Positioning Global Portfolios for the Next Phase of the Economic Recovery

Transcription

1 FOR INVESTMENT PROFESSIONALS ONLY Positioning Global Portfolios for the Next Phase of the Economic Recovery Portfolio manager discusses his views on the global economic recovery and how they help determine his approach to managing Capital Group s All Country World Equity (ACWE) strategy. He shares his definition of a quality growth company. And he also offers his thoughts on: Portfolio Manager Based in London 26 years of experience How the global recovery is shaping up in various regions, including the US, Europe and emerging markets Why Japan s Abenomics is of little interest to him compared to long-awaited changes in corporate governance Which European countries are getting their fiscal act together and which are not The pro-cyclical positioning of the ACWE portfolio and why he believes we are only midway through the cycle His approach to finding quality growth companies in all corners of the globe What s your outlook for the rest of the year? Can the global economy support higher stock prices? Putting aside geopolitical issues in places such as Ukraine and the Middle East, I think most of the world is actually in good shape. Most economies are growing, though not very fast. You certainly cannot call this a boom time. Rather, it s a time of slow, moderate economic growth with occasional bouts of uncertainty. In many ways, I actually feel very confident about the outlook for global markets. Starting with the emerging markets, we ve seen the beginning of a potentially incredible transformation in India with the election of Prime Minister Narendra Modi. He is seen as an agent of change and the market has reacted very favorably to that. In China, there are still many uncertainties, but the government has finally given up on the unrealistic 8%-plus economic growth objective, which frankly no one ever believed anyway. It seems the current government wants more balanced growth, shared more widely by the population at large. That includes a continuing crackdown on corruption and the opening up of financial markets, which is also ongoing. Things are heading in the right direction. Meanwhile, the US economy is doing just fine. Unemployment is down. Inflation is virtually nonexistent. The Federal Reserve is winding down its quantitative easing program with seemingly very little impact on the markets. I don t think the Fed will need to increase interest rates in a hurry in fact, I think that s a scenario that could thecapitalgroup.com/emea 1

2 develop over several years. US economic growth is spread across many states, from the Midwest to Texas to California. It s not just one area. GDP growth isn t very impressive at roughly 2% to 3%, but it s steady, measured, moderate growth. What about Japan? Do you have any faith in so-called Abenomics, or Japan s attempt to boost its economy through massive stimulus measures? If the goal of Abenomics is to increase inflation, we are not interested in that theme; we have not invested to a great extent in financials or real estate companies. But what we do find interesting in Japan is the push for change in corporate governance, which is much less discussed these days. The Abe government is advocating for improved corporate governance to address the issues of low returns to shareholders and low returns on equity, which are both signs of poor management. Some Japanese companies have billions of dollars in cash sitting on the sidelines and their dividend payout ratios are under 1%. That is unacceptable. To the extent the government can influence Japanese companies to be more transparent and to focus on returning cash to shareholders, that s the kind of change that could be very meaningful to investors like us. So we are not at all focused on the inflation part of Abenomics, but we are paying close attention to corporate governance. For me, that is the most interesting development unfolding in Japan right now, and it has nothing to do with the performance of the Japanese economy. One example of this shift is the new JPX-Nikkei Index 400, which has been embraced by the Government Pension Investment Fund. The index features companies that are shareholderfriendly and profitable. It is a very positive development. What is your view of the European economic recovery? Is it sustainable? Europe as a whole is doing fine at the moment. But the problem is there are so many different environments. There s the UK, which is doing well, quite similar to the US, and Germany, which also has a strong economy. There have even been Exhibit 1: Defensive sectors, such as health care and utilities, have led markets higher this year, but more aggressive technology stocks aren t far behind. ACWI Sector Returns Year to Date Through 31 August 2014 Energy Materials 5.1% Industrials 1.9% Consumer Discretionary 1.8% Consumer Staples 5.5% Health Care Financials 5.8% Information Technology Telecommunication Services 3.7% Utilities MSCI All Country World Index 7.2% 11.1% 14.2% 12.8% 13.2% Source: RIMES/MSCI. Returns in US dollars with net dividends reinvested. 2

3 significant and surprising turnarounds in Spain, Portugal and Greece. But then there s Italy, which remains on the fence, unsure whether it wants to restructure or not, and France, which doesn t seem to be getting the reform message at all. In that sense, Europe remains the sick man of the world. I do think the European recovery is sustainable despite weak economic growth and troublesome deflationary pressures. But the big question is what will France do? France is the secondlargest economy in Europe. It s still a wealthy country, so the French people can just stay where they are for a long time and do nothing. But if they are going to have any hope of healing their economy over the long term, they are going to have to make significant cuts in government spending. There is absolutely no way around that. The encouraging thing is, I think public opinion is changing in France. People are starting to realise that to share wealth you first need to create wealth. How does your view of European economic conditions translate into your portfolio? We are not investing in European economies we are investing in individual companies, many of which are affected very little by the fact that they are based in France or Germany or anywhere else. More than companies in any other region of the world, European companies are export-oriented, so they are dependent on the entire world rather than one small part of it. The larger companies in particular the ones that we like to invest in are the most global of all. For those companies, the bulk of their sales are in China, or the US. The best companies know how to balance the need to return cash to shareholders with the desire to reinvest in the operations and grow the business. High-quality growth companies have mastered that balancing act. Those are the companies that I like to invest in. Exhibit 2: Although the World Bank recently lowered its global economic growth projections for this year, the global economy is on track for much stronger growth by GDP Growth Developing Countries 4.8% 4.8% 4.8% 5.4% 5.5% 3.4% 3.5% World 2.5% 2.4% 2.8% 2.4% 2.5% High-Income Countries 1.5% 1.3% 1.9% e 2014f 2015f 2016f Source: World Bank. GDP growth is estimated for 2013 and forecast for

4 Quality growth companies should be profitable businesses; they shouldn t lose money. How would you describe the overall positioning of the ACWE portfolio? It s a pro-cyclical portfolio, positioned for global economic growth. We think we are, at best, midway through the cycle for many of the companies we invest in. And we believe that cycle is going to be longer than normal, because economic growth has been relatively slower than we ve seen during past recoveries. In the second leg of a recovery, it s typically the mining and energy-type stocks that take the lead. Whether that occurs now or gets postponed because of an exogenous shock a geopolitical event the fact is that s where we are in this economic cycle. We will see a second leg of the recovery sooner or later. In terms of sectors, we have invested in many consumer discretionary, industrial and information technology stocks. The portfolio very much weighted toward an improving global economy. That said, we are very comfortable with the idea that economic growth will come gradually. There are no booming industries and no booming countries, but we think that s good because it may help us avoid some of the boom-and-bust activity that characterised the last two decades. We remain concerned about valuations, but on the positive side, corporate earnings are coming through. In our view, that should allow valuations to compress over time, providing a more stable base for the next leg up. How do you pick stocks for the All Country World Equity strategy? Specifically, what do you look for in a company? We look for quality and growth. These are characteristics that you find in many Capital portfolios because very typically our stocks are chosen through fundamental, bottom-up research. How do we define these terms? High-quality growth companies are leaders in their respective industries. They participate in the overall long-term growth of the stock market, generally with a higher growth rate than their peers. And because of the quality component, they also tend to protect investors on the downside. That s a very important part of our approach: downside protection, which is pursued through investing in the highest quality companies in the world. Additionally, our search for quality and growth includes a metric called return on assets (ROA). We want companies capable of generating a ROA that is superior to their global peers. ROA demonstrates very simply the profitability of a company relative to its total assets. In other words, how efficiently does management use the company s assets to generate a profit? We chose ROA because it s a broad measure of profitability and, more importantly, it takes leverage out of the equation. Leverage can boost a company s return on equity, even while its return on assets is disappointing and perhaps in decline. ROA is an understandable concept for all investors and that s one of the reasons we prefer it to other more complicated metrics. We also believe that quality growth companies should be profitable businesses; they shouldn t lose money. That s another very simple concept, but it s often forgotten by investors, especially growth investors. There are always exceptions, of course, but generally speaking we avoid investing in companies that have had negative earnings or negative cash flow over the past five years. Again, that s a fairly ordinary idea, but it speaks to the definition of a quality company. On the growth side, we want companies with higher growth of both earnings and free cash flow than their key competitors on a global basis. And while we do pay attention to valuation, the strategy does not have a valuation objective or a yield objective. We are strictly about quality and growth. 4

5 We are always hesitant to sell a stock just because it seems expensive at the time. Growth stocks have sold off sharply several times this year. What are your thoughts on that and how do you handle those periods? During the sharp sell-off in the second quarter, much of our discussion focused on valuation. One danger of being a growth manager is you may forget about valuation. All five of our ACWE portfolio managers had allowed their valuations to creep up a bit. During that turn in the market, our results lagged and it was our expensive stocks that hurt us the most. We are always hesitant to sell a stock just because it seems expensive at the time. There are some stocks that you want to keep, even though they may appear to be overvalued by some measures, because you feel strongly that they will provide solid long-term results. But there are other stocks whose valuations can t be ignored when they get too lofty, and you need to take some corrective action. Over time, the ACWE managers have made some changes that have led to a reduction in the overall valuation of the portfolio. We reduced our exposure to some pharmaceutical stocks, for example, and redeployed some of that capital to industries that were generally less expensive. That led us to invest in some integrated oil companies, for instance, that we had not invested in for quite a long time. Interestingly, the ACWE portfolio has behaved much better during the market sell-off since late July. We are putting much greater focus on downside protection generally, particularly given where we are in the market cycle. Past results are not predictive of future results. The statements expressed herein are opinions of the individuals identified, are as of the date published, and do not reflect the opinions of Capital Group or its affiliates. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited. This communication is issued by Capital International Limited, (authorised and regulated by the UK Financial Conduct Authority). This communication is intended for professional investors only and should not be relied upon by retail investors. While Capital Group uses reasonable efforts to obtain information from sources which it believes to be reliable, Capital Group makes no representation or warranty as to the accuracy, reliability or completeness of the information. This communication is not intended to be comprehensive or to provide investment, tax or other advice Capital International Limited. CR