THE SECRET PM: 2015 H1

There is good reason to believe that right now stock markets in the US and Europe are putting in highs and that going forward high investment returns are going to be just a lot harder to come by.

For the past few years stock markets have enjoyed a perfectly proportioned cocktail of low and falling interest rates, pushing up P/E ratios, and at the same time rising corporate profits. But we now find ourselves at a point from which any further support to P/E ratios coming from even lower interest rates is almost certainly going to be accompanied by falling profits. Indeed expectations for Q1 2015 S&P 500 profits are for a 4% year-on-year decline.

The fall in commodity prices, and in particular oil, has removed the single biggest incentive for global corporate investment and the single biggest source of EM government revenue. And it has been corporate investment and EM government spending, not the US consumer, that has been driving global economic growth in recent years.

S&P 500 company capex and R&D spending in each of the past 2 years has been around $900bn nearly double the $500bn spent in 2004, with energy companies leading the growth in spend. But at current oil prices there is no longer any incentive to continue investing. Conoco, for example, has cut its spending plans for 2015 by $6bn, ie 30%. The speed of the cutback is striking. In the US oil drilling activity peaked in October of 2014 with 1,606 active rigs. Today the number has fallen to 1,019. When you consider that US gas drilling activity peaked with 1,600 active rigs in 2008 only for that number to fall to 289 today, it is clear the potential exists for further drastic investment curtailment. Outside of the US the picture is very similar. For instance $20bn of planned energy investments in Uganda and Mozambique are not economical at current prices. Governments that depend heavily on oil revenues like Nigeria, Angola and Russia are all dialing back domestic infrastructure spending.

The spillover from the collapsing commodity and energy cycle is far reaching. In Brazil, which is heavily dependent on iron ore revenues, 2014 truck production fell 26%. Caterpillar VP explains: “Now there are other indirect impacts from substantially lower prices that we think can play in 2015. In countries and in fact in some areas of the U.S., where oil production is significant for government entities and local economies, it will likely be a negative for the sales of construction equipment and our electric power generation business.

In some cases, it can be fairly direct like building roads to service new wells, or it can be very indirect like construction spending in a country, where the government relies on oil revenue to fund government spending.” The slowdown in the investment cycle in emerging markets is even having an effect all the way down to the consumer. Unilever, for example, which reported essentially no profit growth in Q4 commented: “… it’s worth reflecting for a moment on just how difficult the year it was… the slowdown in emerging markets continued. China stands out but almost all of the major economies weakened. Growth in consumer spending in 2014 hit multi-year lows in many countries… There was no volume growth in these markets. It is many years since we actually have seen that.”

Without volume growth companies with competitive threats are having to respond with price cuts to maintain volumes. Whirlpool, for example, described: “… our volumes were negatively impacted by very aggressive and value destroying promotions on import products.” Ralph Lauren said: “…we saw a little bit of a drop in the consumer purchase behavior … And as a result of that what we saw was that a lot of the competitors ratcheted up the promotional intensity.” While Swedish Match reported: “The Swedish snus market remains highly competitive with the value segment growth continuing to outpace the overall market growth… In the premium segment we have noted an accelerated volume decline.”

The picture emerging is pretty clear. The regime we have known for the past decade of low US interest rates encouraging capital flows into emerging markets, spurring cheap-debt-funded industrial investment, commodity demand and mining investment is over.  As Volvo describes this is impacting the entire industrial supply chain across many countries: “China in fact is not only China effect that we’ll see; we also said that we have a lower demand in mining you can say yearly speaking especially in South East Asia and other parts of Asia… we have 21% capacity utilization that is of course extremely low… what we’ve managed to do is actually to stop up the production in a way that we have not built any kind of inventory of new products and also managed to stop the supply chain.”  The engine of global economic growth is exhausted for now as cheap debt and abundant capital flows have resulted in excess industrial capacity and high debt levels.

According to Mckinsey, China, for example, through its extensive industrial investment increased its debt from $7trn in 2007 to $28trn in 2014 – at 125% of GDP China’s corporate sector now has twice the relative debt load of US companies. We are now in a new regime where high debt levels mean low US interest rates no longer operate as an incentive for EM borrowers to take on more debt. With spending by corporates, governments, and consumers all restrained corporate profit growth is going to be a challenge.

Most energy and commodity company shares have already to some extent “re-priced” to take into account the commodity slump, but large risks still exist, in many consumer companies for example, which have been very reliant on price increases to support margins in recent years. As the CEO of Diageo explains: “ …when you look at the source of underperformance and why, there are a few things going on. One is that we did take a lot of price in the last couple of years which has really hurt us… I mean if you look at the last three years, we expanded operating margins in North America 450 basis points. And a brand like Captain Morgan is now sitting at a 25% premium to the leading rum brand.”

If you think that UK supermarkets had to give up their entire profit pool through price cuts in order to stop share leakage you get a sense of how damaging price competition can be. Procter & Gamble looks particularly vulnerable since they are relying on big price increases to offset FX moves, yet price increases to-date are being met with big volume declines: “If we look at sales in Mexico were down almost 20% on the quarter… the driver there is a combination of… We also took pricing to deal with the value in peso.” The evidence suggests P&G may in fact have to cut prices: “I mentioned the family care business, that’s a big business for us in North America where we’ve been losing share. We’ve adjusted pricing on that business and are starting to see both volume and sales respond.”

Given the weak corporate profit outlook current high asset valuations are a major risk for stock market investors. The median P/E ratio for the S&P 500 is 21x – comfortably higher than any point in the past – equivalent to a 4.7% earnings yield. Such a low return for taking on equity risk is reasonable only in the context of stocks serving as an income alternative to bonds (30 year term US corporate bonds yield 4.7%).  A company like Lowe’s, for example, has earned annual profits of around $2bn over the past ten years yet has a valuation of over $70bn (29x reported earnings) in part because it has used cheap debt to facilitate annual shareholder returns of over $4bn. Stock market valuations are being supported by corporates’ willingness to take advantage of low interest rates to borrow and buy back stock. US corporates have borrowed over $1trn since the beginning of 2012, spending roughly $1.5trn on stock buybacks. In Q3 of 2014 75% of S&P 500 companies engaged in some amount of share repurchase. Companies are doing their best to send all of their profits and more back to shareholders, but believing this level of cash return is as sustainable as a bond coupon is a mistake. As the CEO of Chevron said: “We have cautiously spread out share repurchases over time, so we’ve tried not to just be in for a short period of time, we were in for a longer period of time. But obviously with the price environment we’re seeing, we’re discontinuing that program.”

Pricing stocks on the current level of cash returns makes stocks extremely sensitive to any threat to profits that in turn may jeopardise shareholder returns. Take bank IT-outsourcer, Fiserv, as an example. Fiserv’s revenues have grown from $4.3bn in 2011 to $5bn in 2014. Over that period Fiserv’s market cap has grown from $8bn to $20bn. Why has this company re-rated from 1.9x sales to 4x sales? Largely because cash return to shareholders has grown from $460mln in 2011 to $1,095mln in 2014, a level 40% above reported profits. This trend is pervasive. Disney, for example, has added $2.5bn to its annual profits since 2011, but has added over $100bn to its market cap over that time. Why? Cash returns to shareholders are up from around $4bn to $8bn.  It should be a big warning sign then for shareholders that the major source of this cash return – the cable networks business (especially ESPN) – has reported falling profits over the past two quarters. If the corporate profit cycle has peaked the shareholder return theme that has supported stock markets is also over. Without an attractive cash return there is little to support stock prices, Transocean, for example, which has slashed its dividend trades at 25 year lows and 0.4x book value. The time to be greedy is over.

Looking ahead in 2015 the risk from equity exposure trumps the potential reward. Given the dearth of return available from financial assets cash is currently not a severely disadvantaged holding. Investors are thus probably best served in 2015 by booking profits and holding cash. Investments in stocks should be limited and very selective, focusing on companies that have already endured a profit downturn resetting investor expectations about the future level of cash returns. Handbag maker, Coach, is a good example. Coach has deliberately closed stores and ramped up product and marketing investment in order to rejuvenate its brand. All told this will reduce Coach’s profits from over $1bn in 2012 to around $700mln. The share price has adjusted to this new reality, Coach’s market cap plummeted from $18bn in 2011 to $11bn. While the outcome of Coach’s dramatic resizing and brand reinvestment is uncertain, the 7% rebased earnings yield provides investors a lot of return. IBM, similarly, is divesting sales and increasing spending to better align its business with its clients demands. Net income from continuing operations was down around 10%, or $1.5bn, in 2014 as a result. Yet over the year $70bn was wiped off IBM’s market cap. With $16bn of profits and a market cap of $160bn, IBM offers a rebased earnings yield of 10%, roughly double the market’s average. Rolls Royce, Vallourec, and adidas too are three businesses all currently earning profits significantly below their potential, where investor expectations have adjusted dramatically lower – these are the areas to hunt for selective equity investments.

There is good reason to believe that 2015 will mark highs for US and European stocks, as Emerson’s CEO put it: “The world’s clearly changing from the last conversation we had in November with a lot of moving dynamics, but fundamentally as we see it today, we see much slower global growth and we’re concerned that there’s not a lot of momentum relative to turning that growth around.” Unless profits and expectations have been rebased: cash out.