This “recovery” is in its 4th year. Unfortunately, we have yet to see robust growth in employment or incomes. The recovery continues to be about low interest rates and abundant liquidity. Cheap debt capital benefits equity owners. Whether real or nominal, as revenues grow and the cost of capital becomes cheaper, the benefits flow to equity owners.
Companies are not investing to grow and meet increasing demand, although this would be preferable. Instead, they are merely refinancing and often increasing debt at low interest rates. The lower capital costs also enable companies to buy back a portion of their equity. The change in capital structure is very positive for equity returns, but it does add risk. If the top line falters, this will have an amplified negative impact to equity. Investors seem overly focused on the positive effects of these structural factors. But, at current valuations, the continued sluggishness of incomes and the potential implications for revenues going forward has us concerned. There is no denying the current benefits flowing to equity owners. This environment has produced year to date market returns north of 10.6% for large cap US stocks. Now that the economy has added leverage at very cheap rates, will revenue growth follow?
From my perspective, the spectrum of possible outcomes for today’s stock market is wider than normal. As penned previously, this higher variance in possible outcomes is the very definition of increased risk.
In the bullish scenario, employment and incomes gain traction and we get an inflationary boom. In the bearish scenario, unit volumes are in decline, the coincident indicators do not follow and we get recessionary pressures while at zero interest rate policy, a deflationary bust.
For the past two months, we have reduced our equity exposure. This week, we have looked at valuations and attempted to replace stocks with very lofty growth expectations.
This is what a chart looks like when investors reassess optimistic expectations. A stock goes from a 16 P/E to a 12.7 P/E or a P/B of 4.5 down to 3.6. Infosys reported revenue of 2.5% below estimates and lowered growth guidance from 11% to a range of 6%-10%. The stock was down 20.68% after the announcement. This 20% drop on a 2.5% top line miss is reflective of the risks in the market today.
We sold two growth stocks this week, DASTY and BAM. Dassault has consistent, historic earnings growth of 9-12%. Last year earnings grew at 28% but expectations for 2013 are in the single digits. With a current trailing P/E around 34, this company became a valuation concern, and we booked the 30% profit. BAM is an asset management company whose equity trades at 6x book but returns to equity have dwindled recently. The stock will benefit from higher asset prices, but with assets/equity of 6x and debt to equity of 2.25x, BAM is very exposed to higher interest rates and economic slow down. BAM has also received some negative press on transparency and structure which may provide additional headwinds for the stock . We booked 115% gains and will look for better valuation in the future.
We added a familiar name, Xerox. Xerox has been reinventing itself and investing its extensive free cash flow in new growth segments. Xerox is consolidating their legacy printing and hardware business and concentrating more on services such as information technologies (application development, IT infrastructure and solutions) and business processes (accounting, human resource and customer relations outsourcing). With a current P/E of 10.3, expected earnings growth of 30% and equity that trades at book value, we feel Xerox gives plenty of upside potential with less risk than the stocks sold.
We have also doubled our target weight on our Japanese bank holding, MTU. The BOJ has indicated massive quantitative easing in an attempt to devalue their currency. We think these monetary policies will continue to affect the currency in the near term which will benefit stocks like MTU which have negative correlation with the Yen.
Third we rebalanced MBI to target. MBI is entrenched in a nasty law suit, accusing Bank of America of fraud. BAC is using all sorts of ploys to try and draw out the process and bleed MBI. All rulings have come out favorably for MBI. We feel once the lawsuit is settled, MBI will be in a position to assume more normal business operations. There may be stock movement from short covering and the stock should resume a more normal and higher valuation.
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“Wealth preservation and accumulation through thoughtful investing.”
For information on Alhambra Investment Partners’ money management services and global portfolio approach, Douglas R. Terry, CFA is reachable at: dterry@alhambrapartners.com
Disclaimer: The information, data, analyses and opinions contained herein (1) include the confidential and proprietary information of Alhambra Investment Partners LLC, do not constitute investment advice offered by Alhambra, are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and are not warranted to be correct, complete or accurate. Except as otherwise required by law, Alhambra shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, this information, data, analyses or opinions or their use.
