Equity strategies for today’s unpredictable markets

A KEY TO SUCCESS IS THE ABILITY TO IDENTIFY FUTURE DRIVERS OF RETURNS AND INVEST ACCORDINGLY. MATTHEW LAMB OF GAM EXPLAINS MORE

Global equity markets have once again responded enthusiastically to a dose of exceptional monetary stimulus, believing that European Central Bank actions have lessened the possibility of a catastrophic bank failure in Europe. More fundamentally, despite some signs of improvement in recent data, the global economic outlook remains extremely fragile and imbalances substantial, with the oil price a key variable. Political cycles will continue to feature prominently, but no amount of policy will change what looks very much like the typical aftermath of a credit bubble. In other words, we have both a debt and a growth problem in the Western world.

In such an unpredictable and fragile environment, the truth of the old adage that “equities will eventually win out” is currently in doubt – especially in light of recent performance relative to inflation. See Figure 1.

So what should investors be doing with their money? Is it wise to invest in equities and is it possible to do so without suffering wild market swings?

We believe that it is – subject to careful stock selection. Why? First, the recent move away from equities to fixed income by risk-averse investors has created a huge opportunity, as many stocks are at 30- or 40-year lows in terms of metrics such as their price earnings ratios.

Second, although often cast as the victims of the complex forces currently buffeting the economy and society as a whole, equities can also be seen as the potential beneficiaries – and in many cases the drivers – of future growth. Examples of these trends include but are not restricted to globalisation, the rapid rise of new industries and leaps in technological innovation. The “squeezed middle” in the G7 countries is feeling all of these acutely in the form of falling real wages and job insecurity, while national politicians struggle with coherent responses.

However, the increasing number of global companies with cross-border operations are in an enviable position; they can be actively involved in the creation of new products and services to appropriate growth markets around the world. Similar reasoning can be applied to suggest that selective globallyorientated equities are in fact a safer bet than government bonds. This may appear a bold statement but 2011 saw many countries’ debt become subject to unheard-of speculation. New instruments such as CDS (credit default swaps) allow for the articulation of a negative view on a single country’s debt far more quickly than in the old days when a bond had to be borrowed and then sold, with the shorting party bleeding out interest while waiting for the price to fall. The new financial innovation of CDS, for all its controversy, can now quickly signal what markets think of a country’s solvency. And the verdict was made abundantly clear as the peripheral European countries were de-rated and then supposedly more solid prospects such as France, Austria and – shock horror – Germany at one point saw their CDS premiums rise. Yes, US Treasuries withstood both a downgrade and the debt ceiling debacle during the year but unwanted attention will surely revert to both them and their UK Gilt equivalents soon enough.

Why does all this matter for equities? Distilled, the fact is that governments are stuck with their “market’, i.e. their countries and their electorates, for better or worse. Equities endure no such obligation even if they happen to be issued or traded in a particular country. They don’t have to deal with the challenges that are rapidly bankrupting western nations and turning government debt into a junk-rated credit instrument to be humiliatingly analysed for future solvency.

The future of the welfare state and the impact of baby boomer retirement in the light of low growth and declining tax receipts is quite simply not their problem. Should a nation respond to the difficulties described above by raising company tax rates to punitive levels or introducing other politically popular but economically restrictive regulations, a firm can avoid victimhood by rebalancing its operations away from that specific jurisdiction or simply move elsewhere altogether. Equities are the perfect hedge against the trends that are making life so difficult for immobile national governments and their securitised debt today.

So what to invest in specifically? We have mentioned global companies but even they are not entirely immune to bouts of elevated volatility as investors translate long-term structural issues into short-term panics that can engulf all sectors. This means that careful selection must be combined with longtermism. A sensible allocation should therefore focus on stocks that can be bought cheaply and that are the least sensitive to the long-term issues described above.

In our view, three types of stock seem to fit the bill: quality firms with a history of stable earnings through the economic cycle, stocks with a genuine ability to grow despite low economic growth, and, finally, stocks with belowmarket valuations with similar growth prospects to the wider market. Happily, these categories tend to include the kind of globally-minded firm that is best placed to ride the very forces that are making investors so nervous in the first place.

Established businesses with strong brands and resources, stable and healthy margins and sales, favourable dividend yields, strong cash flow yields and low to reasonable levels of debt should be considered as the core of an investor’s holdings. See Figure 2.

This quality core should be supplemented by satellite holdings of thematic investments. Investors need to identify the future drivers of returns and invest accordingly – concentrating on those stocks with good structural growth prospects independent of aggregate growth.

Investors should focus on a selection of investment themes – as it is never prudent to make aggressive bets on any one single investment theme. Some key thematic opportunities we have identified are: inflation, emerging markets, and technology.

Inflation – Imbalances in supply and demand can create investment opportunities through rising prices. Whether broad-based or isolated to regions or industries, companies with strong fundamentals and/or pricing power may benefit from inflation.

By identifying conditions that drive price changes, and then dynamically aligning portfolios with different sources and levels of inflation globally, skilled investors can generate returns from high, moderate, low or isolated pockets of inflation by investing in solid underlying companies with attractive pricing. The reality of the situation today is that pricing power is the key. Although the current inflation outlook is low to moderate and stable, pockets of inflation are coming from industries where there are bottlenecks and tight supply conditions. It is vitally important therefore to understand the sources and benefits of inflationary price pressures, and rotate from producers to suppliers to consumers as the cycle progresses.

Emerging markets – The investment case for emerging markets has been well made. Emerging markets offer attractive thematic growth opportunities versus developed markets, with the secular tailwinds of strong demographics, growing affluence, technological innovation, improved credit ratings and increased global distribution likely to continue, regardless of market cycles. Emerging markets also have better corporate governance, greater liquidity and higher levels of investment sophistication than they are often given credit for. We are witnessing the continued rise of new middle and wealthy classes in many key markets such as China, Brazil and India, whilst emerging economies are also in a far stronger position than developed markets in terms of fiscal balances, less public debt and more favourable forward-looking real GDP and currency appreciation expectations. And finally, emerging markets are currently at cheap valuations relative both to their own historic levels, and importantly, to those of developed markets.

Finally we come to Technology – which is potentially one of the most interesting opportunities around. Since 2008, the sector has seen something of a turnaround, delivering double the return of the MSCI World index over that time.1 This has triggered an industry shift and the start of a positive performance trend, reviving hope that the unfulfilled promises of the 1990s may finally be fully realised. Indeed, amid the market turmoil of 2011, the once-branded “high-beta high-risk” sector delivered close to a 300 basis point outperformance.

As with any sector, there are plenty of losers peppered among the winners. Having watched Nokia suffer a dramatic fall from grace, it has become clear that backing the big names does not guarantee returns. Instead, the key to capturing upside is a high-quality active approach that is not afraid to move away from the traditional leaders and seek out the little-known or out-of-favour names that show true potential. For example, at first glance, the hard disk drive sector seems like it is on the out as the obsession with NAND flash lives on. But on deeper analysis, none of the new technologies on offer eradicate the need for reliable and cost-effective data storage, yet rapidly growing demand for streamed media ensures a sustained client base.

In contrast, Facebook, Twitter and LinkedIn are heralded as the stars of the technology revolution – the marketing buzz is strong, and from a functional point of view, the value and impact of these companies cannot be doubted. However, from an investment perspective, the revenue flows required to meet sky-high valuations are somewhat harder to account for. Targeting the beneficiaries of capex – such as cloud computing, rather than the companies spending the capex – such as social networking firms, may prove to be more fruitful.

In conclusion, investing in equities can still benefit investors – particularly those who are able to maintain a truly long-term time investment horizon. “Quality” stocks can help mitigate some of the volatility/uncertainty along the way, and when they are complemented by a satellite portfolio of thematic investments, investors may well find they have a successful strategy for today’s unpredictable markets.

Matthew Lamb,

Head of Institutional and Fund Distribution (UK)
GAM