Finding Low Risk Value in Today's Market
GaveKal Capital
By Team
March 9, 2011
We have made the case in our research that the investment environment is slowly transitioning from a macro-driven, reflation environment into one where earnings will once again be the driving force behind performance. We have also argued that US companies are especially well positioned at this juncture, as emerging markets are having to deal with rising wages, rising input costs and tighter liquidity (see our 4Q Quarterly Strategy Chart Book, Where Will Earnings Growth Be Found?). And contrary to consumers and the government, US companies have come out of this crisis in very good shape and corporate profit margins are now approaching their pre-crisis highs. Predictably, this has led some commentators to question the outlook for US corporate profitability, arguing that profits are mean-reverting and that they can only weaken from here on. Our regular readers will know that we disagree with the notion that profits are by nature mean-reverting (see The Myth of Reverting Margins and Why We Love US Equities). At this juncture, however, we readily acknowledge that commodity-driven price pressures are now showing up in import prices, and in order to maintain margins, companies will need to offset these increased costs with increased prices and/or rapidly improve their productivity.
On the productivity side of things, companies are loaded with cash and we fully expect that corporate investment will be one of big drivers of growth going forward. Having said that, productivity gains may take a while to show up, even with aggressive investments, which, on the shorter-term, leaves prices as the variable of adjustment. But are hard pressed consumers ready to pay increased prices? What are the implications for corporate margins and therefore equity markets?
On pricing, there are signs of renewed pricing power for US corporates (see Signs of Returning Pricing Power). Even small business are now finding some maneuverability on prices, as evidenced by the recent NFIB small business confidence index (see below). As the larger businesses of the S&P 500 have much stronger market positions than the average small business (who are by definition price takers), then it is a pretty safe bet that they are seeing returning pricing power as well. However, we hesitate to claim that all cost pressures will be passed on through higher prices, especially if oil shoots up further from here. So our view is that the profit outlook remains positive, but still uncertain. The natural follow up question is then: What is one paying for these earnings streams? Fortunately, the picture on valuation is much clearer. At least in the US, many large-cap sectors have equity valuations well below their average–and contrary to profit margins, we do believe that valuations are mean-reverting. If we were to describe the ideal equity investment in the current environment it would be (a) a quality business making good money, (b) with a high chance that profitability will continue, (c) not making an implicit bet on commodity prices, up or down and (d) priced at a valuation below its long term average. So where can find these assets?
Below we show a chart that compares the price changes that would occur for each GICS sector if (1) operating margins returned to their average, (2) P/E ratios returned to their average and (3) the combined effect of both. On this metric, the most attractive sectors are health care (low growth expectations have depressed P/E ratios) and tech (recent profit boom has been offset by declining valuations). On the flipside, energy stocks have above average margins and valuations, while
consumer discretionary and materials are trading at a level that implies that their recent increase in operating margins (currently 40% and 60% above their long term-average respectively) is sustainable. This seems excessive, even if one does not believe that profits are mean-reverting. In essence, energy and materials stock prices contain the implicit assumption that the commodity boom will continue, while consumer discretionary stock prices assumes it will not. Thus, for investors who, like
us, are not sure which way the commodity markets will swing (though we certainly hope for a correction), health care and tech stocks are an attractive bet.
Question: What do you make of the correlation between low interest rates and large budget deficits? Isn’t the level of US borrowing through maintaining very low short rates akin to a deliberate attempt to subsidize the government?
Anatole replies: The whole point of very low interest rates is to encourage companies and households to start spending their "massive positive cash flows" and thereby reduce excess savings. Until this happens, the government will have to remain in deficit by definition. It is a matter of simple arithmetic that the government's deficit can only be reduced either if the private sector savings surplus must be reduced by or the current account deficit must be reduced by the same amount. If you believe raising interest rates will lead to a smaller budget deficit, you therefore have to explain why one of the following will happen:
(i) Higher interest rates will reduce savings
(ii) Higher interest rates will increase investment
(iii) Higher interest rates will produce a smaller current account deficit
The only known mechanisms for these things to happen are the following:
1. Higher interest rates could decimate personal incomes and corporate profits, therefore reducing savings
2. I don't know of any mechanism whereby higher interest rates lead to higher investment. Rational businesses will always undertake the most profitable investment projects first, regardless of the level of interest rates. Thus if one feels that “malinvestment” is happening because of zero rates, one must logically believe that US investment levels are too high overall.
3. Higher interest rates, other things being equal, will tend to produce a stronger dollar, and hence a larger current account deficit. The only way that raising interest rates could reduce the CA deficit would be if they squeezed consumption and investment so severely as to overwhelm the stronger currency effect.
It seems therefore that, whatever other arguments one can present in favour of higher interest rates, the budget deficit cannot be one of them. The one thing we know for certain is that higher interest rates will tend to increase budget deficits. The reason why large budget deficits and low interest rates often go together is that they are both symptoms of the same fundamental cause: When domestic savings are greater than domestic investments, interest rates will be low and budget deficits will be big (leaving trade out of the picture, since it is driven mainly by other causes). This means that one way to reduce budget deficits is to maintain low interest rates until investment rises to absorb excess savings.
(c) GaveKal Capital
