THE SECRET PM

It has been a frustrating year for equity managers, especially those in Europe. The reason it feels so much harder to make good returns is because the market environment has subtly changed.

The two main tailwinds for the market: (1) falling interest rates and (2) shrinking credit default premiums, are slowly ebbing. In January 2010, for example, long term interest rates in the US were 4.6% and credit spreads were 1.8%, meaning long term cash flows were valued at a discount rate of around 6.4%, equivalent to a PE ratio of about 15. By May of 2014 long term interest rates were 3.6% and credit spreads just 1.34%, giving discount rates of less than 5%, equivalent to a PE ratio of over 20. All you needed to do in 2012 and 2013 was buy almost any cash flow generator and simply enjoy the rising tide of higher PE ratios: whether you bought 3M, an industrial, Johnson & Johnson, in healthcare, Microsoft, in tech, Wells Fargo, in financials, or Pepsico, you made at least 30% over those two years.

The challenge today is that there is just precious little precedent for interest rates and credit spreads remaining sustainably below levels of 3% and 1.5%. Indeed risk-free interest rates remaining lower than 3% have historically been seen only during the aftermath of the Depression when corporate defaults were high and hence credit spreads were elevated, around 3%. Similarly, very low risk-free interest rates that occurred briefly at the end of 2008 and during 2011 were also associated with “growth shocks” and elevated credit default premiums.

What all this means is that the steady trend higher in PE ratios we have enjoyed is largely complete and thus the relentless bid that supported the market in 2012 and 2013 can no longer be counted upon to provide returns. This subtle shift away from the market providing most of the return to the underlying stocks providing the good (and bad) returns is easiest seen looking at Next plc, Tesco and the FTSE 100. Over the past 12 months the FTSE is frustratingly flat yet Next is up 30% and Tesco is down 50%. Owning the market simply isn’t enough anymore to provide high returns. The “easy” money in this bull market has been made.

Sideways markets may seem strange, especially with the memory of the 2008 fall and recent rise in mind. But sideways markets are not uncommon. The S&P, for example, went sideways from 1965 until 1982. Interestingly the mid to late 1960s quite closely resembles today’s market: with very low risk-free interest rates, around 4%, and very low credit spreads, sometimes less than 1%. This low discount rate high PE ratio combination served as an anchor holding back the overall market performance for several years.

In a trending market, as we saw during 2012 and 2013, the key strategy is to “stick with it,” i.e., do not bank profits too soon. Poor stock selection was well compensated by just staying broadly long the market. This year, with the tailwind of higher PE ratios gradually exhausted, the regime changed and poor stock selection could no longer be made up with the correct market call.

Opposite to a trending market the key strategy in a sideways market is to consistently rebalance positions as mean reversion is likely to trump trend extension. Huge YTD roundtrips in Anglo American, Lafarge, Colfax and Ross Stores, for example, all clearly illustrate this point: “stale” longs and “exhausted” shorts can quickly reverse. Given the outsized potential to be whipsawed and a general sideways moving market, stock selection and portfolio concentration, is paramount to good returns. Despite overall market falls in 1966 and 1969 Buffett’s Berkshire Hathaway grew book value by more than 15% in both instances with a concentrated set of stock holdings. Specifically in 1966 Buffett had over 40% of his capital invested in one stock: American Express.

Another lesson from the 1960s is that the broad market is very sensitive to the economic cycle. The ISM index peaked in February 1966 at 62 and dropped to 46 by November, during that period the market fell 17%. Not long after that the ISM index troughed, at 46 in January 1967, rising to 55 by August. Over that time the market rose 12%. Again in November 1968 the ISM index peaked at 61, falling to 45 by June 1970, over that period the market fell 28%.

With this observation in mind looking back at Q3 growth indicators were strong – the ISM index in the US since July had been high, over 60, implying expectations of accelerating growth. These high expectations of growth was the risk. Also in Q3 stocks looked stale, with fewer and fewer stocks in the US and Europe making new highs. The set up was perfect to rebalance: take profit or even short. In the context of a sideways market the S&P’s 9% YTD gain through September and the European market’s 7% gain through June were punchy.

Moving forward, growth indicators showed deceleration in Europe – September’s PMI reading of 50.3 was a 17 month low. So it should be no big surprise that markets fell in Europe: high expectations for growth were not met. In sideways markets reacting quickly and flexibly to new data protects profits.

The set up today is an almost perfect mirror of the situation in Q3 for Europe, while the US is in a less decisive position. European economic growth indicators are currently depressed – German industrial production shrank aggressively in August – and downside stock trends look extended, with the European markets 15% off their Q3 highs.

Within the context of a sideways market chasing European stocks lower by shorting now is the wrong strategy. The shorting opportunity has passed. Mean reversion instead of trend extension is the gameplan. Shorts should be closed and a concentrated long portfolio gradually constructed, focussed on growth-sensitive industrial and consumer discretionary companies. The market itself can’t be counted on to provide good returns so stock selection is going to be key. Rolls Royce, down 27% from its high, with rebased defense business expectations, a streamlined product list and a large buyback, Pirelli, down 20%, quietly executing on a clear and achievable plan to boost margins, and Victrex, down 20%, in the middle of bringing new production capacity online, are all examples of potential candidates.
The Secret PM is buying:

Pirelli (PC IM)
Aggreko (AGK LN)
Rolls Royce (RR LN)
Senior (SNR LN)
Spectris (SXS LN)
Renishaw (RSW LN)
Rotork (ROR LN)
Swatch (UHR VX)
Richemont (CFR VX)
Experian (EXPN LN)