- If economically sensitive stocks lead the market recovery, as we expect, history would repeat itself.
- Many cyclical companies, such as global industrial conglomerates, capital-rich banking institutions, and travel & leisure companies, should experience a substantial rerating.
- With over 50% of the ACWI index invested in the lowest Covid-19 beta sectors, passive index investors appear to be underexposed to upside recovery.
“People should value manufacturing–the world of atoms vs. the world of bits–far more. It is looked down upon by many, which is just not right.” -Elon Musk
Although less controversial than some of Mr. Musk’s recent tweets, markets appear to disagree with his tribute to the physical over the digital. This year-to-date’s sector winner in the MSCI ACWI Index (“ACWI”) is information technology, with software & services devouring the world of atoms. In the volatile first five months of 2020, these companies trafficking in bits rose nearly 10%, overcoming the pandemic, lockdown-induced market correction, falling interest rates and ballooning government debt. In contrast with information technology, the industrials sector declined 15% during this period, weighed down by capital goods. Other economically sensitive sectors, including energy and financials, have fared even worse.
New-economy glamour is only one driver of information technology’s outperformance. As interest rates have fallen in the years following the 2008-09 global financial crisis (“GFC”), investors have preferred long-duration growth stocks. In recent years, as global central banks used increasingly unconventional monetary policy tools to prolong post-GFC economic expansion, growth stocks became even more coveted. In the three years to December 31, 2019, the ACWI information technology sector gained 98% cumulatively while industrials rose a respectable 38% and financials 31%. Global software & services companies trade at approximately twice the valuation levels of capital goods companies as of end-May 2020, as shown in the chart below. The earnings multiples for capital goods may even be temporarily inflated because of depressed profits from lockdown-afflicted economies.
Is a dollar of earnings from a software firm that has yet to return capital to shareholders twice as valuable as a dollar of earnings from a global industrial conglomerate with over a century of brand building and operational expertise? Even giving technology firms full credit for their disruptive potential, we believe these differentials are unsustainably wide. We have been taking advantage of this market dislocation to add to capital goods stocks and other economically sensitive companies. From a valuation perspective, it is perversely reassuring to hold securities that trade at GFC valuation troughs–or lower–but with more admirable characteristics, such as stronger balance sheets and more profitable business mixes than they had during the last recession.
Many industrial companies found themselves on the wrong side of the Covid-19 shutdowns, but adept managements are not letting this crisis go to waste. For many companies in our clients’ fundamental value portfolios, managements are cutting costs, reorganizing operations, and employing automation tools that should allow them to reach high levels of efficiency. In the meantime, they are ensuring they have sufficient liquidity to weather a prolonged shutdown. Driving down costs makes a return to revenue growth even more profitable. Like a coiled spring, this expansion in latent profitability should ultimately warrant outperformance from quality cyclical stocks as economies reach recession lows and markets anticipate economic recovery.
Investors can find attractive cyclical investments beyond the world of durable goods. Banks, particularly those headquartered in Europe, may be the most misunderstood. Some banks trade at valuations equal to (or less than) their surplus capital, implying that the banks themselves–including their interest-rate-resilient wealth management divisions, trading and operations segments, and automobile and mortgage lending businesses–are free. Global markets have priced most bank stocks as if a surge of bad debts will wipe out pre-provision profits and consume capital, as occurred in the GFC. Yet banks in many geographies have spent years shrinking bad debts, diversifying loan books, exiting many risky or low return lines of business, and decreasing leverage by beefing up capital. No longer culprits at the locus of government aid, banks provide essential liquidity to businesses struggling with precipitous cash flow declines.
Continue reading here.
This article first appeared on GuruFocus.