The shock of US President Trump’s election and Britain’s “yes” to Brexit are now in the rearview mirror, allowing portfolio managers and researchers to cast forward to a less volatile global equity environment.
Download full In Focus report, Still to come in 2017, as a pdf.
As we look forward to the rest of 2017, here are some of the key strategies and concerns
of three prominent players.
Value and quality investor Perpetual Investments expects opportunities in listed companies influenced by a “more comfortable” macroeconomic environment.
Perpetual Global equities portfolio manager Garry Laurence says the US will lead developed markets into strong GDP growth, pushing interest rates higher.
“I think volatility has come down quite significantly in the calendar year to date, so people have become more comfortable with the macro environment, seeing a pick-up in GDP growth around the world,” Laurence says.
US unemployment rates have fallen in the past five years, leading to wage growth.
“So you’re seeing signs of inflation and that has led to people realising that the Fed’s been behind the curve in terms of raising interest rates – a key theme that’s driving the financial services and banking sector,” he says.
Laurence is happy to buy small-cap or large-cap stocks. His investment choices target quality businesses with strong balance sheets. This 50-year-old strategy has allowed Perpetual’s
global fund, now in its seventh year, to outperform the benchmark MSCI World Index by 2.91 per cent for the past five years, as at 31 March 2017, at 19.18 per cent a year.
“We look at debt-to-equity but we also have a hard focus on EBIT cover; for us, EBIT-to-net interest needs to be greater than three times. [That provides assurance] during periods of rising interest rates,” he says. “[That way] you’re pretty comfortable in terms of your bank covenants and also during periods of weakness in economic demand, when your earnings could fall, so there’s a nice buffer there.”
The evergreen investments in the portfolio are stock exchanges in developed markets that have “very high barriers to entry” and are monopoly businesses benefiting from increased regulation, such as the Deutsche Börse and Nasdaq.
Perpetual accesses businesses that provide people with life’s staples – food and healthcare – through branded food manufacturers Britvic, General Mills and Colgate, and health company Sanofi Aventis.
Wells Fargo, a US bank with a low cost of funding and a leading retailer, is also in the mix.
In emerging sectors, Laurence likes online businesses with a first-mover advantage, such
as advertising portals eBay and China’s Zhaopin.
“We like those types of online businesses where you are seeing a structural shift from old media to new media types of advertising, or transactions taking place online rather than in bricks-and-mortar stores,” he says.
Technology companies that are using artificial intelligence (AI) are also in the crosshairs, because of their positive impact on “swallowing costs” for business.
Google’s listed vehicle Alphabet, Cap Gemini, Facebook, and an IT consultant using IBM Watson software are all working with AI to improve performance, which meets Perpetual’s parameters.
In China, Laurence sees “huge growth for the consumer and services sector” in technology and healthcare, with exposure available through US and Hong Kong sharemarkets.
“We are largely invested in developed markets [through companies we own] in the US that are exposed to them, and we do have some investments in emerging markets, like China for instance, but they’re probably smaller positions.
“We own Zhaopin online employment classifieds – it’s about to be taken over by Seek. We own Autohome, which is the carsales.com.au of China, and Shandong Weigao, which is a healthcare company operating in China but listed in Hong Kong.
“We do think there’s a structural shift from manufacturing towards the services sector in China, and businesses within that consumer/healthcare/tech space are going to pick up, as they are in developed markets at the moment.”
On the flip side, rising interest rates will affect valuations in markets over the next few years, which Laurence says will be a negative for real estate investment trusts (REITs) and other bond proxies.
“Many valuations in those sectors got extended and those stocks are quite expensive at the moment. Even though they have started to de-rate a little bit, that trend will continue…same with the valuations and performance of bonds.”
Less active management
From a product perspective, Lonsec Equities general manager Peter Green sees investors moving away from actively managed global equity funds, which generally have higher fees but are not necessarily offering equivalent yield. These include smart beta exchange-traded funds, which are active equity products using alternative index construction rules, providing systematic exposure to certain sectors taking into account size, value and volatility.
“On the product side, active versus passive, there are some pretty strong longer-term trends that are affecting us and we’re seeing active management depressed. [It’s] hard to justify unless you have a high conviction or a regional point of view,” he says.
Still on the radar, however, are global fund products that ‘stand for something’, like those run by Henderson and the Aberdeen Actively Hedged International Equities Fund, which has a high conviction, a buy-and-hold strategy, and a significant divergence from the benchmark.
Self-managed super funds and wealthy investors looking for a direct investment in global markets are choosing separately managed accounts (SMAs), giving them access to different managed investment funds, Green says.
Active managers are grappling with strong growth in US markets, where valuations are high, slimming the options for growth and value managers. Focus will be more on Europe, Japan and emerging markets over the next 12 months, with geopolitical risk subsidingin Europe, he explains.
Go with what you know
As long as equities perform well above low-risk assets, like term deposits and bonds, stay invested, says Farrelly’s Investment Strategy founder Tim Farrelly, who takes a 10-year view of large-cap companies.
The broad asset allocation investor sees the yield gap closing in an environment with rising interest rates.
“You may as well be invested now but there may come a time, particularly when these markets are starting to run, where you say, ‘The amount of extra return I’m expected to get from being in equities is too narrow. If things go well, I get [just] 1 per cent more. Why would I bother?’ ” he says.
Farrelly has used the same approach for the last 17 years. He invests in large-cap stocks and recommends only those sectors he knows well.
China is a “fabulously interesting place”, but current valuations of Chinese banks at five to six
times earnings are hard to believe and while “they may turn out to be the bargain of the century”, there is too much uncertainty, he says.
“But if you’re worried you’ll leave a lot of good opportunities on the table, find managers who can make those decisions,” Farrelly advises. “Rather than saying, India, China or Russia’s no good simply because they have lousy government, often you’ll find managers or companies who do have good governance in those countries – and they’re a bargain.”
Farrelly’s asset allocations have typically outperformed market benchmarks by 1-2 per cent, depending on the portfolio and its risk level.
“Once every eight to nine years, markets go to extremes and that’s the time my system shines…
That’s the time you’ve got to take action,” he says. “Also, you should be saying, if things are extreme I’m going to take money away from the fund managers.”
He says company earnings are depressed in Europe, Britain and to a lesser extent Asia; in most cases they’re well below the pre-global financial crisis level.
“We’ve got depressed earnings and economies that are slowly recovering there and price-earnings ratios are not too bad. I think we get decent returns out of there, 8 per cent or something, which is fine,” he says.
The United States was a different story, with good earnings growth and expensive equities priced at up to 24 times earnings in some cases.
“When you hear most people talk 18 to 19 times next year’s earnings, you’re assuming a big turnaround. But prices are stretched. The conviction I have is, if you buy assets with a long-term frame of mind when valuations are reasonable, you’ll do pretty well over the long term,” Farrelly says.
If all goes well, an investor can expect a return of 6-8 per cent in any “risky” asset, he says.
TOPICS: eBay, EQUITIES, farrelly’s Investment Strategy, Garry Laurence, Lonsec Equities, markets, Perpetual Global, Peter Green, Tim Farrelly, Zhaopin