The current bunny market is characterised by subdued economic growth, scapegoat politics, increased bureaucracy and ineffective policies. However, despite this seemingly bleak outlook, we believe there are still good companies that are well managed and that offer attractive valuations.
Yesterday (looking back)
Fund managers with 20 years plus experience all over the world have experienced terrible returns. Nothing appears to be working. We’re in what Jim Paulson (Wells Capital Management Inc.) calls a “bunny market” – not a bull or a bear market, just a market that hops around a lot. So why is the confidence in future investment returns so low?
Like most of us, markets and economies are maturing
A long economic growth period has left developed market governments with aging and declining populations as well as excessive debt and little growth. In addition, the Chinese economic miracle is over. China’s population is also both aging and declining. Furthermore, the economy is burdened by large, inefficient, state-owned (and -managed) enterprises, excessive infrastructure and too much debt. This is not a good foundation for a 6% or even a 4% growth rate.
Simplistically speaking, there are three ingredients that help facilitate economic growth:
1. a growing labour force,
2. improving productivity levels (increasing competitiveness with the outside world), and
3. increasing debt levels (to improve production capacity or increase consumption).
China and Europe battle on all three fronts. How does Europe grow jobs when labour is expensive and inflexible and bureaucrats keep adding red tape?
Trump versus Sanders and scapegoat politics
Paul Donovan wrote an excellent report (UBS: The Economics of Prejudice Politics, 22 March 2016) highlighting the negative economic implications of a social climate that supports “anti-parties” or politicians:
When an individual’s economic position is threatened, especially when it is threatened in a relative sense, it is very tempting to seek a simple solution and look for a scapegoat.
The seductive argument is ‘If only we can remove the influence of ‘xyz’ from the economy, everything will return to the way it was.” (For additional read on this point, please see the article “Things Fall Apart” by Gavekal Research, published on 01 Apr 16)
“Scapegoat economics replaces a vague, uncontrollable cause of relative economic loss with a specific, controllable target – generally a minority in society.”
Deteriorating economic circumstances have allowed politicians such as Trump, Sanders, Weelders (Holland), Le Pen (France) and Gauck (Germany) to gain strong support. Why? During recessions, management of companies focus on profitability at the expense of labour. Every company we visit in developed markets is downsizing and reducing staff. No wonder socialism and fascism grows. Socialism goes against capitalism, which places return on capital ahead of preserving jobs. Fascistic thinking is spurred by the threat of cheaper foreign labour competing for scarce jobs (and government hand-outs), directly via immigration or indirectly via reduction of trade barriers.
The number of countries where opposition to migration has become more pronounced in the wake of the global financial crisis has grown sharply. The UBS report highlights the correlation between prejudice and economic growth. Those countries exhibiting higher levels of prejudice are less likely to be economically competitive, while politicians are using those fears to get elected.
Trump or Sanders: which of the two candidates is better for supporting growth?
The moment you think about who is better for growth you get the broader picture. Trump (who is anti-free trade but pro less bureaucracy) will most probably be better for the S&P 500 Index (US), while Sanders will chase away capital with his focus on reducing the wealth gap via increased red tape and interference. This scenario of more regulation and less growth is happening everywhere in developed markets. (In the UK, George Osborne is an exception).
Increased bureaucracy strangles the goose that lays the golden egg
Governments can’t escape it. The world has become a global marketplace. The lowest cost producer wins. You have to be better, quicker, smarter. To create jobs, governments must focus on increasing labour flexibility and ensuring the education system produces a competitive labour force. In other words, improve education and training and attract foreign capital. Yet, the focus is on protectionism, which makes corporates less competitive and less profitable and, as a result, chases away job-creating capital.
Yes, capital must be controlled and regulated, but the state’s role should be to ensure level and honest playing fields and attract capital. It has been proven many times that increasing minimum wages also increases unemployment. But increasing unemployment can, in turn, cause a rise in instability. To solve these equations, one needs a government with the infinite wisdom of Solomon, a quality sadly lacking in most governments today.
Central banks and regulators are prescribing the wrong medicines
Firstly, central banks are trying to keep interest rates low or negative in the hope that low or negative interest rates induce spending. It hasn’t and won’t. Secondly, regulators are fighting the last war by increasingly loading banks and insurers with more regulatory and capital burdens.
Our recent visits to US, European and UK banks and insurers in March highlighted how prescriptive the US Securities and Exchange Commission (SEC) has become. Not only have they increased the workforce of banks and insurers by more than 10% simply to meet their information demands, they also play a huge role in the capital allocation decision about whether and to what extent banks can pay dividends or buy back shares.
They have almost succeeded in their stated goal of turning banks and insurers into regulated utilities. It is no wonder markets don’t want to give managements the capital they need to grow (the discounts to net asset value or P/NAVs bear witness to that) and that managements don’t want to lend or write new business. The bad news is that from 1 January 2018, it will most probably get worse. New rules will ensure that banks lend only to the best borrowers. This will constrain loans to higher risk borrowers and increase bankruptcies worldwide as banks will not be allowed to use their own internal risk assessment models.
At a fascinating dinner hosted by Citigroup’s European Banks Research and Global Sector Head for Banks, Ronit Ghose, with guest speaker, Richard Meddings (Standard Chartered CFO from November 2006 to June 2014) gave insight into the environment that regulators have created. The information now required is a nightmare for large, complex banks, especially those with many legacy systems. The poor regulatory oversight that allowed American International Group, Lehman Brothers and Royal Bank of Scotland to damage the system is now being replaced by a monster machine. In effect, the regulators are neutralising the intended impact of the low interest rate policies of central banks.
The current environment has made it very unattractive to provide credit or capital
The fundamental principle of capitalism is that capital is put at risk in creating jobs that produce products (think Henry Ford or Bill Gates from Microsoft). The third point – in addition to central banks’ and regulators’ unsuccessful interventions – is that, instead of investing in productive capacity, capitalists are resorting to using leverage and financial engineering.
Tomorrow will not be the same as yesterday; yet, there will always be new investment opportunities.
(i) Many companies are generating a consistent (and growing) 4% dividend yield
In yesterday’s terms, this may seem low, but bear in mind that we live in a low/negative inflation environment. A real 4% return compounded over 10 years is not bad at all. The SIM Global Equity Income Fund (launched September 2012) has generated a low-risk annualised return of 6.2% per year in US dollars.
(ii) Well-run companies do grow shareholder value and investors are rewarded over time
Our recent company visits once again highlighted that the well-managed, legacy-free banks and insurers trade at a premium to their legacy-troubled peers. However, they trade at significant discounts to their history even after adjusting for tomorrow’s lower returns on capital or equity (ROEs). Many investors have destroyed value by seeking to guess “the bottom” share prices of banks such as Standard Chartered, Barclays and Deutsche Bank. Our visits highlighted the troubles these banks are still facing, again proving our past research project finding: “turnarounds” always take considerably longer than anticipated. Needless to say, we’ve used the January/February sell-off to increase the quality of both the Sanlam Global Financial Fund and the South African-based Nedgroup Investments Financial Fund that we manage.
Value investing in financials generally doesn’t work. Figure 1 is an example of how investing in the more expensive higher quality franchises generated better returns. (We have done extensive research covering longer time periods in different countries to test this.)
Figure 1: Quality outperforms in financials
Sources: Company financials, Denker Capital research
(iii) Different polices have different results in different countries
Uganda is not Greece. The principle of what the Ugandan government tried to bring across in 2010 is correct. There are governments that are following “capital-friendly” (attractive) policies and do indeed generate wealth for both workers (via growth in GDP per capita) and investors. A classic case at the moment is that Brazil is not Indonesia, as shown in Figure 2.
Figure 2: Divergent government policies in Indonesia and Brazil lead to vastly different outcomes
Sources: Bloomberg, Denker Capital research
(iv) Emotional overreaction from the market creates good investment opportunities
Being invested in emerging markets (EMs) has been a losing strategy measured in dollar terms since 2011. Consistent outflows combined with trade deficits of commodity-exporting countries have weakened many EM currencies significantly. But in my opinion, investors have overreacted and the tide is now turning. Figure 3 gives a rare insight into how differently US and European investors have reacted. But more importantly, it shows how European investors seem to have given up on EMs – an excellent contrarian investment signal! European-based managers have taken out everything they have put into EMs over the last 15 years.
Figure 3: Divergent reactions from US and European investment managers to emerging markets
Source: Morgan Stanley Research, Asia/GEMs Strategy, 1 April 2016
Countries such as Indonesia have demonstrated that good policies do make a difference and are now poised to reap the benefits. In India, Prime Minister Modi was overoptimistic about what he could achieve when he won the election in 2014. However, he is slowly overcoming the corrupt and inept bureaucracy he inherited, creating many new jobs on a daily basis!
How have we performed for our clients in this environment?
The SIM Global Equity Income Fund versus the Sanlam Global Financial Fund over the past three years
The SIM Global Equity Income Fund, managed by Douw Steenekamp, has done very well – it is ranked as one of the top 10 funds globally over three years in the category “Global Income Funds”, as per Morningstar. Why? The Fund invests in companies that allocate capital well. It is a proven fact that good capital allocation is a key differentiator between good and bad management. Also, research has proven that paying dividends forces discipline onto management. As a result, dividend-paying managements tend to outperform over time. But Douw has also done well by not investing in EMs or banks during the past three years.
The Sanlam Global Financial Fund generated disappointing returns over the past three years. Banks and insurers had to restructure, increase capital and add a layer of staff to satisfy regulatory demands in a low-growth, low interest rate environment. It is therefore no surprise that they were de-rated. Figure 4 shows the effect of the regulator curse – the enforced higher capital levels have resulted in lower valuations, increasing the cost of capital and making it more expensive to raise capital for growth.
Figure 4: The impact of increased capital demands by regulators on banks and insurers
Source: Denker Capital research
In addition, the Fund retained an exposure of more than 40% to EMs. This was based on the conviction that banks in these countries have considerably better growth prospects than banks in developed markets (DMs) over the long term.
As mentioned above, while EM banks did deliver – even in a lower growth environment with many headwinds – currencies ate away the gains (refer to the Fund’s December 2015 fact sheet.)
The bottom line – there are affordable companies with attractive valuations
So yes: yesterday was easier. The high-octane environment that started after US Fed monetary pragmatist Paul Volcker launched his attack on inflation in the US in the mid-1970s, causing interest rates to rise to record highs in 1982, is long gone. The high-growth environment and extended bull market that was created as a result won’t be repeated for a while.
However, tomorrow brings different opportunities. As we mentioned in our last article (“Markets are ruled by fear, but not panic”, 19 February 2016), banks and insurers in both DMs and EMs have become extraordinarily cheap and valuations are looking attractive. Our company visits over the past six months, ranging from Indonesia and India to Europe and the US, have highlighted the extent to which company managements have and are adapting.
In the current low interest rate environment, these companies are growing shareholder value at 10% per year. Although this is not as exciting as yesterday, it is considered good in today’s negative interest rate environment. There are never guarantees, but four things remain important:
1. valuation,
2. real returns on capital,
3. good management, and
4. experience
We’re invested in good companies with attractive valuations generating favourable real returns on capital. Our 25 years’ experience has taught me that the returns eventually follow.
Interested in benefitting from EM growth?
We launched the SIM Global Emerging Markets Fund in June 2015 for those who want to capitalise on EM growth potential. The Fund is still tiny and very nimble and leverages off our research base and many years of accumulated experience.
By Kokkie Kooyman
Portfolio Manager
