image Antipodes Partners’ expands investment team and opens London office image AFR: Three big reasons not to like traditional titans of tech

Market Outlook

Socio-Macroeconomic Overview

Following on from the June quarter, the September quarter offered a series of vignettes relevant to the longer-term macro discourse, including:

  • The overarching appetite for change, stemming from rising inequality (principally driven by a lack of minority rights, government deficits, regressive tax systems, privatisation of essential services, labour and capital market deregulation) and exacerbated by declining real wages.
  • Related to this, the rise of the far right Alternative for Germany (AfD) party, winning 13% of Germany’s national vote in recent elections, along with the growing voice of Catalonia’s secessionist movement, is a further evidence of the growing polarisation of the Western political environment.
  • The increasingly uncertain relationship between China and the US over the management of North Korea’s nuclear arms ambitions with serious potential negative implications for global trade.
  • A growing rift in post-war alliances, with the E.U., U.K. and U.S. looking increasing inwards as China looks to expand its geo-political footprint.

Figure 2: September Quarter Price Performance (USD, Market Cap Weighted)
socio-macro
Source: Antipodes Partners

Figure 2 above highlights the uniformity of Global Cyclicals outperformance across all regions and coincides with manufacturing Purchasing Managers’ Index posting multi-year highs, record setting stock market indices and continued benign financial conditions. Headline inflation remains subdued against a backdrop of growth surprises.

Chart 4: G7 Productivity Trend (1985-2017)
chart4
Source: Conference Board

Sustained inflation has proven elusive in developed economies throughout this cycle, but with developed economy productivity gains having persistently decelerated in recent years (Chart 4), output gaps or excess capacity may be significantly lower than that typically modelled. In a recent trip, the common refrain amongst Japanese corporates we met was the severe shortage of skilled workers available to satisfy their requirements, perhaps signaling building wage pressure.

With employment indicators in most developed economies approaching the peaks of 2007, combined with the upsurge of nationalism and related cries to roll-back decades of trade liberalistion, upward wage pressure across developed economies appear to be building. U.S. average hourly earnings grew at their fastest pace in three years in September (Chart 5) and the August Consumer Price Index reading accelerated to 2.5% annualised.

Chart 5: U.S. Average Hourly Earnings (YOY, 2007 – 2017)
chart5
Source: U.S. Bureau of Labor Statistics, Bloomberg

Against this backdrop of growth surprises, developed economy monetary policy remains remarkably loose. Constant doses of liquidity (asset purchase programs) have swelled central bank balance sheets such that the combined balance sheets of the Bank of Japan (BoJ), ECB and Federal Reserve now approximate U.S. GDP in size. Though the Federal Reserve’s formal QE program has ceased, the ECB and BoJ programs have more than offset this impact. Chart 6 below demonstrates the likely impact on the net supply of the instruments targeted by central bank purchase programs, as policy settings are normalised. As outlined in our June report, these purchase program have been concentrated in the 8-9yr maturity range with the BoJ for instance now own more than 60% of Japanese Government bonds maturing in 2025-26. Aggregating the five instruments on Chart 6, net issuance will turn from having been negative in 2016-17, that is more than 100% of issuance has been absorbed by purchase programs, to significant net supply in 2018-19. As a consequence traditional price discovery mechanisms may be re-instated, with implications for long-dated yields.

Chart 6: Net Supply After Subtracting Central Bank Net Purchases (2010 – 2019)
chart6
Source: Citi Research

Exposures have, by our assessment, reached extremes. Low volatility strategies have also been a major beneficiary of central bank purchase programs, with such interventions possibly reinforcing the belief that “low vol” should be equated with low risk. In a July research report we pondered a potential scenario associated with a global growth surprise leading to an accelerated normalisation of central bank policy settings. Macroeconomic data over recent months seems to confirm this prospect, as do equity market moves. However as noted in our market commentary, long dated yields (with a small number of exceptions) are yet to reflect what equity markets are now embracing. As in the forest fire analogy, Antipodes is more inclined to believe that extended periods of low volatility are likely to be associated with building risk, but with the timing of its manifestation inevitably difficult to predict. We therefore continue short the most egregious examples of this excess as part of our overall portfolio positioning.

Table 4, Figures 1, 2 & 3, Charts 7 & 8 apply our proprietary quantitative tools to determine the broad geographic sector and factor exposures that are most or least prospective for future returns. We use these as a contextual framework (or peripheral vision) rather than a deterministic tool for allocating team resource. Furthermore, if valuation dispersion is high across sectors or factors, as it is today, a competent stock picker will find attractive investment opportunities regardless as to whether the broader group appears expensive. Above all, the analyst will have the benefit of the broader contextual thinking of the CAPE analysis, sector/factor heat-maps and industry/company level screening before commencing any deep dive analysis.

To the extent that we describe a sector or factor as cheap/attractive or expensive/unattractive we’re referring to a historical mean reversion relationship. Clearly, there are limitations to such a framework, i.e. this is not a statement regarding absolute value as this can only be made after performing our industry/stock level analysis. However, at a large sample size and in the right hands, such a framework still has merit.

Geographic Sector Valuations

Note: Cyclically Adjusted PE, Sector and Factor definitions can be found in the Glossary

Table 4: Future Expected Sector and Geographic Returns (2017)
table4

See Glossary for CAPE, EMR and Sector definitions. Source: Antipodes Partners
In terms of the broader outlook for equity markets, we find it useful to examine the long-term empirical data in terms of what starting multiples imply for expected future returns. Given broad differences in the timing of earnings cycles across both regions and sectors, we prefer to measure broader expectations for future returns based on “Cyclically Adjusted PE” (CAPE) based valuations. On this basis, the more attractive broad sectors are Developed Asia Global Cyclicals, Financials and Domestic Defensives in all markets outside of North America. The least attractive areas are dominated by the very large Global Defensive sector (~25% of global market capitalisation), Emerging Asia Global Cyclicals and North American Domestic Defensives.
Our Region-Sector Heat-map (Figure 2) further extends this analysis and we broadly observe:

  • Consumer Staples enamored for their perceived Profitability and Growth characteristics (Chart 7), though having underperformed over the past 12 months, still remain one of the most expensive Developed Market sectors.
  • Healthcare has underperformed to the point now that relative value has appeared.
  • Interestingly, in a market paying-up for yield (Chart 8) and Global Defensive exposures, Domestic Defensives including traditional yield sectors such as Infrastructure (outside of North America) and Telecommunications have become very cheap, coinciding with the apparent value of Good Yield (funded through cash-flow); within the Global Funds we have taken advantage of this primarily within our European Recovery exposure.
  • Financials though having significantly outperformed over the past 12 months remain one of the cheapest sectors globally with sentiment and profitability expectations weighed down by macro-concerns, low rates and yield curve compression.
  • As the broad relief rally in China growth sensitive equities has played out over the past 12-18 months, Materials have outperformed, though Energy has lagged and remains one of the most de-rated sectors by historical standards.

Factor Valuations

Most quantitative strategies would measure the attraction of a certain “factor” exposure on the basis of its price momentum. These same systematic strategies see Value as a separate factor, by which they mean low multiple stocks, but will only buy Value if it exhibits momentum. At Antipodes Partners, we worry that factors favoured by systematic strategies will eventually become overvalued (a symptom of crowding), offering little margin of safety at the stock level and exposure to “regime change” style draw-down risk at the portfolio level. Hence, we value a range of factors (e.g. Profitability, Growth, Resilience, Multiple Dispersion, Good Yield, Volatility and Momentum, etc., Charts 7 & 8) rather than Value in isolation (we prefer to label Value as Multiple Dispersion to make a clear statement that the starting multiple is meaningless without the context of growth).

Keeping with our philosophy of finding investments with multiple ways of winning, another way we can win is by gaining:

  • Cheap exposure to an expensive factor, e.g. Cisco Systems, a very cheap “Profitability” exposure at a PE of 13x where an equivalent exposure would cost on average +20x PE.
  • An exposure to an out of favour factor based on the view that the market view may change, e.g. “Good Yield” (cash-flow funded) is offered cheaply by many Utility and Telecommunication stocks, as opposed to the expensive “Bad Yield” (capital market funded) offered by many Infrastructure stocks.

Accordingly, Charts 7 & 8 apply our proprietary quantitative tools to determine how expensive various factors have become relative to the last 30 years (expressed as a Z-Score) by comparing the valuation of the most profitable (highest growth/momentum or lowest multiple) stocks to the least profitable (lowest growth/momentum or highest multiple) stocks.

Chart 7: Z-Score (Median EV/CE of Upper Quintile Relative to Lower Quintile (1987 – 2017)
chart7
See Glossary for factor definitions. Source: Antipodes Partners

Chart 8: Z-Score (Median EV/CE of Upper Quintile Relative to Lower Quintile (1987 – 2017)
chart8
See Glossary for factor definitions. Source: Antipodes Partners

With reference to Charts 7 & 8:

  • The market is celebrating stocks that display high Profitability, Growth and Momentum independently of starting multiple. Further, it’s noteworthy that the market’s willingness to pay-up for Growth, Profitability and Momentum is approaching the heady days of the late 1990’s tech bubble. One can also observe the subsequent derating that occurred as high Growth and Profitability attracted competition and these stocks lost their allure, a clear example of how a high starting multiple was predictive of future sub-par returns.
  • The market’s love affair with low volatility appears to be waning with a notable retreat in the valuation of this factor from the extremes of mid-year.
  • Momentum is simply the outcome of the market’s obsession with an ever narrowing group of stocks selected on a systematic preference for high Growth and Profitability. Whilst clearly Growth and Profitability matter, for Antipodes Partners these descriptors only offer real meaning in the context of valuation rather than momentum.
  • A global preference for small-mid caps over large caps, especially in North America, with Asia Ex-Japan the major exception; in many ways an extrapolation of the valuation dispersion observed between hyper and mature growth businesses.
  • Extreme thirst for equities with bond like characteristics, i.e. Yield and Low Volatility, without concern as to the inherent risk equities represent. Interestingly, the market fails to pay a premium for Good Yield over Bad Yield.
  • Encouragingly, Multiple Dispersion is evident across all regions.

More specifically, extreme policy settings in Europe/Developed Asia have led to severe investor herding, evidenced by the extreme overvaluation of Profitability and Growth in these regions. Ironically, investors have the cheapest opportunity to buy balance sheet Resilience and cash covered dividends (Good Yield), even when macro concerns are heightened!

To find out how Antipodes has positioned itself in global markets, read our September quarterly report