes. Another option is to use a broker to access the alternative venues and leverage their SOR. The benefit of this option is that by using a leading broker, you will most certainly enjoy the most advanced technology but also automatically benefit from all the upgrades that broker will have to implement for their own business anyway. This solution however means that you do not access directly the alternative trading venues. Is that a problem?

Accessing directly the different alternative trading venues also present some challenges. First there is the cost of each membership and the time to implement. But more importantly, once you are a direct member of a trading venue, you have to set up a clearing solution. Do you want to become a self clearer? Is this a core business you want to invest in because it adds value to your clients? Alternatively you can look for a general clearing member to clear your activity. On this last option, the question is how much appetite is there out there for this business, particularly if it does not include the custody that you will want to keep on your Iberclear account.

Coming back to the option of using a broker to access the alternative exchanges, there is also here an issue: Spanish entities probably want to keep their membership on the primary exchange and therefore don’t want all the activity to be executed by the broker, only the transactions the SOR would send to the alternative venues.

The solution is for the broker to set up a mechanism through which it re-routes to the client’s membership the orders that the SOR will have directed to the primary exchange. Then the client can process completely that flow under their membership. The broker will only execute the orders directed to the MTFs, clear them and get them settled directly on the Iberclear account of the client.

That way, the client gets both of both worlds: it gets Best Execution, maintains its membership on the primary exchange and gets an all-in solution for the flows directed to MTFs.

This should be the fastest and cheapest option, avoiding expensive technology build and allowing to concentrate on the core business, be it brokerage, private banking or else, and focus on things that really add value to the underlying client.

In short, alternative trading venues are now a reality that cannot be ignored anymore. Regulators will increasingly monitor whether investors get the best execution service. It will become a requirement to be able to execute on the venues available, be it for regulatory reasons or simply competitive pressure. There are different ways to achieve this, some will take a lot of time and require significant financial and human resources. Others will ask for the support of brokers to get it sorted fairly quickly, allowing the client to direct their energy and resources to other tasks and add value to their own underlying clients.

It is now high time to move on that front if you want to stay in the race.

 Opinion article by Benoit Dethier, Head of Sales and Relationship Financial Institutions, Citi Securities Services in Spain

Monetary Policy: Is A Change Coming?

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¿Asistimos al fin del mercado alcista de 35 años para los bonos del gobierno?
CC-BY-SA-2.0, FlickrPhoto: Oliver Bruchez. Monetary Policy: Is A Change Coming?

Against the backdrop of weak global growth and soft inflation, central banks have been biased towards loosening policy further or talking down the prospect of future tightening. Stimulus measures, however, have recently come into question as evidence suggests that unconventional monetary policy may have reached its limits.

For example, the Bank of Japan has recently moved away from a commitment to buy a  xed quantity of government bonds and adopted a yield target instead. This may be more sustainable in the long-run, but re ects an inability to expand its government bond holdings inde nitely. Similarly, market participants have speculated that the European Central Bank may move to taper its bond purchases before long and have lost appetite for pushing interest rates to ever more negative levels.

As a consequence, many investors are beginning to look for fiscal policy to take a greater role in stimulating growth and are starting to call for a turn in the direction of interest rates and bond yields. Our view is that although we may have moved to an environment of less aggressive monetary easing, it is too soon to look for a decisive in ection point. Central banks will be cautious about changing direction given the risk of derailing the economic recovery, and  scal policy is hard to expand quickly. Fiscal expansion may also be limited in some countries by debt levels, and requires a level of coordination which will challenge most governments.

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Government bond yields, as a result, are adjusting to a less supportive policy environment, but are expected to remain largely range bound, with fair value only modestly above current yield levels.

A structural increase in yields will require either a rise in trend growth, a rise in trend inflation or a clearer change in the direction and mix of policy. None of these are likely to happen quickly, but we may now be at the end of a 35-year bull market for government bonds.

John Stopford is Head of Multi-Asset Income at Investec.

Gold in Presidential Transition Years

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Gold in Presidential Transition Years

We get a lot of questions on how gold will perform in 2017. While we have no crystal ball, we thought the tidbit below might be of interest to you as you evaluate whether adding a gold component might provide valuable diversification to your portfolio.

Please consider the chart below:

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Since Nixon took the US dollar off the gold standard in 1971 there have been seven Presidential transition years, i.e., years when a new president was inaugurated. Those years were 1974, 1977, 1981, 1989, 1993, 2001, and 2009.

Looking at the data, gold achieved above average returns during those calendar years, +14.8% in Presidential transition years vs an overall average of +8.4%. Perhaps equally important is that those have been years when the S&P 500 greatly underperformed its average over that same time period, -0.9% in Presidential transition years vs an overall average of +9.0%.

The S&P 500 on average was negative for those seven calendar years of Presidential transition. The average return in Presidential transition years is +14.8% for gold and -0.9% for the S&P 500.

One possible theory as to why this might make sense is policy disappointment of a new incoming administration, the high hopes of the newly elected administration may be tougher to achieve in practice, leading to weakness in equity markets. In addition to policy disappointment may be a general sense of policy uncertainty as the rules of the game potentially change under a new administration, which might boost gold as a safe haven.

One caveat is that seven transitions is a small sample size; the reason we limit ourselves to transitions since 1971 is because before gold was pegged to the dollar in one form or another for much of US history.

Column by Axel Merk

Where’s The Growth?

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Cinco factores para no perder de vista en 2017
CC-BY-SA-2.0, FlickrPhoto: Clint Budd . Where’s The Growth?

Looking into 2017, our primary investment thesis is based on the belief that investors are underestimating the prospect of stronger growth and inflation in the US economy relative to the rest of the world over the next year.

Where’s the growth?

Global growth has been weaker than many policymakers and market participants expected following the 2008 global financial crisis. The deleveraging cycle in the developed world and the Chinese economy’s transition to a lower-growth path have both acted as major headwinds to the global economy. In response, central banks have undertaken extraordinary policy measures to provide support, which, in turn, have strongly in uenced the direction of asset prices.

Pessimism is in the price

We believe the global economy’s structural issues will remain with us for some years to come, resulting in a continuation of the low-growth environment. However, this has largely been accepted by investors. Looking into 2017, our primary investment thesis is based on the belief that investors are underestimating the prospect of stronger growth and in ation in the US economy relative to the rest of the world over the next year.

Following an easing of financial conditions over the past year, with government bond yields and mortgage rates having declined significantly, we see positive trends emerging in US credit growth and the housing market in particular. In our view, this implies higher longer-dated US bond yields and a stronger US dollar looking forward. As a result, we believe that many of the areas that have struggled through 2016 appear to offer some of the most attractive opportunities.

Sectors are diverging

The large decline in longer-dated government bond yields this year resulted in a meaningful division within equity markets. This has been particularly prevalent in the US market where, although the S&P 500 has made little overall progress, there has been a high level of dispersion in performance between those sectors that gained from lower bond yields and those that lost.

US banking bounce?

An example would be the performance of US banks relative to utility companies, with the former underperforming significantly. While a stronger US dollar and higher bond yields may act as a headwind to US equities more broadly, we believe there is scope for a rotation within the equity market and consequently we have been sellers of US utility companies and buyers of US banks.

Greenback revival?

We have also been sellers of government bonds and have been reinitiating long US dollar positions against the currencies of countries where we expect monetary policy to remain loose or even be eased further, such as the Korean won, Taiwanese dollar, New Zealand dollar and Japanese yen. With the exception of the latter, these currency positions are designed to act as defensive positions at a time when government bonds may struggle to perform.

Positioning for 2017: Flexibility is the key

Although we believe there are a number of compelling opportunities in 2017, we acknowledge that valuations across the majority of asset classes are not as attractive as they have been in recent years, as we remain in an environment of structurally low growth with economies more susceptible to shocks. As a result, the overall risk level of our strategies will likely remain lower than would otherwise be true, were risk premia to be higher, and we will continue to use our flexibility to identify opportunities as they appear and to seek to protect capital as risks emerge.

Iain Cunningham is a Portfolio Manager in the multi-asset team at Investec Asset Management.

 


 

Private Funds: Venturing Off the Beaten Path

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Las oportunidades para 2017 pueden estar en el mercado privado
CC-BY-SA-2.0, FlickrPhoto: Chris D Lugos Z. Private Funds: Venturing Off the Beaten Path

This year, we expect a continuation of many of the same themes we’ve seen in private markets this year. The global macroeconomic environment remains weak, and central banks continue to pursue accommodative monetary policy. Top line growth is still hard to come by – both for companies and for the US economy.

Investors are looking for private market yield more than ever. So alternative investments continue to be popular among institutional investors as their comfort level in traditional assets of listed equity and fixed income is tested. Fixed income looks fully valued to many as interest rates can only go up from here and investors wait for the negative consequence of central bank intervention and negative rates to materialize. Long range forecasts for public market equities among major institutional investors are as low as 4%-5%, which is far below their actuarial assumptions for the growth of their liabilities. So where else can investors turn?

We think the biggest change just may be among investors themselves. When the world is becoming compartmentalized, investors feel crowded. Everyone is following the same themes and feeling the same pressures. Investors are looking for new opportunities and ways to optimize their exposure through a “best ideas,” unconstrained portfolio of private assets, whether it be in emerging markets or developed markets.

Finding opportunities

We’re seeing large buyouts in private markets, purchased at over 10 times (x) a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) using 6x leverage for larger deals. In the general secondaries market, pricing is also becoming fully valued because more people are looking for truncated J curves and a visible portfolio that has growth potential. (The J curve shows a private equity fund’s tendency during its life to deliver negative returns and cash flows early on and investment gains and positive cash flows later on as companies mature and are sold off.)

We think investors should go where most of them aren’t – that is, areas of the market with less capital formation. It may be harder to do the work to generate returns, but it may actually be a lower-risk strategy than following the path of least resistance that many other investors follow. In particular, we are focused on opportunities in the small and midmarket segments of the private market, along with private credit. We believe that investors should focus on smaller companies and/or funds to pursue alpha, while keeping in mind that these segments require greater expertise and selectivity.

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A small midmarket business will generally trade at a lower multiple than a large market business. Among the same types of companies, just different sizes, investors can pay 7x EBITDA for the smaller company but 9x for the larger one. Why? Because the leverage is easier to come by for the larger company. The bigger the fund, the more pressure to put money to work. Of course, small midmarket transactions are hardly cheap, but it’s a relative value proposition as opposed to an absolute value one.

There’s another advantage to small and midmarket deals. Not only can investors get the benefit of higher growth, but once the company gets to a certain size, investors may get the benefit of an expanded multiple such that the next investor uses more leverage to buy the company. Investors should never use the expanded multiple as the main justification, in our view – they should look for growth, operational efficiency, and good bottom lines – but an expanded multiple can be a bonus.

Be mindful of risks

Of course, investors need to be aware of the risks and special skills involved in the private equity markets. Investors should do the proper due diligence to make sure the managers they pick are able to execute on the type of mandate they’ve been given. This execution risk is even broader in cases where an investor is looking for a manager to provide a “best ideas” portfolio. In the past, investors needed only to ensure that the manager was capable within a constrained or compartmentalized context. Now, managers need to demonstrate the breadth and depth of their capabilities in several areas or markets.

Another risk in the private markets is that portfolios cannot react as quickly to market developments or uncertainty as compared with more traditional asset classes like listed equities and fixed income. The ship turns much more slowly in private markets, and a level of uncertainty can slow things down. If an adverse event were to cause corporates to step back from markets, liquidity will become constrained for private equity. Exit trends have been favorable over the past three years as low interest rates have caused corporations to become more acquisitive. However, we expect the number of exits to moderate into 2017 and 2018. Exit trends have the potential to revert to the mean over the next 12-18 months because of the continued uncertainty over the global macroeconomic picture and investors’ nervousness about what central banks will do. On top of that is growing political risk, particularly in Europe and other developed markets.

Currency movements have had a huge impact on returns for international investments. EM currency performance relative to developed market currencies and even within Europe (for example, the euro versus the pound) has been dramatic. Most investment professionals believe volatility will still be the name of the game going forward, so general partners (GPs) of funds should be cognizant of currency effects. Many investors in the UK and continental Europe did not expect the pound and euro to move so dramatically. GPs should think about hedging within their funds versus telling their clients to manage it themselves, in our view.

Finally, it’s worth repeating that something that looks low risk can come at a high price. Investors can end up paying too much because debt is readily available. Paying up for an asset and then putting leverage on it makes something once solid and straightforward become more risky because of high purchase price multiples and high debt use.

One size will not fit all

The search for yield is becoming a catalyst for change in the private markets as investors now focus on determining the right strategy. Many are turning to alternative investments because of their ability to generate yield when there is little to be found in the traditional markets. Growth opportunities may also be more readily available in the private markets.

However, investors must remember that it’s not easy. As interest in these opportunities grows, assets become more expensive. And as competition for yield grows, returns are moderated. While there are many obstacles, we believe there is still more opportunity for skilled investors to generate yield and growth.

Steven Costabile is the Global Head of PineBridge’s Private Funds Group (PFG).

This information is for educational purposes only and is not intended to serve as investment advice. This is not an offer to sell or solicitation of an offer to purchase any investment product or security. Any opinions provided should not be relied upon for investment decisions. Any opinions, projections, forecasts and forward-looking statements are speculative in nature; valid only as of the date hereof and are subject to change. PineBridge Investments is not soliciting or recommending any action based on this information.

 

 

What The Markets May Be Miscalculating?

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El repunte de los mercados podría haber ido demasiado lejos
CC-BY-SA-2.0, FlickrPhoto: Toby Oxborrow. What The Markets May Be Miscalculating?

The last few days of 2016 have receded amidst continued pain for Asia’s markets. The year had begun with a rally in Asia’s equity and fixed income markets, but it ended in a slump. I wish performance had been better, but the sectors that rallied—materials, energy and other cyclicals—did so less due to fundamental reasons than due to expectations of inflationary conditions rising once again. Sectors with more robust secular growth profiles, such as health care, have recently suffered. This environment has been a difficult one for investors, including our team at Matthews Asia, which is focused on making long-term strategic decisions to buy secular growth at reasonable prices. But it is also an environment of which we have warned investors, one that I believe is transient, and so we intend to stick to our investment philosophy and our commitment to long-term growth, not short-term trading. But sentiment is against us right now.

Indeed, as markets have marched on since the victory of President-elect Donald Trump, each footstep seems to bring new confidence into the U.S. market, just as it sends tremors through the East. Expectations of higher inflation, easier regulations, and an America-first trade policy are being priced in as being a boon to the U.S. and a burden to Asia. But have the markets been marching blindly? Is the focus too much on NOW and too little on the far future? Has the market been relying too much on conventional wisdom, what it feels is true, rather than spending the time to think through the issues in a cooler, more logical fashion? If it has done so, it would not be surprising—given the shock and emotional reaction by many over Trump’s surprise win. And yes, I do believe that the market has gotten some things wrong.

First, the markets may be overestimating the inflationary stimulus from President-elect Trump’s economic policy. Tax cuts will raise the budget deficit, yes. But that will be offset by a faster pace of interest rates hikes by the Federal Reserve. Tax cuts that save money for the wealthiest and broaden the tax base at the bottom are more likely to be saved than spent. That is not stimulative. Plus, many on the new administration’s economics team are advocates of hard money and tighter control over, even auditing, the Fed. This is not an environment in which it will be comfortable for the Fed’s doves (those happy to see higher inflation) to operate.

Second, the markets may be overestimating the effects of looser regulation. Yes, there are costs associated with it, but it is not as if profits are at a low level. Indeed, they are close to peak levels of GDP. Where is the evidence that regulation has imposed high costs? The effect of tax cuts in the corporate tax rate are real—but for how long are they likely to persist? Perhaps the market is overestimating the boost to valuations from these potential events.

And the effect of trade tariffs? They are likely to impose costs—a one-off jump in import costs, on the U.S. consumer and businessman alike. The reaction in the markets has been stark—as if the U.S. was isolated to this effect and Asia is incredibly exposed. This is the old canard about Asia being an export-led economy. It is not. Asia grows because it saves, it invests and it reforms. The excess that it produces beyond its immediate needs, it exports. But that is not vital to its citizens’ standard of living. Indeed, Asia would simply consume even more of what it produces (and it already consumes the vast majority) if tariffs became punitive. The short-term impact is likely to make the U.S. dollar stronger—but less trade means less cross-border investment and that could weaken the dollar further down the line.

Would supply chains be affected? Shortened? Probably, but again, don’t take too much of a U.S.-centric view of the world. China and other large Asian manufacturers are building out their supply chains in more developing parts of Asia only in part to satisfy Western demand. The long-term goal is still to produce for their own citizens. China will keep investing in the rest of Asia. Yes, some businesses will suffer, but others will benefit. Our portfolios largely consist of those companies focused on the domestic consumer and the domestic business in Asia, where long-term trends are overwhelmingly positive.

Simultaneously, markets are, I believe, mispricing Asia’s long-term prospects. The better performance we saw in the early part of 2016 was, I believe, partly a recognition that Europe had its own problems, but also that in Asia, equity valuations were reasonable and real interest rates were actually very high in global terms (hence the rally in bonds)—and that despite several years of poor earnings results, Asia’s economic growth would sooner or later translate into profit growth. That confidence has gone for now. But the fundamentals remain in place and even as valuations in the U.S. become increasingly stretched as markets price in an idealistic interpretation of the next administration’s policies, valuations in Asia are getting cheaper for long-term secular growth businesses.

Indeed, as I meet clients these days, I am often asked: “Where is the good news?” As I talk about the likely issues to come—trade issues, more worries about China’s currency, a strong dollar, and all the other issues that the markets are focused on, it’s a fair question. The answer is twofold. First, Asia appears well set to weather the storm! This may seem mealy-mouthed, but it’s important to recognize the current issues and also to see that high savings, high current accounts, low inflation, and low budget deficits give Asia a lot of policy room to maneuver—room that Latin America, for example, largely does not have. Second, Asia’s economies are still growing faster than the West and that should ultimately mean stronger profits. This is no small advantage. It may seem like a thin thread to hang your hopes on, but it only appears thin because it is not tangible—corporate profits are not growing quickly NOW.

Still, Asia right now has much going for it—economic growth, stable politics, strong fiscal and monetary positions, and reasonable valuations. The only things it lacks are momentum in corporate profits and the change in sentiment which that would bring. As I look into 2017, I do not know if this is the year when profits will turn (though margins are close to 15-year lows). But with dividend yields in the market near 3%, I know we will be paid to be patient. And now in Asia, more than ever, there would appear to be prospective returns to patience. That patience may be tried at times by “junk rallies” and sensationalist headlines, but we will continue to look beyond the headlines and help you see the opportunities in the region. And we intend to keep investing in the companies that are set to grow sustainably for the long term, not try to time rallies in those companies enjoying their last days in the sun. When the market is thinking “now, now, NOW”… we are trying to be patient, patient, patient.

Robert Horrocks is Chief Investment Officer at Matthews Asia.