The indiscriminate sell-off through the late fourth quarter of 2015 and into 2016 is exactly the type of environment the Invesco International and Global Growth team has been waiting for. While the correction year to date has begun to improve the risk/reward ratio for many stocks, it’s important to recognize that share-price declines have in many instances largely tracked earnings estimates lower. We’ve yet to see risk premiums rise to adequate levels in the higher-quality areas of the market we prefer, but our research “watch list” of stocks approaching buy levels is growing.
Understanding global market drivers
Collectively, there was more negative than positive news for markets to absorb, leading to declining equity prices during the fourth quarter of 2015 and a more dramatic step down in the first weeks of 2016.
- The trend of negative earnings-per-share (EPS) revisions has dominated every region of the world recently, accelerating downward during the last quarter of 2015 due to further deterioration in emerging-market growth outlooks and commodity-price deflation, particularly in oil
- The U.S. dollar strengthened relative to most developing-market currencies, which saw another leg downward as the U.S. Federal Reserve followed through with its much-anticipated token rise in interest rates
- Investors also digested deteriorating credit spreads in sectors outside of energy and materials, as well as visible shifts toward e-commerce and online retail spending at the expense of the brick-and-mortar variety
Looking through the EQV lens
A focus on Earnings, Quality and Valuation (“EQV”) is at the core of our team’s investment philosophy and process. Let’s take a look through that lens
Earnings. Downward earnings revisions dominated the fourth quarter, with world revisions in aggregate down 22%. Japan, Europe and the U.S. saw the fewest downgrades, while emerging markets and Asia, excluding Japan, saw the largest downgrades.1 From a sector perspective –
- Unsurprisingly, energy, materials and industrials are seeing the most dramatic reset of expectations
- Consumer staples and technology have seen modest cuts in the low single digits. A year ago, we pointed to strong evidence that corporate investment would remain biased to improving productivity and technology stocks to better compete in a low-growth world. Indeed, this is evident when we look at relative revenue and earnings trends for the technology sector, and particularly for software and consulting services
- Only health care stocks have seen positive revisions, aided by the U.S. dollar’s strength and the large weight of U.S.-dollar earnings
Quality. Corporate balance sheets are healthy for the most part, outside of many emerging-market firms, where a penchant for taking on U.S.-dollar-based debt threatens earnings and credit ratings as the dollar has strengthened. Global liquidity trends aren’t constructive, and we have yet to see much-needed debt deleveraging among emerging-market companies. Our high-quality bias toward strong balance sheets and cash flow remains and should serve as healthy support should the situation worsen from here.
In the meantime, our team is focused on companies with tangible evidence of improving quality from a bottom-up perspective, such as Mexico’s Fomento Economico Mexicano S.A.B. de C.V. (FEMSA) (0.54% of Invesco International Growth Class as at December 31, 2015), a multinational beverage and retail company where management continues to consolidate market share and exploit growth avenues in retail gas stations and the drugstore channel, as well as drive higher returns on capital from a mix perspective.
Valuations. Valuation premiums for high-quality defensive earnings streams remain near historic highs outside of the U.S. market, where the premium versus cyclicals is far lower. The price-to-book and price-to-earnings premium of non-U.S. defensive stocks versus cyclicals ended 2015 at 15-year highs.2
Through much of last year, we saw better relative value emerging in cyclical areas of the market. But as cyclical growth outlooks have deteriorated in conjunction with the market’s unwillingness to reward value, we reduced our net exposure in the fourth quarter to cyclical areas of the market where visibility had eroded, seeking to protect portfolio downside.
As we enter results season, we’ll be looking for evidence that bottom-up growth expectations have been adequately reset. The primary risk we see is that consensus expectations for 2016 earnings growth could still prove optimistic relative to many forthcoming fiscal-year corporate outlook statements in terms of both revenue growth and margins.
It’s worth noting that 2016 margin expectations have recently deteriorated in every region except Japan, which had already seen the largest margin decline, while U.S. margins have remained the most resilient to date. Again, the path of least resistance remains down in the near term and informs a conservative earnings and cash-flow analysis for our holdings and new opportunities.
We remain constructive on these areas:
- Digitization of corporate workflows, which represents a multi-year investment cycle that should drive investment and opportunity, in our view
- Luxury goods, where brand equity remains strong, supporting prices and superior return on invested capital (ROIC)
- Financials, where business models and valuations are beginning to reflect the realities of a less-leveraged path to profits, although regulatory capital requirements continue to exact a toll, with adequate return on equity (ROE) above cost of capital harder to find in this still-risky macro climate
As energy prices have declined further, the sector has become more interesting. But we remain cautious regarding the amount and duration of capacity reduction necessary before ROIC can begin to rebuild. In addition, we would like to add exposure to high-quality durable staples should market volatility yield better prices, but we’re not quite there yet.
Finally, our expectation is that trailing and prospective volatility will remain elevated, yielding incremental investment opportunities that meet our balanced EQV criteria. We believe our long-term, bottom-up, stock-picking approach can reward investors in uncertain environments.