DATAROMA
02 Nov 2011 Pzena Investment Management - Oct 2011 Commentary ( Portfolio )
Investors are tethered to the saga of the European sovereign debt crisis, producing gut-wrenching market gyrations. The threat of Greek (Spain, Italy…) default, European bank recapitalizations, and financial contagion have driven fear and uncertainty to the extreme, and caused investors globally to move en masse away from equities: “highly correlated moves,” in Wall Street parlance.
Expecting the worst, investors have particularly penalized cyclical (or high-beta) stocks, driving valuation spreads between those and stable (low beta) stocks to almost unprecedented levels (Figure 1). On this basis alone, one could conclude that it is an awful time to reposition to low-beta stocks, as they are expensive compared to their cyclical counterparts. Even more importantly, we believe there is significant value opportunity in today’s beaten-down sectors. Over time, managements have demonstrated the ability to adapt, and overcome the obstacles in front of them, and to restore profitability in the wake of significant macroeconomic disruptions. Corporations today are well positioned to deal with near-term shocks should they arise, having deleveraged their balance sheets and realigned cost structures following the 2008/09 recession. So rather than concluding that equities, and cyclical stocks in particular, are in trouble, in many cases we see a different picture: one of resilience, adaptability and solid financial footings. We see opportunity.
PROFITABILITY IS STRIKINGLY RESILIENT
From a global perspective, we find convincing evidence of corporate adaptability to all types of economic environments. Figure 3 presents the return on equity for the MSCI World index over a 37-year period, which includes recessions, high inflation, low inflation, and a myriad of other conditions. Though somewhat variable over the short term, returns on equity have stayed within a reasonably tight band around a long term average of 12%. These data reinforce our on-the-ground observations of company managements taking the necessary actions to meet the challenges of the current economic environment. Most investors were surprised by how quickly corporate profits rebounded after the last recession despite only a muted recovery in GDP. We take encouragement from corporate performance in 2008 as we survey the landscape today.
STOCK PRICES OVERREACT
For businesses with good franchises and well capitalized balance sheets, we would expect an economic downturn to affect long term earnings potential very little. The most relevant impact to valuation is the near-term, temporary disruption in earnings and cash flow, as the normalization process occurs. Using a standard net present value approach of discounting the future stream of earnings to calculate the value of a business, we would offer that the impact of a recession to valuation should be modest, as we are faced more with a shift in timing, as opposed to any diminution in long term earnings.
The true risk of recession lies with those companies where a near-term dip in earnings could be catastrophic to the equity holder due to high levels of debt and the attendant risk of bankruptcy, representing real, long term capital impairment. We have studied this issue in depth, and in our recently published white paper “Assessing Risk and Return,”1 determined that limiting exposure to bankruptcy risk by avoiding companies with high levels of leverage, which also tend to display the highest stock price volatility, is additive to long term returns. Today, leverage in our portfolios is extraordinarily low, with debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratios of 0.7x in Large Cap Value and 0.6x in our Global Value portfolios2.
WHERE WE ARE NOW
From the start of the recovery in 2009 through mid-2011, we experienced a traditional, though short-duration, value cycle, with spreads narrowing and value-based strategies outperforming. Since mid-2011, there has been a dramatic reversal, leading to wider spreads as uncertainty has grown around economic growth, recession, and the potential contagion from European sovereign debt woes. Though this looks like the beginning of a recessionary cycle, there are significant differences from the cycle we most recently experienced, namely:
-The 2008/9 recession started after the economy peaked in 2007. So far this cycle, we have had only a partial recovery, with some industries (e.g., auto production, construction) still at deeply depressed levels;
-Corporations have, by and large, de-levered their balance sheets during the last few years, significantly mitigating bankruptcy risk;
-Companies have cut costs and positioned themselves for an extended period of anemic growth, demonstrating their ability to generate normalized levels of profits in a challenging environment; and
-Valuations are already at highly attractive levels, approaching those experienced during the 2008/9 market meltdown (Figure 4).
As a result, we are finding high quality companies with little stress, high returns on capital, strong balance sheets, and high free cash flow yields trading at deeply depressed valuations.
Investors are tethered to the saga of the European sovereign debt crisis, producing gut-wrenching market gyrations. The threat of Greek (Spain, Italy…) default, European bank recapitalizations, and financial contagion have driven fear and uncertainty to the extreme, and caused investors globally to move en masse away from equities: “highly correlated moves,” in Wall Street parlance.
Expecting the worst, investors have particularly penalized cyclical (or high-beta) stocks, driving valuation spreads between those and stable (low beta) stocks to almost unprecedented levels (Figure 1). On this basis alone, one could conclude that it is an awful time to reposition to low-beta stocks, as they are expensive compared to their cyclical counterparts. Even more importantly, we believe there is significant value opportunity in today’s beaten-down sectors. Over time, managements have demonstrated the ability to adapt, and overcome the obstacles in front of them, and to restore profitability in the wake of significant macroeconomic disruptions. Corporations today are well positioned to deal with near-term shocks should they arise, having deleveraged their balance sheets and realigned cost structures following the 2008/09 recession. So rather than concluding that equities, and cyclical stocks in particular, are in trouble, in many cases we see a different picture: one of resilience, adaptability and solid financial footings. We see opportunity.
PROFITABILITY IS STRIKINGLY RESILIENT
From a global perspective, we find convincing evidence of corporate adaptability to all types of economic environments. Figure 3 presents the return on equity for the MSCI World index over a 37-year period, which includes recessions, high inflation, low inflation, and a myriad of other conditions. Though somewhat variable over the short term, returns on equity have stayed within a reasonably tight band around a long term average of 12%. These data reinforce our on-the-ground observations of company managements taking the necessary actions to meet the challenges of the current economic environment. Most investors were surprised by how quickly corporate profits rebounded after the last recession despite only a muted recovery in GDP. We take encouragement from corporate performance in 2008 as we survey the landscape today.
STOCK PRICES OVERREACT
For businesses with good franchises and well capitalized balance sheets, we would expect an economic downturn to affect long term earnings potential very little. The most relevant impact to valuation is the near-term, temporary disruption in earnings and cash flow, as the normalization process occurs. Using a standard net present value approach of discounting the future stream of earnings to calculate the value of a business, we would offer that the impact of a recession to valuation should be modest, as we are faced more with a shift in timing, as opposed to any diminution in long term earnings.
The true risk of recession lies with those companies where a near-term dip in earnings could be catastrophic to the equity holder due to high levels of debt and the attendant risk of bankruptcy, representing real, long term capital impairment. We have studied this issue in depth, and in our recently published white paper “Assessing Risk and Return,”1 determined that limiting exposure to bankruptcy risk by avoiding companies with high levels of leverage, which also tend to display the highest stock price volatility, is additive to long term returns. Today, leverage in our portfolios is extraordinarily low, with debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratios of 0.7x in Large Cap Value and 0.6x in our Global Value portfolios2.
WHERE WE ARE NOW
From the start of the recovery in 2009 through mid-2011, we experienced a traditional, though short-duration, value cycle, with spreads narrowing and value-based strategies outperforming. Since mid-2011, there has been a dramatic reversal, leading to wider spreads as uncertainty has grown around economic growth, recession, and the potential contagion from European sovereign debt woes. Though this looks like the beginning of a recessionary cycle, there are significant differences from the cycle we most recently experienced, namely:
-The 2008/9 recession started after the economy peaked in 2007. So far this cycle, we have had only a partial recovery, with some industries (e.g., auto production, construction) still at deeply depressed levels;
-Corporations have, by and large, de-levered their balance sheets during the last few years, significantly mitigating bankruptcy risk;
-Companies have cut costs and positioned themselves for an extended period of anemic growth, demonstrating their ability to generate normalized levels of profits in a challenging environment; and
-Valuations are already at highly attractive levels, approaching those experienced during the 2008/9 market meltdown (Figure 4).
As a result, we are finding high quality companies with little stress, high returns on capital, strong balance sheets, and high free cash flow yields trading at deeply depressed valuations.