Headwinds Return
In February we mentioned three headwinds that we see as recurring motifs of the current investment landscape – sovereign default risk, political interference and Asian overheating (most acutely in China). Having brushed them aside for most of February and all of March, investor attention turned back to them all at the end of April, with Greece a particularly acute source of worry, and markets retreated sharply. Our take on these issues is as follows:
1) Sovereign Debt
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. Another worry is that the European banking sector is very highly exposed to the sovereign debt of southern Europe - this presents a clear risk of deflationary consequences for not just the european economy, but also the global economy. As Warren Buffett put it this week when asked for his view on the Greek situation “I really don’t know how the movie ends, and I try not to go to movies like that….but in my view it will end in high drama”.
2) Political Interference
The issue of political interference, at its core, is that the general public in most parts of the world feel aggrieved that they have suffered at the expense of corporations through the recession, and want some recompense. Politicians are harnessing this mood music - developments at Goldman Sachs and the proposed Henry Tax on Australian resource companies are both manifestations of this trend. It seems highly likely that we will all need to adjust to a world in which ongoing political interference in the private sector is normal, and particularly in the financial sector where much of the government’s largesse over the past year has been focused.
3) Asian Overheating
The numbers coming out of the Asian economies are at once envy-inducing and worrisome. In Hong Kong money supply (M1) has grown by 36% and mortgage loans by 12% over the last year. Property prices are up 6% in 2010 after a 27% gain in 2009, reaching their highest level since the Asian crisis of the late 1990s. In Singapore industrial production has grown 43% in the last 12 months. The Monetary Authority of Singapore recently estimated that the economy has now fully recovered the output lost during the recession.
Clearly, inflation risks are building in the region. However, the most acute risk we see in Asia is within the Chinese residential and commercial construction market. Driven by bank loan growth (which has been running at more than 30% year-on-year) Chinese property prices have risen sharply over the last year, rising 12% in March alone. As short-seller Jim Chanos (of Enron fame) colourfully puts it, the Chinese real estate market is on a ‘treadmill to hell’. The better the numbers posted from here, the more difficult the unwinding will be when it eventually comes. Almost unnoticed this month, the Chinese equity market has fallen 10%, and now sits at a six month low. Whether this represents an early sign of gathering clouds remains to be seen.
The Case For Quality Revisited
Despite this bunching up of negative and uncertain news-flow over the last couple of weeks - intensified by the UK election, the volcanic ash cloud and the Gulf of Mexico oil spill - our guess is that the equity market’s path of least resistance will be up again when panic subsides. As we noted last month, the average blue chip share in the UK stands on an earnings yield of 8%, a healthy premium to government bonds yielding 4% and cash-in-the-bank yielding next to nothing. Recent developments in Europe also suggest that interest rates around the world are likely to stay lower for longer.
However, the more relevant question for us is which part of the market looks most attractive. On this point our view has been largely unchanged over the last six months. In October, shortly before Evenlode’s launch I wrote the following:
"We are seeing a very good opportunity in that segment of stocks that, if you were being unkind, you might refer to as boring. No problem for us here - the right kind of boring stocks have a habit of making a lot of money for investors as the years roll by, and all things being equal this is the section of the river we’d far prefer to cast our line into. High-quality stocks in the UK are now at their cheapest valuation relative to low-quality stocks this decade."
Not much has changed in the six months since I wrote that passage. The market has wiggled its way higher without a great deal of differentiation.
The following analysis puts a bit more flesh on the bone. We rank quality as a combination of high returns on capital, consistent returns on capital, and low debt levels. Normally, the first two factors go hand in hand with the third - businesses with consistently high returns on capital can generate high returns on equity without needing to push debt into the capital structure.
The following is the forecast earnings yield* of each quality quintile of the market, based on our definition of quality as outlined above. Note that as forecast numbers the statistics below already take into account analyst's bullish 2010 recovery numbers for lower quality cyclicals.
Top quality quintile: 12.6%
Second quintile: 9.7%
Third quintile: 8.3%
Fourth quintile: 8.1%
Bottom quality quintile: 5.8%
As can be seen, the highest quality quintile of the market currently trades at a discount to every other quality quintile. We see this as an anomaly worth exploiting. In the normal course of events one would expect to pay a premium for a higher quality business model – they present the investor with superior growth in shareholder value and less risk of capital loss than the overall market. Not so in the current market.
We are not arguing that this group of stocks is always the best place to allocate capital. GlaxoSmithKline for instance (a member of the top quintile) traded on an earnings yields of less than 3% at the beginning of the millennium – a valuation that, in hindsight, presented no margin of safety. It now trades on an earnings yield of 13% despite having grown these earnings by more than 8% per annum over the subsequent decade. Generally, we are seeing starting valuations in high-quality names that represent both relative and absolute value, particularly given their growth prospects in coming years. At the same time, they look uniquely placed to deal with the twin risks of economic volatility and rising inflation.
Hugh Yarrow
1st May 2010
Please note, this investment view contains the personal opinions of Hugh Yarrow as at 1st May 2010 and does not constitute investment advice.
*All earnings yields quoted are EBIT/EV figures. Source Bloomberg.
