THE SECRET PM

From a top down view, and since mid-2014, the main challenge for an equity investor is the ultra-low level of government bond yields or risk-free rates. Low risk-free rates translate into low corporate bond yields – long dated corporate cash flows are currently discounted at 4.98% – which is the equivalent of a stock valuation PE ratio of over 20x. In other words low risk-free rates imply low future returns for bondholders and stockholders. Perhaps the best big picture advice for investors today is to have low expectations!

That said, investors must choose between cash, bonds, and stocks. Between those options, what is different today, in early 2016, from mid-2014, is that stocks are now the best option. In mid-2014 corporate risk premiums, the rate investors are paid to accept corporate default risk, was a decade low 1.4%. Today the rate is over 2.6%, a level exceeded only three times since the 1970s. So while the compensation investors receive as capital owners – as given by the risk free rate – is very low, the compensation investors receive to take on equity risk (the so called equity risk premium) is actually very high. Thus in the context of a low return environment investors are much better placed today to overweight stocks. But what to buy?

Since 2009 the Fed has held US interest rates very low. Probably too low for too long. This encouraged US savings to seek out yield. Two key destinations for these savings were US high yield bonds and emerging market government bonds. From 2005 through 2008, for example, the US high yield bond market saw average annual issuance of around $100bn. Between 2010 and 2015 that number increased to $300bn. This enormous supply of capital disproportionately found its home in the US energy sector, enticed by the made in America “Shale revolution”. Mountains of cheap funding allowed the energy sector to expand without the need to be self-funding. In other words oil wells were drilled because there was money available and not because of the great profits to be had from drilling. Shell, for example, reported losses or virtually no profit in its North American business in every single quarter since Q1 2012!

The US oil rig count grew from 200 in 2009 to 1,600 in 2015. All the associated spending led to a tremendous boom in the US industrial economy. US heavy truck sales, for example, grew from 200k in 2009 to almost 500k in 2015. From mid-2013 through 2015 the ISM manufacturing new orders index, a lead measure of industrial activity, averaged around 60, indicating that manufacturers saw the industrial economy as about as hot as it has been since the 1960s.

The problem with the booming US industrial economy, at least from an investor’s perspective, was that most US oil drilling did not have a strong enough economic rationale. Shell’s incredible $15bn of cumulative losses reported in its North American division since 2012 shows very clearly that shale oil was no profit bonanza. This meant that much of the industrial sector’s profit growth was on a weak footing. Not only were the profits suspect but the valuation applied by the market was very high. This was a dangerous place for equity investors, well illustrated by the US driller, Helmerich & Payne, which saw its profits grow from $4 a share to $6.66 and its share price increase from $40 in 2012 to $120 in 2014. From a valuation of 10x profits to a valuation of 20x peak profits. The market clearly believed the new profits could be sustained.

The rest of the story is well known history: uneconomic drilling led to an oil surplus and a consequent oil price crash with the spillover being widespread cuts in industrial investment. Industrial sector bellwether, Emerson Electric, for example, reported order trends of -15% in its process management division and -20% in its industrial automation division in November, December and January. Profits across much of the US industrial economy have fallen sharply.

The nuts and bolts distributor, Fastenal, described the environment in late 2015: “The industrial environment is in a recession… Right now in the third quarter, 44 of our top 100 customers are negative… Of that 44 that were negative, 32 of them were negative more than 10%. Of that 44 that’s negative, 17 of them were negative more than 25%. That’s a sign of a recessionary environment.”

The economic environment in the industrial sector has obviously had a sea-change since mid-2014. The difference today for an investor, however, is that we are no longer at peak cycle industrial profits, and crucially, we are no longer at peak industrial valuations. A business like pump maker, Weir Group, which sells directly to the US energy sector, has seen profits per share fall 40% from £1.30 in 2012 to £0.80 in 2015. But at the same time Weir’s share price has fallen from £27 to £9. In other words Weir has gone from a PE ratio of 21x peak profits to 11x trough profits!

It is absolutely clear from the Weir Group example how the opportunity set for investors has changed dramatically since mid-2014. Today many industrial companies have seen both their profits and their valuations reset materially lower, providing investors with an excellent opportunity to buy their stock. Going forward the risk from further sustained profit declines and/or valuation compression is mightily reduced. Cummins, the truck engine maker, for example, has seen profits fall from over $9 a share in 2014 to $7.8 in 2015, and over that time its share price has fallen from $150 to less than $100. 17x peak earnings down to 12x earnings. The message to investors is straightforward: while the recent profit trajectory has been poor for the industrial economy the risks from investing in industrial businesses today is actually significantly reduced. Indeed, when industrial company profits start to grow again these companies are likely to be excellent investments – far exceeding the otherwise low returns on offer – because these companies have the potential to see their valuation multiples rise.

Forecasting the exact turning point in the industrial profit cycle is not easy ahead of the fact, however we are at such a low level of industrial activity today that in all likelihood the near future will see a pick-up in orders. For example the total US drilling rig count is down from around 2,000 in 2014 to less than 500 today. In fact the rig count today is now the lowest in at least 50 years. Joy Global, which sells mining heavy equipment, has seen orders fall 85% since peak. Raven Industries, which sells plastic films to the oil sector, saw orders fall 90%. National Oilwell Varco, which sells oil rigs, reported orders of a mere $89mln in its most recent quarter, compared to $2,300mln in Q2 2014, that’s down 96%! Outside of an economic depression orders cannot be sustained at these extremely low levels for long. Indeed the ISM manufacturing new orders index, which fell below 50 at the end of 2015 (indicative of a contraction in activity) is now at 51.5.

In early 2015 the stock market was a risky place. Today the industrial end of the stock market is a place of opportunity. IMI plc, the mechanical engineer, is a good example. IMI’s CEO, Mark Selway, aims to double the company’s operating profit through a mix of organic investment and acquisitions. That target translates into a profit of £400mln, which means the stock is valued today at just 6x potential profits. IMI’s shares could double or even triple. While at a high level investors need to be cognisant that low risk-free rates still mean we are in a low return environment, with the big reset in industrial sector profits and in investor expectations it is evident that selective risk taking in cyclical stocks has the potential to deliver superior returns.