Stanford Brown Investor Insight Series November 13

Editor's Notes

• #3: After a 25% rise in recent times in global sharemarkets,investors are asking where to from here and the market rally over the past nine months has been amazing in the sense that global earnings expectations have declined, economic growth has lessened and the rise has been primarily driven by defensive sectors.
• #4: US outperformance is the most obvious feature of global equities over the past two years. This has largely been due to the superior earnings growth reported by domestically-focused US corporates. The US has avoided the sharp macro setbacks seen elsewhere, while firms have expanded margins, in large part by driving unit labour costs to multi-decade lows. Almost all equity markets rallied sharply from the global crisis lows, and went on to make new post-crisis highs in the first half of 2011. Since then, however, the US has been the only major market to make fresh highs (with the S&P 500 is up almost 20% from early May 2011, while emerging markets have fallen over 10% and developed markets by 5%). GDP outperformance provides only a partial explanation for the better earnings performance of US-focused US companies, but the heavy lifting has been driven by margin expansion.   The question is whether margins will improve this year and to the extent that margins have been assisted by fiscal easing, the significant fiscal tightening now being introduced suggests margins are unlikely to expand enough to generate double digit EPS in 2H 2013.
• #5: Earnings outside the US have been falling, consistent with very weak GDP growth.  The GDP growth series in the chart below may surprise you.  There are two reasons why it’s weaker than generally perceived.  First, I’ve used GDP at market prices and exchange rates (because investors do not live in a PPP-adjusted world).  Second, it’s GDP in US$ terms, so US$ strength damps this aggregate.  Investors watch earnings and indices in US$ terms. The surprise with the US is not that GDP has been strong.  It hasn’t been.  The surprise is the profits have improved as much as they have in this lacklustre recovery.I concede that QE has added something to equities. But if the key to relative performance has been earnings, then ending QE may not, by itself, be a rally-ending factors for equities – unless ending QE causes big problems in debt markets, and hence growth and earnings (a risk, to be sure).  US equities are now trading at a substantial PE premium to other major markets.
• #7: The tremendous global equity rally over the past year – 29% from the November 2012 low to the August 2013 high – has been due solely to valuation expansion.  Trailing and prospective EPS are unchanged over the period.  In my view this is largely due to investors pricing a ‘return to normal’, and less due to global QE. While US earnings have been good since 2010, recent performance has been subdued with flat growth in revenue and profits in the current reporting season. Elsewhere, earnings have been the missing ingredient from the market rally. Earnings have been declining whereas share prices have been rising. This is not unusual and has occurred in individual years such as 1975, 1982, 1991, 2001, 2008 and now 2012, but it has never occurred in two consecutive years, so earnings growth from now is key for the rally to be sustained and added to. Nevertheless, consensus earnings expectations is that EPS will continue to fall. The rolling 12 month-ahead forecast for global EPS has flat-lined, and is no higher now than three years ago, but is lower ex-US.While, I'm sceptical that recovery based on loose monetary policy, record low rates and rising leverage is sustainable on a medium-term view, for now, the prospect of unusually loose monetary policy is likely to be a supportive mix for risk assets as long as growth holds up.
• #8: The economic growth moderation has meant that downside risks to earnings have increased, with companies in a more difficult environment more likely to disappoint earnings expectations than exceed them.IMF latest forecast for global GDP in 2013 is 3.1%If history is any guide, earnings growth can be expected to be around 1%, which is well below the post-1980 average of 7% , with an additional dividend yield of 2%-3%, you are still talking about modestsharemarket returns, butif valuations expand a bit more it could be better. However, within the regions, US looks promising and Europe looks cheap, whereas Asia is likely to be the primary victim of changes in US Federal Reserve policy.However, given modest EPS growth, the global economy doesn’t have much room to disappoint before EPS turns negative. Consequently, we may have seen the majority of the market’s rise already this year and corporate earnings may not be overly constructive in the period ahead.
• #9: The most surprising thing about the aftermath of the global financial crisis which highlighted to dangers of excessive leverage is how little deleveraging has actually occurred. Overall leverage in the five largest advanced economies (US, UK, Japan, Germany and France) has risen by 24% since the end of 2007 (with total debt in Japan up by 41%, France by 27% and the US 24%). The US is the only economy that has seen any form of deleveraging, and that largely reflected reduced debt in the household sector due to mortgage defaults, more than anything else. The rise in G5 debt reflects a rise in public sector debt. Global economic prospects won’t start to get better until de-leveraging begins and the process will be protracted as result in many years of sub-trend growth, even if interest rates are kept at record lows.
• #10: Cyprus
• #14: Ad lib from the slide
• #17: Income has been supportive for the cyclical recovery, but cyclical sectors have lagged the rally. Indeed, the search for yield has boosted dividend-paying equities. The relative valuation on stocks with above-average dividend yield already looks rich on some measures. However, the factors pushing investors into equity yield seem likely to persist for the foreseeable future and dividends may be an outperforming theme for several reasons:Firstly, economic and earnings growth remains tepid. That reduces the relative attractiveness of cyclical equities that are leveraged to the economic cycle. Secondly, with global profits already at a relatively high share of global GDP, it seems unlikely that earnings can grow faster than GDP for a sustained period.Thirdly, the payout ratio (the percentage of earnings distributed as dividends) is relatively low. This means that corporates can, for a time, increase dividends faster than earnings. This could partly reflect a shift away from distributing earnings via buybacks to dividends. Fourth ageing baby-boomers, who control a disproportionate share of invested capital, are moving from the stage of building up their nest egg to living off the nest egg raising demand .The question, of course, is whether corporates will increase dividend payout ratios. My view is that they will if the incentives are right – and the incentives appear to be changing. S&P CEOs are now more likely to have stock than options – so they receive dividend checks, along with other owners.
• #20: It's been five years since the peak in the Aussie market. Only the 1973 and 1987 corrections were longer in duration, taking ~6.5 years to recoup losses (left chart below). On those occasions the market rallied hard after about 5 years but valuations were cheaper than now (13.6x now vs 10.8x in 1978 and 11.4x in 1992). So where does it leave the latest recovery?The key question to ask is what sectors can push the Aussie market higher from here? Banks led the market out of the post-1987 funk, increasing around 90% between November 1992 and January 1994, but they had good prospects for earnings growth coming out of the last recession since households only had half the leverage of today. This time around there's a smaller chance banks can meaningfully increase earnings, and we are sceptical miners will record stellar earnings growth over the next 5 years. However, healthcare and US-exposed stocks are prime candidates to record solid earnings growth and quality industrial companies with strong balance sheets and surplus cash-flow generating business models should remain core portfolio holdings, in our view as they will provide upside potential with downside protection. … But given the subdued global and domestic outlook it could take longer for the Aussie market to regain its peak than the 1973 and 1987 episodes and the market is more likely to grind higher than have a large bionic leap as has been the case in previous recoveries. So with price growth likely to be around nominal GDP (which has averaged 6% since 1959) and a four 4% dividend yield, we are talking about a total return of 10% - less than the historical average of 12.0%, but not bad considering the headwinds out their. This tells us, the income and income growth are going to remain large determiners of market and portfolio performances.
• #21: The 1974 crash in the wake of the first oil crisis was the only time Australian investors lost more money than what they did during the GFC. And like today, investors back then faced a similar quandary – should we put our money into this risky asset class given how unstable the environment is. Now we can look back and ask did the risky sharemarket really reward people for taking extra risk, considering on three occasions, it fell by more than 30%.Lets have a look how each asset class performed. Gold – no income, total return of 14 times your moneyCash – income, but no capital growth – 28 times your money (twice that of gold)Residential property – little income with large capital growth – 48 times your money (around twice that of the cash market)Listed property – more income less capital growth – 102 times your money (double that of residential property)Shares – the most income, the most capital growth and 180 times your money (double listed property, four x residential property, six x cash and 13 x gold).No correlation between price and total return, but perfect symmetry between income and total return – because income generation is the basis of successful wealth creation and it has been since the dawn of time.
• #23: When you exclude the four years of unusually high dividend growth you can see the trend in share dividends is very consistent, as is cash but the only problem there is that the trend is downwards. Cash not only has less income, but it is more volatile than other forms of income.
• #24: When you exclude the four years of unusually high dividend growth you can see the trend in share dividends is very consistent, as is cash but the only problem there is that the trend is downwards. Cash not only has less income, but it is more volatile than other forms of income.
• #27: So if 007 was an investor he might think he is at an existential crossroad and perhaps in this film Daniel Craig considered his own shelf life, in the knowledge that in the revolving door James Bond franchise, where the character lives on far longer than the actor, his days as a secret agent are also numbered. As an investor, he and all of us, can’t help but remember the power of income – it is the greatest source of wealth creation – it always has been and always will be. And while times are slowly getting better, diamonds are not forever and for your ears only - the power of quality companies to deliver the income and income growth to investors is the best path forward in any economic terrain.Thanks so much.