The last 12 months will be remembered as one of the most difficult periods in recent times for equity investors to navigate, as political shocks and economic uncertainty saw markets oscillate between underlying styles and sector leadership. Head of Income Mark Whitehead reflects on 2016 and assesses what the overriding themes will be for income investors in the year ahead.
What were the key drivers of markets last year?
2016 can be summarised as a year that started off as the great rotation and ended as a battle of value versus quality – with a clear win for the former. This has been dubbed the ‘reflation’ trade. Up until the UK’s vote for ‘Brexit’ at the end of June, markets were characterised by a rotation into what had been the weakest sectors of the previous three years, notably energy and materials. Returns, meanwhile, were relatively lackluster with global markets up 2.6% to the 22 June*, the day before the referendum. Energy and materials are seen as among the most cyclical sectors in the market. Performance in these sectors was driven by a recovery in commodity prices – oil, for example, troughing at around U$27 per barrel (bbl) in January and nearly doubling to around US$53/bbl by June.
However, following the UK referendum (and then reinforced by the US elections in November) the market leadership extended to include all cyclical sectors – consumer discretionary, industrials, technology and financials. There was particularly strong performance in financials, aided by a steepening yield curve and expectations that President-elect Donald Trump will ease the regulatory burden for the sector in the US. For sterling-based investors in global equities, currency weakness has been very positive for returns.
Why is global equity income currently such an attractive proposition for investors?
A critical draw for investors of a global income approach is the yield offered by equities relative to other asset classes – most prominently bonds. Government bond yields in large markets like Germany and Japan at one stage moved into negative territory and remain low, while the corporate bond market has also suffered. Secondly, although global markets are highly interconnected, conditions still vary and valuations can diverge a great deal. A global approach therefore provides the greatest width of opportunity. Finally, high-yielding, quality equities typically outperform over the long term. High quality companies also have the majority of dividend growth.
What differentiates your strategy from competitors?
One of the key strengths of our strategy is our seven-strong team, containing portfolio managers and analysts, each with significant expertise in income investing. Our approach also differs from many other income investors in that our starting point is growth, not yield. Starting with the latter runs the risk of a portfolio containing high-yielding companies with no growth, putting rising income and potential capital growth at risk. Our research focus is another key differentiator, centered on credit analysis, dividend stress testing, and governance and sustainability factors. Credit analysis in particular has allowed us to gain a greater understanding of a company’s liquidity and capital structuring, which helps us gauge whether or not its credit profile is appropriate for the type of activities it is undertaking. The use of stress testing enables us to model how a company will be able to operate in a more challenging environment, analysing how cash flows and dividend sustainability may be affected. Finally, we also need to be comfortable with the softer ‘qualitative’ side of a business, which means analysing governance and sustainability factors. This is fundamental to our conviction building and allows us to identify management teams that are likely to be good stewards of capital and provide durable dividend growth.
With growth as your starting point when researching stocks, how challenging is it to find opportunities in a low-growth environment?
Company growth is generally linked to the overall economic environment. As a result, high levels of growth are hard to find in the current conditions, where lower-for-longer interest rates reflect difficult economic realities. However, with a global mandate, we have access to a broad universe of opportunities. We are still able to find plenty of companies generating strong cash flows – even in the tough economic conditions – which are able to reward shareholders on a sustainable basis. The portfolio turnover is testament to that, with new high-conviction investment ideas still being added. Indeed, we are able to identify companies which are benefiting from long-term structural trends, such as rising (and ageing) populations. As an example, the dietary requirements of future generations may prove positive for companies like Dutch-based animal and human nutrition company DSM, which produces nutrition products, such as dietary supplements. Elsewhere, while we are cautious over pharma companies (due to the continued debate over drug pricing and its implication for the sustainability of future returns), we believe the aggressive government intervention may now be less likely.
How are valuations looking relative to historic averages and other markets?
Based on some traditional metrics, global equity markets look expensive. In terms of price to earnings (p/e) and enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA), the MSCI All Countries World Index (ACWI) is more than one standard deviation above the longer-term average. On a dividend-yield basis, the MSCI ACWI index is yielding slightly beneath its historical trends. However, alongside the traditional, we also look at intrinsic valuation methodologies, such as discounted cash flow. In our research, valuation is considered alongside growth and quality and all three aspects have to be satisfied.
What will the key drivers be for your market in 2017?
It is likely that the value rally in equity markets has largely played out and how the current ‘value-versus-growth’ dynamic continues in 2017 depends on a confluence of factors. Loose monetary policies have underpinned equity markets in the absence of economic growth, so how policymakers withdraw from their highly accommodative stance from here will be a key concern, as markets are vulnerable to any form of disappointment. The broad consensus now is that the emphasis will shift to fiscal stimulus, in the form of tax cuts, infrastructure expenditure and favourable free-trade deals, which could prove to have a positive impact on corporate and consumer spending. A fiscal splurge in the US, for example, to rebuild infrastructure and generate a surge in employment, would provide a welcome backdrop for banks. That said, it will take some time to come through and the market may already have priced this in after a very strong rally for the financials sector in recent months. Alongside these factors, there is the spectre of political uncertainty. While the UK referendum and US elections were focal points of 2016, the rise in populism – and attendant lack of predictability – is likely to continue, with the French presidential election and the German federal election key points on the political calendar.
What this means for sector leadership is unclear, and the lack of macroeconomic visibility will doubtless result in periods of sharp equity-market volatility in 2017. However, we continue to focus our investment process on identifying high-conviction ideas that offer us a mixture of organic growth, high quality and attractive valuations. The credit analysis we employ should enable us to avoid companies with inappropriate balance sheet leverage and liquidity for the business models they operate, which can lead to dividend cuts and capital volatility. We expect recent additions to the portfolio to exhibit organic growth even in a sluggish economic environment.
* Source: Factset, data from 1 January to 22 June 2016. MSCI All Country World Index.
§ Source: FactSet as at 31 December 2016.