The Greatest Fortitude
Value managers have had to have the patience of Job over the last two years – but last month saw the first sign that the market’s fixation with commodity plays may be drawing to a close. The popular short financials/long commodities trade suddenly reversed, but was this just a technical adjustment, or the beginning of the end for the metals and mining story?
Markets have always been susceptible to manias, but the commodities strain has proved unexpectedly virulent, persisting far longer than the TMT bubble. “There are aspects to this market that are extraordinary,” says Paul Ehrlichman, CIO, Global Currents, part of Legg Mason. “If you had just bought what was going up the most, and sold what was going down the most – that gap is wider than at any point since 1927. This has been a very challenging and severe period for value managers, with five and sometimes 10-year track records being threatened.”
Mark Donovan, managing director at Robeco Boston Partners, says that there are normally some low-valued stocks that have attractive momentum characteristics, but in this mania, the spread that investors have been willing to pay for high momentum stocks is much higher than the valuation of medium and low momentum stocks.
In 1998-99, when everyone ran to TMT names, the belief was that the unit volumes of internet usage would explode. This time, it is more of a pricing story than a unit volume story. “But it seems to me that it has to fail, as you can only increase commodity prices so much before demand destruction occurs,” he says. “Farmers can only pay so much for fertiliser, and when gasoline went over $4 a gallon in the US, there was a meaningful decline in gasoline consumption. So the notion that the commodity bubble – which is largely price driven – can continue, doesn’t make much sense.”
Style reversal
Indeed, there is now a sense that style performance is about to reverse, with momentum running out of puff. According to Andrew Lapthorne, of SocGen’s Cross Asset Research Group, valuation dispersion measures suggest that the market is starting to differentiate again, with dispersion reaching levels that would typically imply better value returns going forward. Unfortunately, value styles also remain sensitive to the economic cycle, and tend to perform better when the profits cycle is accelerating rather than decelerating. Value investors will just have to keep telling themselves that the more they suffer now, the better it will be when the reversal finally comes.
As a contrarian manager, Donovan says Robeco Boston Partners looks at companies that are experiencing some stresses, where it feels the problems will work out over time and the market is incorrectly viewing those problems as permanent in nature. This time the lagging stocks have been the financial, property, and consumer discretionary companies such as car manufacturers, retailers and restaurants. “Amongst that large group of stocks, some will prove the diamonds in the rough that have been thrown out unnecessarily by investors,” argues Donovan.
Ehrlichman adds that there are two types of value investor, and each will be attracted to different kinds of stock. The defensive value managers are more likely to buy the laggards in sectors like healthcare, food and telecoms, which should pay high dividends. And the deep value managers will look at financials, consumer discretionary stocks, and tech companies – the really beaten up stocks.
But deep value could face further pain, as it only outperforms when profitability is below trend. “The super-boom in profitability is way above trend so the earnings cycle isn’t yet set up for deep value to outperform,” he says. The problem is that value factors – meaning low P/E, low price to book, and low price to cash flow – tend to be pro-cyclical.
Feel the pain
So although the financial leverage part of profitability has been devastated and is unlikely to see further downwards revisions, there is still pain to come courtesy of operating leverage. “That means the scarcity plays will get hit, and you can already see that with the cyclicals because they are going down. We’re trying to be disciplined. Cyclicals can suck you in on a low P/E – that’s a value trap in a stock that’s down because profits are peaking. But value managers are also inherently sceptical of structural changes in profitability and may not be willing to pay up when profits have improved.”
In financials, he says TD Ameritrade and Fidelity National Information Services are interesting stocks, adding: “We are still concerned that earnings won’t be supportive of many of the out-of-favour stocks – we want more visible and durable earnings.” A deeper value, more out-of-favour stock would be Infineon, the semi-conductor manufacturer, or Cisco: “The IT sector has very depressed profitability and expectations and it has been trashed. But it is focused on free cash flow and share buy-backs – compare that to the massive capital spending in metals and mining.”
On the consumer discretionary side he cites Nobel Biocare, which makes dental implants, as a good example. “This is under new management and is essentially an oligopoly, but it has been ripped down to record low levels of valuation. There are some short-term threats to elective procedures like this and laser eye surgery, but we don’t think it’s quite that discretionary.” Ehrlichman also likes Symrise of Germany, which has been hit very hard. Symrise is a global leader in natural and organic fragrances and flavours, but it has been more than cut in half since its IPO and is trading on a low multiple.
Bear warning
Donovan adds that amongst the financials he is looking at insurers and asset managers now, but warns that in a bear market, financial companies can and do go to zero. Bear Stearns lost well over 90 percent of its value, and IndyMac has declared bankruptcy. “Value investors are naturally attracted to financial institutions but you have to be quite careful. The incidence of financial firms failing is probably higher than that of industrials, as small problems on the asset quality side can become big problems for banks with fairly thin capital,” he says.
“The other problem with investing in financial companies is that there is nothing to look at – it’s a leap of faith in management that they have soundly underwritten their loan portfolio. When credit cycles go bad it’s always surprising how far institutions like Countrywide, for example, have gone into the very shaky credits. They didn’t need to – they had by far the leading market share – and yet they strayed into those areas.” He says that Boston Partners prefers to spread the risk with a range of small to medium-sized positions. “So we own about a dozen bank stocks and if eight of them prosper, two of them do okay, and two of them go to zero, our portfolio will be okay.”
If you want to read more about how value managers are positioning their portfolios in these troubled times, please go to:
The Currency Conundrum
Rampant inflation has set the cat among the pigeons for currency managers seeking rewards in emerging markets. The problem is partly that central banks in Asia have failed to tighten monetary policy as expected, preferring fuel subsidies and restrictions on food exports to a modest period of austerity.
Elsewhere, those traders who attacked the Middle East dollar pegs throughout the Spring have failed to break them. But that hasn’t deterred them from trying again. “Just recently we’ve seen an enormous surge in investor appetite for GCC trades especially around the Saudi currency,” says Peter Rosenstreich, chief market analyst at Advanced Currency Markets, an FX broker. The excitement followed a comment by a senior Saudi council member that a 20 percent revaluation of the riyal is necessary.
“This has always been a story that people are watching and many still have this sort of revaluation priced into their macro trade,” Rosenstreich explains. “So every time you have a statement like this, the market regains that appetite. But we believe traders need to temper their reaction right now.” He says the underlying fundamental reasons why policymakers would revalue remain intact, but they are concerned about another bout of dollar weakness and the fact that a destabilising revaluation could complicate the progress towards monetary union in the Middle East. This is despite the fact that inflation in Saudi Arabia is over 10 percent.
An unsuitable peg
In July, Goldman Sachs published a report examining whether the Gulf currencies are more suited to a dollar peg or a euro peg, and found in favour of the latter. In particular, Qatar, Saudi and the UAE all had very low scores for dollar peg suitability. The report argued that the dollar peg is unsuitable for Middle Eastern economies because they also have strong trading links with the Eurozone – so when the dollar weakens, their own currencies depreciate noticeably versus most currencies – especially the euro. This has increased import prices.
Mark Farrington, head of currency at Principal Global Investors (Europe), believes the dollar has now bottomed, “but it won’t rise for a while, so it takes the pressure off the pegged currencies to deal with a moving target”. He says it is fine for small economies to have a dollar peg, as long as they understand that the impact of an adverse movement must be taken through the domestic economy, rather than through the currency.
“In Hong Kong everyone now understands that if Asia has a recession, asset prices collapse in Hong Kong because they have to take the slowdown effects through wages and asset prices domestically rather than through the currency and interest rates,” he explains. “I don’t think the Middle East is familiar with that picture, although in the Gulf the business cycle can be smoothed for the general population via subsidies.”
But over time he expects this to change: “In Dubai there is now a lot of non-Arab money and they are exposed to the same economic forces. So I don’t know how they’re going to cope with a major recession in the Middle East. I think it will be a big boom and bust story.”
This happened in Hong Kong’s property market in the early years of the peg, which wiped out a lot of speculative money. “Then it made a stand and defended its peg and now it is accepted as part of the furniture there. So the Middle East still has a lot of pain to go through before they are as stable as the Hong Kong peg.”
Political pressure
Currency managers like Investec are not optimistic that the Gulf pegs will be abandoned any time soon. “At the moment the political pressure to retain the dollar peg is too high, so it is unlikely that they will move in the next six months,” says Werner Gey van Pittius, emerging markets currency manager at Investec Asset Management. “But we might see the central banks start buying euros. That’s what Russia did when it came off the dollar peg.” He adds that countries like Ukraine, where consumer price inflation is running at over 23 percent, is buying euros with the aim of moving to a euro/dollar basket. When their reserves are 50/50 euro/dollar, they will peg to this basket.
Investec has stayed away from the Gulf currencies because of this uncertainty over the dollar peg: “It uses up your capital and we prefer to play Egypt as a proxy, which runs a managed float,” Gey van Pittius explains. He sees more willingness in Egypt to allow the currency to appreciate and some Middle Eastern countries are re-investing their oil revenues there. “It also has the Suez canal and tourism revenues, so it is a much safer bet, as the likelihood of appreciation is much higher.”
Whilst high yielding emerging market currencies are still paying off for currency managers on the back of strong inflows to emerging market bonds, some analysts are growing uneasy. Jim McCormick, global head of FX strategy at Lehman Brothers, believes that many emerging market currencies are close to their highs, and is far from impressed with how central banks are handling the rise in inflation. “We are also seeing systemic risk increase. Currency weakness is already being seen in Iceland, Vietnam and Romania.” Poland, Hungary and Turkey have also exhibited recent spikes in risk.
PGI’s Farrington points out that the most vulnerable currencies are those where the country is relatively close to a current account deficit and dependent on high commodity prices to keep it above water, especially if it has a large amount of foreign currency debt. If commodities come off, these countries could be looking at an old-school balance of payments crisis.
Currency contagion
One saving grace is that emerging market contagion will probably play out in a more benign manner than in previous crises. He suggests that countries like Venezuela, Argentina, the Philippines, Vietnam and Zimbabwe will break first. “Then you will have the contagion trade, where everyone trades those currencies that look a little bit vulnerable. Next it will hit the stronger emerging market currencies, but they will be able to withstand the attack. So contagion will roll out but it won’t roll very far.”
Instead of chasing the high yielding emerging market deficit currencies, Farrington recommends shorting the Anglo-Saxon business model currencies, such as the Australian and New Zealand dollars and the UK pound, against the US dollar, as their banking sectors will be more affected by the credit crunch. “This should help bring inflation down as GDP will run well below trend for at least a year, it will create an output gap, and this will allow rates to be cut.” In other countries, however, inflation is unlikely to come down far enough to allow their central banks to cut rates.
He adds that currently, the currencies that get punished the most are those where the central bank is given the freedom to cut interest rates. He points out that the South African rand is rallying, regardless of the negative underlying fundamentals, because the central bank is tightening. “Whereas Australia has fantastic fundamentals and the minute the bank starts to cut rates they will sell that currency. It’s a lingering perverse logic driven by the carry trade.”
If you want to read more about how currency managers are positioning their portfolios against a backdrop of inflation in emerging markets, please go to:
The Bears Bite Back
With the summer reporting season now upon us, those looking for some relief amidst the bearish gloom are likely to be disappointed. Whilst pharmaceutical stocks like AstraZeneca staged a recovery last week, other traditional defensives like BT have been punished after reporting a lower than expected rise in first quarter earnings. Expect trading to be extra light once the Olympics start.
Several asset managers who have traded through previous bear markets have pointed out that the race to the bottom has been much quicker this time around, possibly due to the sizeable participation of hedge funds. “The market fell out of bed at the start of June and over a six-week period we had a precipitous fall in share prices,” says Alan McIntosh, CIO of Cheviot Asset Management. “In past bear markets it has tended to take several months for share prices to fall so far, but the market reacted very quickly and has already priced in a deep economic downturn.” Because of this, McIntosh believes the current bear market may be one of the shorter-lived ones. “Bear markets tend to run for about 12 to 15 months, so it may run another three to six months.”
Adam Steiner, head of research for public equities at SVG Capital, believes that active trading by hedge funds is partly behind the accelerated share price fall. He points out that global hedge fund assets under management have increased from under US$200 billon in 1995 to over $1.8 trillion in 2008. As a result, over the last decade the average holding period of FTSE 350 stocks has collapsed. “In the mid-1990s it was about two years whereas now it is down to five or six months,” he says. “In mainland Europe the fall isn’t as pronounced due to large bank and family stake-holdings, but it is still down from about 18 months to 10 months.”
Know your rights
The rise of hedge funds has also created a conflict between financial markets and the real economy. “Until this bear market we never had a significant number of people who make money if a company goes bust,” he says. This has been reflected in the recent rights issues by the banks, where HBOS only managed to attract an 8% take-up because its share price was driven below the rights issue offer price.
Regulators have responded with a temporary ban on naked short selling in the US, and the disclosure of trading in rights issues in the UK market. “But the reason why the banks are trading below their rights issue price is more to do with the fact that they are in trouble, and people think that there will be further fund-raising,” says Steiner.
He points out that once, no one would have benefited from a rights issue failing so there was pressure for them to go ahead. Investment banks can make a lot of money from rights issues and they allow struggling companies to continue trading. But now hedge funds can express a view that a rights issue is priced incorrectly, and they will make money if that view is borne out. “Hedge funds remove muddled thinking from the market – they take prices very quickly to what people think they should be,” says Steiner. “That removes the ability of markets to muddle through, and muddling through can be quite useful at times.”
Steiner believes the pending UK recession could be as bad as that of the 1990s, and possibly that of the 1970s, but for totally different reasons. “The basic problem is that central banks have spent the last 15 years trying to iron out the economic cycle, and their focus has shifted from controlling inflation to steady growth,” he says. “In the US, whenever there was the slightest hint of a normal slowdown, Greenspan tended to throw money out of helicopters as fast as he could.”
This approach has led to a 15-year accumulation of poison in the system, which needs to be sweated out. “Unfortunately the banks are realising they have a problem at the same time as companies are at peak profit margins. So we would expect corporate earnings to come down even if nothing else was happening.”
Across the market, equities are now trading at comparable levels to the trough of the 1990-1992 recession. “The FTSE is trading at P/Es of 10.5x, against a trough of 10.4x in 1991, whilst bank stocks are at 5.4x, compared with a long-term sector average of 12x,” says Richard Moore, manager of the Santander UK Growth Fund.
A short squeeze
Ironically, financials have become so over-sold that they staged a rally in July, and are up a modest 1.73 percent over the past month. Peter Lucas, global strategist at Ashburton, attributes this bounce to a period of short covering rather than any change in the fundamentals, and Steiner remains wary: “The UK banks still haven’t taken any write-offs relating to the domestic economy [although the likes of HBOS have increased their provisions to cover bad debt], and our view is that there is no point investing in contentious sectors as the rest of the market is so cheap.”
McIntosh is also cautious about the bank bounce: “It is probably a bit risky to load up with those yet because we haven’t heard all the write-offs, and if a recession occurs then all the bad debts will start to come through.” But he adds that some banks haven’t been caught out by sub-prime and will be able to take market share from the weaklings.
Other sectors being given a wide berth by managers include companies that are vulnerable to higher input costs, such as food manufacturers, and consumer businesses that are operationally leveraged. “The impact of slower sales will be magnified by competitive pricing and rising input costs,” says Colin McLean, manager of the SVM UK Active Fund. “A feature of a number of consumer companies is higher balance sheet debt.”
He points out that buy-backs and stock tenders in recent years, combined with high levels of dividend distribution, have meant that many consumer businesses will enter the slowdown with a weaker balance sheet. This will trigger dividend cuts and force some companies to renegotiate banking covenants – something that appears likely to occur with some UK house-builders. McLean expects weak trading to combine with margin pressures and balance sheet problems to trigger further share price falls in many UK consumer businesses.
In such an environment, Steiner says SVG is looking for companies that aren’t reliant on the cycle to generate profits, and are on an attractive valuation, with no major structural problems. As a result, he likes pharmaceuticals, telecoms and non-cyclical industrials, but is frustrated by the sell-side analysis of telecoms, which he believes has made a wrong call on every major development since the dotcom blow up. “It seems like they got so burned by the TMT bubble that now they always assume the most negative outcome of any story affecting the sector. So telecoms, which should be a defensive, hasn’t been from a share price perspective, even though the quality of the management in UK telecoms is the best by a mile.”
Good hunting grounds
Steiner also believes that small caps have been unfairly written off because of the widespread perception that they do poorly in bear markets as liquidity dries up. “But between 1970 and 1979, small caps outperformed the FTSE All-Share by about 200 percent. Our view is therefore to buy small caps because they have fallen the most.” This means looking for individual stories because small caps are vulnerable to banks pulling their funding or changing the terms of their financing.
Another good hunting ground during a downturn is where private equity deals have failed to come to fruition, as companies wise up to their real value. “We are seeing more talks that don’t go anywhere, where one side is looking for a bargain and the other is looking for fair value,” he says. If the private equity house walks away because it found something in due diligence that it didn’t like, Steiner says SVG will steer clear. “But if the private equity firm walked away because the company’s managers are holding out for a good price, then it could be worth looking at.”
As traders and asset managers head for warmer climes and market volumes thin, a major sell off in miners and energy cannot be far away. July’s fall in the oil place has ensured that commodity-related shares have already taken something of a beating – and given that the resources sector has been the FTSE’s life support for the last six months, this is likely to prove fatal.
“The problem is that there is very poor breadth in the market with a concentration in resources and mining stocks – only a few shares have participated in the upside and we need to see that broaden out,” says Lucas. “But over the last few months, even though the oil price has been going up, oil-related shares haven’t followed it. I think the reason for that is people did not believe that the oil price was sustainable at those levels.”
If you want to read more about how asset managers are positioning their portfolios in the bear market, please visit:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=45093
