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Multiples Expand, Margin Pressure is a Concern
While Q4 was especially favorable for equities, most stock and bond investors enjoyed a bumper year. Cash, the top performer in 2018, lagged in 2019 as central banks changed course and the S&P 500 rose to record highs. Over the past two years, however, cumulative gains have been more modest – particularly among foreign equities – as investors tried to gauge the impacts of higher interest rates and bruising trade war rhetoric. Concurrent monetary and fiscal support, mostly absent since the 2017 tax cuts, did not reappear until the second half of 2019 after several rate cuts, some Fed balance sheet expansion and, finally, demonstrable trade progress between the U.S. and China. Overall, stimulus is more in tune globally and investors seem pleased.
From a factor perspective, quality and value outperformed momentum, minimum volatility and the S&P 500 this quarter, though we note investor preference for quality shares (and bonds) persisted throughout most of the year amid substantial geopolitical uncertainty. We commented on the relative attractiveness of Value in our Q2 letter, and subsequently addressed our underweight to the factor. Looking ahead to 2020, we would not be surprised to see the U.S. Dollar weaken a bit as ambitious campaign promises get made and the effects of rather coordinated global policy support start to lift animal spirits outside the U.S. The International Monetary Fund now expects the global economy to grow 3.3% next year, up from 2.9% in 2019, a 10-year low. We are therefore currently considering incremental allocations to international equities for their inherent cyclicality and positive correlation to U.S. Dollar weakness.
As we mentioned last quarter, global equities staged an impressive expansion of multiples this year – even as profits moderated in the U.S. and contracted elsewhere. Anticipation of both higher economic and earnings growth and subdued inflation expectations are key supports for such rallies, but here we inject a note of caution against overconfidence. Not only are profit margins demonstrably mean-reverting, but for many companies they are now quite high relative to history. Technological disruption notwithstanding, the historic commodity collapse of mid-2014 sharply deflated costs, delayed the QE exit plans of many central banks, and probably widened the gap between winners and losers in the following graph.
We wish to avoid any complacency about the durability of profit margins that may have developed since 2014 due to low and exceptionally stable input costs. To illustrate, we have grouped the returns of three types of companies in the chart above: 1) Disruptors, shown in green, have enjoyed record profit margins and huge outperformance. Most FANG stocks are included here and, though narrow leadership is not atypical, the performance gap is striking; 2) Dependables, shown in blue, have been steady performers with consistently high margins relative to their long histories. In this group we include high dividend payers and stocks that exhibit low price volatility; and 3) Detestables, a basket of inflation-sensitive cyclical companies shown in red that have fared the worst, with fairly flat or declining margins. Many of these companies have experienced episodic earnings recessions since 2014.
We ask ourselves which kinds of companies in the graph above will prosper should input costs rise? Many within the red line, heretofore known as Detestables, are geared to make more money if the economy picks up steam and prices for raw materials go up. Judging by their declining share of equity indexes in recent years, they are under-owned. Will the shine come off “secular growers” (FANGs) if global growth picks up as expected and investors find cheaper ways to access expanding margins? It may not take much inflation to make today’s momentum investors, many of whom are effectively short inflation (i.e. some of their favorite stocks may suffer as costs rise), realize they should be adding exposure to cyclicals. In addition, we can see that policy-makers on both sides of the aisle are beginning to understand how intractable current demographic headwinds are, and how disruptive new technologies can be. As politicians try to engineer change on behalf of their constituents, it’s likely their efforts will not be deflationary. Our recent actions taken to rebalance client portfolios underweight the Value factor, and our deliberations about raising foreign equity weights, are efforts to keep client assets diversified against the possibility of changes in market leadership ahead.
Endnotes
Sources of graphs and data not specifically cited: NAM Corp, FactSet, Strategas Research, MSCI and Blackrock. Referenced indexes in U.S. Dollars, unless otherwise stated. All equity returns include reinvestment of dividends. The MSCI Factor Indexes are rules based indexes that capture the returns of systematic factors such as low volatility. All return data through December 31, 2019, unless otherwise stated.
Chart: Our proxy for “The Disruptors,” consists of a equally weighted basket of Facebook, Amazon, Google and Netflix. The disruptors can be volatile, often have little debt, and record or little to no profit margins. Low volatility and dividend stocks, shown by “The Dependables” have steady month-to-month performance and often record profit margins. The Low volatility and dividend stocks are represented by an equally weighted return composite of the iShares Edge MSCI Min Vol USA ETF, iShares Core High Dividend ETF and iShares Core Dividend Growth ETF. Hi-beta and cyclical securities, shown by “The Detestables” generally have been out of favor since 2008, in a profits recession since 2014 (energy, industrial metals, and shipping stocks). “The Detestables” are represented by a equally weighted return composite proxy of Materials Select Sector SPDR Fund and S&P Energy Select Sector Index. The Detestables are heavily disrupted, or victimized by a strong U.S. Dollar (emerging markets).
All data is in USD, and Total Return represents the sum of the dividend, changes in earnings and multiple estimates for each ETF. Investors cannot invest directly in an index, nor is an index subject to fees and expenses associated with investment funds or accounts.
Disclaimer
North American Management Corp. (NAM) is an SEC registered investment adviser located in Boston, Massachusetts and St. Louis, Missouri. The information presented above reflects the opinions of NAM as of January 27, 2020 and is subject to change at any time based upon market or other conditions. These views do not constitute individual investment advice and there is no representation that any of the statements or predictions will materialize. This letter should be read alongside NAM’s quarterly report and is meant to provide clients with additional updates regarding our strategies with allocations to individual stocks (Aggressive Growth, Global Growth, Global Moderate Growth, Global Conservative Growth, Global Tactical Income, and Global Moderate Tactical Income) and Mutual Fund/ETF-only strategies. Please note, if you are not invested in certain strategies or do not hold all of the securities therein, this summary may contain information that does not apply to you. The data in this report is taken from sources that NAM believes to be reliable. Notwithstanding, NAM does not guarantee the accuracy of the data. Any specific investment or investment strategy can result in a loss. Asset allocation and diversification do not ensure a profit or guarantee against a loss. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. Any holdings, asset allocation, diversification breakdowns or other strategy composition discussed are as of the date indicated and are subject to change at any time. They may not be representative of a Strategy’s current or future investments. Past performance is no guarantee of future results.
While Q4 was especially favorable for equities, most stock and bond investors enjoyed a bumper year. Cash, the top performer in 2018, lagged in 2019 as central banks changed course and the S&P 500 rose to record highs. Over the past two years, however, cumulative gains have been more modest – particularly among foreign equities – as investors tried to gauge the impacts of higher interest rates and bruising trade war rhetoric. Concurrent monetary and fiscal support, mostly absent since the 2017 tax cuts, did not reappear until the second half of 2019 after several rate cuts, some Fed balance sheet expansion and, finally, demonstrable trade progress between the U.S. and China. Overall, stimulus is more in tune globally and investors seem pleased.
From a factor perspective, quality and value outperformed momentum, minimum volatility and the S&P 500 this quarter, though we note investor preference for quality shares (and bonds) persisted throughout most of the year amid substantial geopolitical uncertainty. We commented on the relative attractiveness of Value in our Q2 letter, and subsequently addressed our underweight to the factor. Looking ahead to 2020, we would not be surprised to see the U.S. Dollar weaken a bit as ambitious campaign promises get made and the effects of rather coordinated global policy support start to lift animal spirits outside the U.S. The International Monetary Fund now expects the global economy to grow 3.3% next year, up from 2.9% in 2019, a 10-year low. We are therefore currently considering incremental allocations to international equities for their inherent cyclicality and positive correlation to U.S. Dollar weakness.
As we mentioned last quarter, global equities staged an impressive expansion of multiples this year – even as profits moderated in the U.S. and contracted elsewhere. Anticipation of both higher economic and earnings growth and subdued inflation expectations are key supports for such rallies, but here we inject a note of caution against overconfidence. Not only are profit margins demonstrably mean-reverting, but for many companies they are now quite high relative to history. Technological disruption notwithstanding, the historic commodity collapse of mid-2014 sharply deflated costs, delayed the QE exit plans of many central banks, and probably widened the gap between winners and losers in the following graph.
We wish to avoid any complacency about the durability of profit margins that may have developed since 2014 due to low and exceptionally stable input costs. To illustrate, we have grouped the returns of three types of companies in the chart above: 1) Disruptors, shown in green, have enjoyed record profit margins and huge outperformance. Most FANG stocks are included here and, though narrow leadership is not atypical, the performance gap is striking; 2) Dependables, shown in blue, have been steady performers with consistently high margins relative to their long histories. In this group we include high dividend payers and stocks that exhibit low price volatility; and 3) Detestables, a basket of inflation-sensitive cyclical companies shown in red that have fared the worst, with fairly flat or declining margins. Many of these companies have experienced episodic earnings recessions since 2014.
We ask ourselves which kinds of companies in the graph above will prosper should input costs rise? Many within the red line, heretofore known as Detestables, are geared to make more money if the economy picks up steam and prices for raw materials go up. Judging by their declining share of equity indexes in recent years, they are under-owned. Will the shine come off “secular growers” (FANGs) if global growth picks up as expected and investors find cheaper ways to access expanding margins? It may not take much inflation to make today’s momentum investors, many of whom are effectively short inflation (i.e. some of their favorite stocks may suffer as costs rise), realize they should be adding exposure to cyclicals. In addition, we can see that policy-makers on both sides of the aisle are beginning to understand how intractable current demographic headwinds are, and how disruptive new technologies can be. As politicians try to engineer change on behalf of their constituents, it’s likely their efforts will not be deflationary. Our recent actions taken to rebalance client portfolios underweight the Value factor, and our deliberations about raising foreign equity weights, are efforts to keep client assets diversified against the possibility of changes in market leadership ahead.
Endnotes
Sources of graphs and data not specifically cited: NAM Corp, FactSet, Strategas Research, MSCI and Blackrock. Referenced indexes in U.S. Dollars, unless otherwise stated. All equity returns include reinvestment of dividends. The MSCI Factor Indexes are rules based indexes that capture the returns of systematic factors such as low volatility. All return data through December 31, 2019, unless otherwise stated.
Chart: Our proxy for “The Disruptors,” consists of a equally weighted basket of Facebook, Amazon, Google and Netflix. The disruptors can be volatile, often have little debt, and record or little to no profit margins. Low volatility and dividend stocks, shown by “The Dependables” have steady month-to-month performance and often record profit margins. The Low volatility and dividend stocks are represented by an equally weighted return composite of the iShares Edge MSCI Min Vol USA ETF, iShares Core High Dividend ETF and iShares Core Dividend Growth ETF. Hi-beta and cyclical securities, shown by “The Detestables” generally have been out of favor since 2008, in a profits recession since 2014 (energy, industrial metals, and shipping stocks). “The Detestables” are represented by a equally weighted return composite proxy of Materials Select Sector SPDR Fund and S&P Energy Select Sector Index. The Detestables are heavily disrupted, or victimized by a strong U.S. Dollar (emerging markets).
All data is in USD, and Total Return represents the sum of the dividend, changes in earnings and multiple estimates for each ETF. Investors cannot invest directly in an index, nor is an index subject to fees and expenses associated with investment funds or accounts.
Disclaimer
North American Management Corp. (NAM) is an SEC registered investment adviser located in Boston, Massachusetts and St. Louis, Missouri. The information presented above reflects the opinions of NAM as of January 27, 2020 and is subject to change at any time based upon market or other conditions. These views do not constitute individual investment advice and there is no representation that any of the statements or predictions will materialize. This letter should be read alongside NAM’s quarterly report and is meant to provide clients with additional updates regarding our strategies with allocations to individual stocks (Aggressive Growth, Global Growth, Global Moderate Growth, Global Conservative Growth, Global Tactical Income, and Global Moderate Tactical Income) and Mutual Fund/ETF-only strategies. Please note, if you are not invested in certain strategies or do not hold all of the securities therein, this summary may contain information that does not apply to you. The data in this report is taken from sources that NAM believes to be reliable. Notwithstanding, NAM does not guarantee the accuracy of the data. Any specific investment or investment strategy can result in a loss. Asset allocation and diversification do not ensure a profit or guarantee against a loss. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. Any holdings, asset allocation, diversification breakdowns or other strategy composition discussed are as of the date indicated and are subject to change at any time. They may not be representative of a Strategy’s current or future investments. Past performance is no guarantee of future results.
