Keeping Things Simple
Stock markets fell in June as the Greek government and Eurozone leaders failed to agree on a new bailout package for Greece. Investor fears were compounded by developments in China. The Chinese stock market plunged in June and early July, popping an eye-watering bubble in which many Chinese individuals had piled their savings into the market. This has raised further concerns over the ongoing economic slowdown and, in particular, the Chinese government’s ability to manage it.
The latest developments in China and the Eurozone represent the re-emergence of issues that have been bouncing around the global economy for more than five years.
I wrote the following, for instance, on the Greek crisis for Evenlode’s April 2010 investment view:
Probably the best outcome for Greece’s (and the euro’s) long-term future would be an immediate debt restructuring – looking back through the history of emerging market credit crises, countries that restructure early are the quickest to recover and return to international lending markets. An orderly restructuring would also signal a political body in control of its destiny and help stem contagion risk, which currently looks like an open wound ready to spill more blood. However, both the Greek government and the EU seem resolutely against this outcome. As a result, the ‘solution’ is a rescue package that kicks the can a little further down the road, and austerity measures that sound good in theory, but will be very difficult to execute (given the lack of will in the Greek public to accept these measures). Even if a bailout package is enough for Greece to fade into the background for a while the basic problem – too much debt and not enough income – remains.
More than five years on, not much has changed! For the bulk of European politicians, debt forgiveness is no more palatable than it was five years ago. Likewise, a concerted move towards more significant Eurozone integration would be a very difficult sell to the electorates of most members (particularly in light of the resurgence of nationalist sentiments across the continent). It looks like a last-minute, cobbled-together fudge will bring Greece back from the brink of a Eurozone exit, at least for now. But it also seems inevitable that structural questions regarding the region’s future will remain part of the financial market’s mood music for some time (as they have been for more than five years now).
In a similar vein, the following is an extract from Evenlode’s June 2010 investment view:
China’s recent economic growth seems to embody at a country level what we are trying to avoid at the company level. As the years have gone on China’s growth story has needed more and more capital to generate each marginal unit of GDP growth, with a heavy skew toward infrastructure and property development. We are, as a result, very wary of any stock that looks particularly reliant on the continued buoyancy of this part of China’s economy.
Today, with a bit of perspective, it is clear that the decade-long bull market in commodities (or ‘supercycle’ , as it was known at the time) ended nearly four years ago, and China’s slowdown has played a significant role in this downcycle (just as its rapid growth did in the upcycle). The views I expressed above were not at all consensual at the time, but the pendulum of sentiment toward China has swung a long way since then*.
Not Your Father’s Cycle
This is definitely not your father’s cycle (but maybe your grandfather’s)
It is now nearly seven years since the apex of the global financial crisis, but it continues to cast a long shadow over the global economy and financial markets. The above issues in China and Greece in many ways represent aftershocks of this great crisis. More generally, economic growth remains muted globally, and patchy. The lower oil price is beginning to benefit disposable incomes for many consumers, helping a cyclical recovery in several economies. But even in the US, which is a relative bright spot (along with the UK), consumers are currently squirrelling money away in what may, when viewed with more perspective, represent a structural increase in the savings rate. Though the recession officially ended in 2009, six years later the scars are still healing.
This recovery is a new experience for those of us that have spent our adult lives in the developed economies of 1980 onwards, but it is more normal when considered in the context of long-term history and the banking crisis that preceded it. Economists Kenneth Rogoff and Carmen Reinhart published the oft-referenced This Time Is Different in 2009. The book is a study of previous banking crises and subsequent recoveries, going back more than 200 years. These recoveries tend to be far more muted and drawn out than those from inventory recessions (the sort more common in the developed world since the Second World War). While this deflationary episode has not been nearly as extreme as the 1930s, there are echoes. US GDP officially bottomed in 1932, but the effects of the Great Depression rumbled on for another decade.
Keeping Things Simple
Our view on the macro-economic environment is that uncertainty and complexity is the normal state of affairs. In this context, we try to keep things as simple as possible. We continue to focus the Evenlode fund on market-leading companies that sell repeat-purchase or mission-critical products and generate healthy levels of excess cash. This type of business tends to be good at coping with geopolitical and economic uncertainties, whilst continuing to deliver healthy dividend streams.
We see significant valuation appeal in our key larger company holdings and have been adding to several over recent weeks (multinational companies were particularly hard hit during the sell-off in June, due to global worries and a strengthening pound). In the smaller company arena we have also seen more value emerge, selectively. RWS Holdings and RPS Group, for instance, are two smaller positions we have added to Evenlode recently. These companies are both global market leaders in their respective fields of intellectual property services and environmental consultancy. Both are experiencing some short-term headwinds (not least the impact of a strong pound on their reported results) but are high quality, well-managed franchises offering significant valuation appeal. As shown below, attractive current dividends are supported by healthy free cash flow and strong balance sheets. Long-term dividend track records are excellent**:
|Dividend Yield||FCF Yield||Net Debt/EBITDA||10 Yr Div Grwth|
|RWS Holdings||3.5%||5.8%||-0.4x||+16% p.a.|
|RPS Group||4.8%||9.3%||0.3x||+15% p.a.|
More generally, I think it is interesting to note that Evenlode’s current historic yield is more than 3.7%, which is towards the high end of the range the fund has traded in since launch. The chart below shows the historic yield on Evenlode compared with UK bond yields over the last four years***:
Much comment has been made regarding the sharp fall in bond yields and the impact this has had on equity valuations over the last two years. In a general sense I share this sentiment. Equity valuations are on aggregate higher than they were three or four years ago making the prospects for future returns less attractive than they were, and certain stocks in the UK market now trade on significantly lower yields than they did back then.
But the above chart is a reminder that the really big move over the last few years has been in the bond market. To put it simply, quality equities with dividend growth potential are still available on attractive valuations and good starting yields. In an uncertain world with no shortage of day-to-day noise and cross-currents, I think this simple fact is reassuring for the long term equity investor and worth remembering.
Please note, these views represent the personal opinions of Hugh Yarrow as at 17 July 2015 and do not constitute investment advice.
*This mood change is beginning to provide the odd new opportunity for us. Due to our focus on business models with a low capital intensity, the Evenlode fund does not invest in oil or mining producers. However, we do follow several high quality engineering franchises, some of which have exposure to energy and commodity end markets. These companies are highly cash generative business models capable of hunkering down and continuing to pay attractive dividends, despite a slowdown in some of their markets. The addition of a small position in Rotork this year (after admiring the company from afar for some time), is an example of this opportunity.
***Historic yield since Q4 2010 (the first quarter in which the fund had a history of four quartely dividend payments).