“There is lots of savings and lots of government liquidity. The question is: where’s it going to go?”
Vadim Zlotnikov, New York-based partner and chief market strategist at AllianceBernstein, says investors, still spooked by the 2008 crash, are making decisions based on risk management, not fundamental analysis. That is creating massive opportunities to make money in parts of the equity universe, worldwide but particularly in the United States.
Investments over the past two years have gone to protection against tail risks, hence big flows to gold; to insurance against deflation, hence flows to bonds; and to insurance against volatility, hence flows to tactical asset-allocation strategies.
What investment flows to risk assets have taken place have largely gone to three themes in the equity world: emerging-market consumption, cloud computing, and water and agriculture. The rest of the equity universe has gone largely ignored.
“People want to avoid their recent mistakes,” Zlotnikov says. “But in doing so, they could be making a new mistake.”
Liquidity flows to insurance strategies or to a handful of hot themes are creating price inflation and expensive valuations in those areas, as well as value investment opportunities elsewhere.
Zlotnikov lists four examples of these: carry trades on high-quality companies; leveraged buy-outs; companies with earnings growth; and companies that can make better use of capital.
Let’s take a look at his examples.
Zlotnikov says there are worldwide over 100 large companies (totalling $2.8 trillion in market capitalisation) whose CDS spreads trade below their sovereign. In other words, their bond investors don’t believe these big companies are subject to sovereign risk. Yet these companies on average pay dividends of 3% or more. Average CDS spreads are 50 basis points.
So if an investor goes long both the stock and the CDS, the carry trade provides 2.5% (or more when you consider the collateral you can charge for swaps on the dividend), for very low risk (because you are protected if the company defaults).
These opportunities exist because of widespread mistrust in carry trades, but Zlotnikov believes that mistrust is because people are focused on tail risks. He reckons US interest rates would have to shoot up to double digits before some of these trades lost money.
LBOs: Zlotnikov says there is a record number of companies whose private value is higher their public value. He reckons one out of five US companies now generate enough cashflow to be attractive LBO candidates, able to generate returns on both the equity and debt tranches, using the debt to buy back shares or increase dividends.
Right now, however, companies are hoarding cash rather than taking such risks. At some point, however, these companies will get acquired or raise dividends, and their stocks will be re-rated. “And these are big companies,” Zlotnikov says.
Third, investors are ignoring many companies’ potential to boost profitability. Many companies – in technology, healthcare, consumer staples, energy – are enjoying record profitability but their stocks are priced cheaply, with average P/E multiples of 11-12x one-year earnings. Yet they have cashflow yields of 7-10%. Compare that to the 3.4% yield on 10-year Treasuries.
“Right now, investors’ risk perception is painting all companies as the same,” Zlotnikov says. “There’s scepticism there can ever be growth again. There are many large companies whose stock is cheap measured against cashflow, current or normalised earnings, and price-to-book.”
Fourthly, companies are nervous about returning cash to shareholders – yet investors are already rewarding companies that do so. Zlotnikov says active managers are keeping an eye on those companies ready to change the way they use capital.
“Active equities managers always underperform when market correlations are high,” Zlotnikov argues. “When markets are risk-averse, only short-term investment strategies will work. But the long-term opportunities just get bigger as more fund flows go to these short-term investments.”
His final warning is that investors are missing the boat if they are obsessing with the ability of US blue-chips to maintain their profits at home. The risk to profits lies not with companies exposed to the domestic economy, but those exposed to China and other emerging markets.
Margin erosion usually comes from overextending capital expenditure, from wage pressure, or from loss of pricing power. There’s no evidence of those things happening in the United States. But all three are occurring in sectors such as China’s automobile industry.
Zlotnikov is not arguing whether or not emerging markets’ growth trajectory will change. What he’s saying is that there is a disconnect between profit expectations for multinationals operating in Asia, and the compulsion among companies in those markets to grow market share.
He still likes the consensus themes of emerging-market consumption, cloud computing and water and agriculture. But active managers should be looking for second-tier players with smaller exposures to these sectors, because their multiples are trading around 10-12x, as opposed to 30-40x for the more obvious names. That’s where value is to be found.