Mark Breedon, co-Head of 4Factor Equities, highlights the team’s most important themes and market sectors for 2014.
What are the most important themes that could drive returns in 2014?
a. Valuation - We think global equity market valuations are justified relative to fixed income, but in absolute terms it is more difficult to evaluate. However absolute value is not a prerequisite for markets to go higher and there is no doubt that we are seeing decent strength in some momentum measures as we are seeing the feed-through of money coming out of fixed interest and cash into equities. Our proprietary 4Factor screen has been highlighting the US as the most attractive region for some time on the basis of quality and earnings and technical momentum. However the valuation case is now difficult to make in a broad sense relative to other regions around the world.
Emerging markets are ranked as the least attractive area by our screen at present. Earnings revisions have been generally poor due to the higher weighting of commodity stocks, and also rising costs (especially labor). However an interesting positive factor has been the improvement in quality which we put down to improved corporate governance. It is also evident that there is now a clear value case for EM relative to other regions.
b. Utilization of cash balances/CAPEX - Levels of operating profitability, measured by cash flow return on investment (CFROI), have remained relatively high since the global financial crisis but this has been achieved primarily due to cost cutting. As a result, companies have been beating expectations in terms of bottom-line profits but top-line sales growth has been disappointing for some time. Although companies have remained relatively profitable, they have not been using cash to invest in new plant and equipment, as expectations for demand have remained subdued. Merger and acquisition activity has also been limited. As a result, balance sheets currently contain a lot of cash and this is putting downward pressure on returns on equity. Like many investors we are hoping for more in the way of topline growth coming through because that should drive up the confidence levels needed to invest for the future.
Where is the consensus perhaps wrong?
Consumer staples look expensive relative to history and relative to the market. The only support you get for this sector is high quality but there is little value, negative earnings revisions and poor technical momentum.
Which sectors look attractive?
a. Insurance - We like insurance, primarily in US and Europe. Momentum in the form of business volumes in the sector have picked up at the same time as yield curves steepen; insurance companies should make more money. Annuity books are increasing in value as they will be investing at a higher rate and they become more profitable. Capacity seems to have come out of that side of the business, so pricing has remained firm. Capital issues have been resolved over the years partly from selling businesses and partly from becoming more profitable. As capital is building they’re giving that money back to shareholders in terms of stock buy- backs and dividends.
b. Materials - Materials have underperformed considerably and many people are potentially looking to invest based on the value case. However we feel that the sharp deterioration in earnings expectations has hindered optical value for profit driven metrics. The two areas where we’ve been a bit more interested in within materials have been US alternative energy and US refining. Both of which are scoring relatively well in a poor sector. The reasons for this are fracking and horizontal drilling. The big US refineries will start moving towards exporting product as they become more competitive as a result of cheaper feedstock. There are clearly infrastructure bottlenecks but they are being cleared. So we have quite a strong exposure to US refiners, and to drillers.
c. Technology - Technology has continued to be a relatively strong steer from our screen. But performance has been disparate within different sectors. We like semconductor manufacturers where things have not been as bad as many feared. In semi-conductors part of the issue has been the concern that people aren’t going to buy more PCs. That is true but actually there has been a pick-up in demand for chip content in other areas such as mobile internet and cars where demand has been rising around 10% a year. Also valuations here are very low but technicals are weak, so the market hasn’t latched on to this idea as yet.
d. Services - One area where we’ve been seeing the better side of revisions has been the services sector. There is quite good value, reasonable quality, earnings revisions have been at the high end and technical trends have been better. It is a very broad disparate group; so therefore a good area for finding attractive companies.