In 2014 we increased our holding as the earnings potential of the business became clearer, and we still find the company
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Newsletter, Q4 2016
Hermes Equities
Sharpe thinking Brexit, the case for Asian cyclicals and the technology that exposed Volkswagen
Key points The impact of monetary policy has weakened substantially, a trend thrown into sharp relief since Brexit Emerging market currencies are recovering and the outlook for their economies has strengthened this year
For professional investors only
Horiba, the Japanese manufacturer of the testing equipment that revealed Volkswagen’s emissions cheating, is a promising opportunity in the small cap universe We also provide views on the US, Europe and Asia ex Japan stock markets
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Hermes Equities
Newsletter, Q4 2016
Brexit and the policy response: what markets want, markets get Andrew Parry Head of Equities The vote for Brexit dominated newsflow over the summer, impacted markets and led to a new UK prime minister. But in this world of weak growth, extremely low bond yields and coercive central bank policies, where the most reasonable market prediction is that frequent spikes in hope and fear will continue, Brexit is just one of many forces contributing to ongoing volatility. The dire predictions about the fate of global markets if the UK voted to leave the European Union (EU) failed to be fulfilled. Markets fell in the immediate aftermath of the vote for Brexit, especially sterling, but the anticipated collapse of equities failed to materialise. The pan-European indices have declined by less than 1% in euro terms, and, even at their worst, none of the major markets sank below their February lows. In fact, the S&P 500 reached a new all-time high in late August. Even UK mid-caps are up 3.4% from their pre-referendum level, and well off their post Brexit lows, despite being in the direct path of a widely predicted, but still absent, UK recession. An even more startling metric is that since the close of business on 23 June, when Britons cast their votes, the MSCI World Index has risen by 15% in sterling terms – very near an all-time high. Armageddon appears to have been postponed.
Since the close of business on 23 June, when Britons cast their votes, the MSCI World Index has risen by 15% in sterling terms – very near an all-time high. Part of the reason for the relatively benign outcome is that most investors were already positioned bearishly. High cash levels, reduced equities exposure and large open put options provided strong technical support. Such pessimism was not based on politics alone – the consensus view was that the UK would vote to remain in the EU – but fears of stagnating global growth. Monetary authorities, which have learned from previous crises, indicated that they would take action to support markets, and the Bank of England duly delivered. The need for investors to earn a profit also contributed: with $13tn of government bonds globally providing negative yields, the hunt for attractive returns continued.
Liquidity gluttons What happens now? Markets expect that central banks will continue to stimulate growth and support asset prices. This is a typical Pavlovian response in which markets habitually associate uncertainty with stimulus, and exhibits their faith in the benefits of central bank intervention. The Federal Reserve’s glacial approach to raising interest rates, combined with upbeat US jobs reports, plus the reintroduction of QE by the Bank of England, and expectations of further stimulus in Japan, encourage investors’ sanguine view of the world.
But central banks, as influential as they are, cannot alone dictate the course of the global economy. The full consequences of the ‘leave’ vote are unknown and were never going to be felt in the short term: the ramifications will unfold over the rest of the decade and blend in with the ebb and flow of the global economy. What we do know is that there is unlikely to be any immediate surge in growth, even if fears of a recession look misplaced. Uncertainty will dog markets for the foreseeable future and sentiment will suffer amid the inevitable posturing by politicians during negotiations for Britain’s exit from the EU. Yet Brexit, as pivotal as it is, is only one of many influential risks in the global economy. From the US to China, low productivity, weak inflation expectations, excess global industrial capacity and policy uncertainty continue to constrain growth. And as all eyes have focused on sterling, the Chinese authorities have quietly weakened the renminbi as the benefits of their massive Q1 stimulus dissipate. Indeed, by destabilising world trade, a sudden and hefty devaluation of the Chinese currency would shock the global financial system more than the vote for Brexit has.
The limits of policy Uncertainty, ultra-low bond yields and stimulus make it likely that equity markets will be range-bound for the rest of 2016. The amplitude of this range may surprise investors, as the system will be awash with liquidity. More stimulus is undoubtedly on the way in Japan, but the scale of negative interest rates in global bond markets suggests that the potency of monetary policy has been exhausted. Indeed, the biggest risk for equity investors is a sudden reversal in the direction of bond yields.
The scale of negative interest rates in global bond markets suggests that the potency of monetary policy has been exhausted. Fiscal stimulus could be the next policy response – it is the last one to be tried – and may further embolden investors’ risk appetite. For this to work, however, it needs to be well planned, appropriately targeted and globally co-ordinated. Such an outcome is unlikely, as there remains a deep schism on fiscal spending among governments, but it remains the hope of beleaguered investors looking for a permanent improvement in aggregate demand, rather than the short-lived sugar rush from more unconventional monetary policy.
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Hermes Equities
Newsletter, Q4 2016
United States
Mark Sherlock, Lead Portfolio Manager – Hermes US Small and Mid Cap Equities
We seek companies with a strong durable competitive advantage that are trading at a discount to their intrinsic value. As a high-quality cyclical stock, Martin Marietta meets our criteria because it is among the top one or two players in its respective markets, and its pricing power provides strong potential for sustainable future growth.
250 200 150 100
Martin Marietta Materials
Aug 16
Jan 16
Aug 15
Jan 15
0
Aug 14
50 Jan 14
Announcing its results for the first half of 2016, the group reported record net sales and net earnings. The first multi-year US highway bill in a decade, in addition to improving employment and substantial backlogs for contractors, should fuel growth as the recovery in the nation’s construction industry continues.
300
Aug 13
The firm itself has the potential to expand its operations in both Texas and Colorado, which provided half of its 2015 sales, while its strong cash flows enable it to buy back shares and make acquisitions in future. According to one analyst note, EBITDA could double to $1.7bn-2bn by 20201.
Figure 1: Martin Marietta stock price, Oct 2012 to Aug 2016
Jan 13
There are a number of dynamics supporting the long-term investment case for Martin Marietta. Population growth is resulting in increased per capita aggregates consumption, population density is creating demand for greater infrastructure networks, and the superior finances of states in which the company operates supports infrastructure spending. The average lifespan of a federal road in the US is nine years, and we expect the company to provide greater volumes of materials as more money is spent restoring highways and infrastructure.
We first invested in the stock in 2012, as we believed the materials sector could benefit from a recovery in capital expenditure amid the US economic recovery. In 2014 we increased our holding as the earnings potential of the business became clearer, and we still find the company’s fundamentals attractive.
Share price (US$)
Martin Marietta is the second-largest aggregates and heavy building materials company in the US. The firm makes materials used for roads, footpaths and building foundations and has operations in 26 US states, Canada and the Caribbean.
Russell 2500
Source: Bloomberg as at 19 August 2016. Past performance is not a reliable indicator of future results.
Europe
Martin Todd, Co-Portfolio Manager – Hermes European Equities
Our strategy of buying quality companies that can grow irrespective of the economic climate has led us to stocks such as ARM Holdings, which we held from June 2011 until its takeover by SoftBank Group in September. The same qualities that lead to us investing often make these companies targets for acquisition. Over the past 18 months it has led to BG Group, SABMiller and Gamesa being added to various companies shopping lists. A number of other M&A deals were announced in July, particularly in consumer staples. Combine investment grade credit ratings, record low debt yields and a low-growth environment, and a flurry of M&A is unsurprising. Proposed deals included Danone bidding $12.5bn for WhiteWave, Mondelez bidding $23bn for Hershey, and Unilever buying Dollar Shave Club (DSC) for $1bn. The latter deal could well be the most interesting. DSC is an upstart in the lucrative shaving market and has taken a 15% share in the US razor cartridge market in five years. Gillette remains the market leader with a 60% share, down from 70% in 2010. DSC offers customers high quality razors at a fraction of the price of the Gillette equivalent (see image). It is able to do this for a number of reasons. First, it ships straight to the consumer, bypassing retailers and their associated costs. Advertising is another key difference. While Procter & Gamble spends approximately $150m on advertising Gillette each year, DSC produced a $4,500 YouTube video as its primary promotion. The video has subsequently gone viral, with more than 23m views, nullifying the need for additional promotion. DSC’s use of social media has enabled it to achieve big-label brand recognition, with a fraction of the promotional spend.
Compare the pair: a still frame from Dollar Shave Club’s successful YouTube advertisement. Source: Dollar Shave Club.
It is not just the razor market that is facing competition from small, independent disruptors. Craft beer producers have been taking market share for years, craft spirits are increasingly popular, and the eyeglass industry is also being challenged by Warby Parker, a private US company, founded seven years ago. Any consumer market where the price gap between established brands and the cost of production is particularly wide is at risk. Of course the global fast-moving consumer goods groups have deep pockets and many ‘challengers’ will simply be acquired, as in the case of DSC. However, these disruptors will remain a threat, and need to be taken seriously. The onus is on incumbents to invest in innovation if they hope to preserve their price premium and market share.
1 Martin Marietta: Potential for EBITDA to double. Increased delivery of aggregates by rail, by Mike Betts. Published by Jefferies International Limited in 2016. The above information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
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Hermes Equities
Newsletter, Q4 2016
Asia ex Japan
Jonathan Pines, Portfolio Manager – Hermes Asia ex Japan Equities
We believe that investing in selected (quality) cyclical stocks will outperform most defensive stocks, despite the market trending in the other direction over the last few months. Many investors favouring defensive stocks argue mainly in terms of their attractiveness relative to government bonds. However, it is not a two horse race. The relevant comparison is not government debt versus defensive stocks. Indeed, we consider both of these alternatives to be poor. We are not limited to buying expensive stocks or expensive government debt. We can also buy other more attractively priced stocks and have done so. Of course, this means that we have needed to get comfortable with an uncertain short-term earnings outlook. But we believe that, in time, we will be richly rewarded for doing so. Now is a time to favour cheap stocks with a cloudy short-term earnings outlook over expensive stocks one with an apparently rosy one. According to the first principles of equity valuation, current dividend yield is relatively unimportant when analysing stocks. The value of a company is the present value of all future dividends. An investor pricing a stock off only its current dividend yield (which is the way many defensive stocks are currently valued), is placing too much emphasis on the present than the future, and naively favouring stocks that currently have a higher payout ratio. So, for example, if defensive company A earns $10 per share, pays out $9 per share and is priced off a 3% dividend, it will trade at $300 (being $9/3%). If similarly defensive company B also earns the same $10 per share but only pays out $4.5 per share and is priced off the same 3% dividend yield, it will trade at $150.
This makes no sense. The more conservative company is being harshly penalised by the market’s focus on dividend payouts. Indeed, it seems that management teams and the boards of companies, which are often incentivised by a rising share price, are adapting to the market’s current obsession with income – as reflected in progressively increasing payout ratios of certain defensive companies (figure 3). As a result, the stocks appear attractive on dividend yield versus bond yield basis, they are expensive on other valuation metrics, such as P/E multiple. Figure 3: Companies have appealed to investors’ desire for yield Johnson & Johnson
Procter & Gamble
Coca Cola
Taiwan Mobile
2010
2015
2010
2015
2010
2015
2010
2015
CPS
4.76
5.90
3.67
4.01
1.68
2.05
5.53
5.86
DPS
2.11
2.95
1.80
2.59
0.88
1.32
4.62
5.6
Payout ratio
44%
50%
49%
65%
52%
64%
84%
96%
Source: Bloomberg, Hermes as at June 2016. Earnings per share used is a normalised earnings figure, as calculated by Bloomberg.
Japan
Stephen Martin, Pacific Manager – Hermes Global Small Cap Equities
Horiba is a Japanese technology company that applies its core expertise in chemical analysis to a range of laboratory and real-world applications in fields such as medicine, manufacturing and the environment. Though many of its markets are highly competitive and volatile, we believe its continuing efforts in research and product innovation will allow it to retain market leadership and reward investors prepared to be patient. Its management team has defended extended periods of low returns in some of its business areas by arguing that advances and developments made in one field can be applied to others, strengthening the whole group. In addition, it can point to the benefits that have accrued from enduring difficult periods in volatile industries. The company’s highest margins come from semiconductor production equipment, such as mass flow controllers used to regulate the release of gases during production. It has seen off several rivals to take more than 50% global market share. Horiba has 80% market share in auto emissions test equipment, with broader auto test equipment the group’s biggest revenue generator. Its biggest customers are auto manufacturers developing new models. However, it also produces machines for real-world testing. These are about the size of a suitcase and fit in the boot of a car, taking readings from the exhaust as the car is driven. Researchers used Horiba’s equipment to reveal that actual emissions from Volkswagen (VW) diesel cars were much higher than the results submitted to regulators.
Horiba technology revealed the true extent of nitrous oxide emissions from Volkswagen cars.
The VW scandal is likely to lead to more rigorous testing, including real-world monitoring, which will support Horiba’s sales. However, its management team is also preparing for the long-term decline in combustion engines by broadening the company’s range of auto test equipment and services. Last year, Horiba bought MIRA, the UK government owned test facilities based in Nuneaton, which incorporates indoor and outdoor testing services, including vehicle communications and control systems for future road networks.
The above information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
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Hermes Equities
Newsletter, Q4 2016
Global emerging markets
Gary Greenberg, Head of Global Emerging Markets The strength of the US dollar is implicit in the fortunes of emerging market economies, which have significant dollar-denominated debts and whose own currencies are vulnerable to devaluation. The weakening of sterling and the euro in the wake of the Brexit vote has strengthened the dollar’s safe-haven status in the short term and recent data, along with statements from the Federal Reserve Chairman and Vice Chairman, indicate the likelihood of a rise in the US benchmark interest rate this year. The dot plots showing their expectations of future rates suggest that, contrary to market expectations, Fed members expect US rates normalise over the next two years. If Europe stays together, we see this as possible, and the pathway to normalisation should be positive for the dollar and arrival at the destination should cause it to peak. Earlier in the year, we thought this might happen in early 2017, but the Fed’s delay in raising rates has put off our target for a dollar peak to early 2018. Brexit remains a threat to emerging market performance – should there be further weakening of the pound and euro, the resulting flight to quality would naturally benefit the dollar. However, in a situation where sentiment remains cautious but does not descend into alarm, the dollar may lose traction. The valuations of most emerging market currencies already reflect a strong US dollar and are, if anything, undervalued. Historically, any gains by emerging markets through global exports have driven the global emerging market real effective exchange rate (GEM REER) higher. However, since February 2011, a 1.3% decline in export market share has seen a disproportionate 12% depreciation in the GEM REER – based on the long-run historical association, this should have delivered a more modest 6% fall.
In the first half of 2016, emerging market currencies began to recover from the turbulence caused by China’s devaluation of the renminbi and the US Federal Reserve rate rise. Brexit is propelling this trend further. However, a slide in the value of the renminbi remains a significant risk, and better communication with the markets from Chinese policy makers is needed to provide reassurance that any depreciation will not be sudden and extensive. Figure 4: Emerging market currencies (per USD) Brazilian Real Russian Ruble South African Rand Colombian Peso South Korean Won Malaysian Ringgit Chilean Peso Indonesian Rupiah Taiwanese Dollar Hungarian Forint Singapore Dollar Romanian Leu Thai Baht Czech Koruna Bulgarian Lev Philippine Peso Peruvian Sol Polish Zloty Hong Kong Dollar Turkish Lira Indian Rupee Chinese Renminbi Mexican Peso Argentine Peso
-13.67 -15
-7.20 -10
7.53 7.46 6.09 5.51 5.04 4.83 4.56 4.55 4.53 4.35 3.96 2.62 2.59 1.40 0.53 0.47
-0.05 -0.97 -1.00 -2.74 -5
0
5
10
20.97
13.21
15
20
25
Source: Bloomberg as at 5 September 2016.
The above information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments. This document is for Professional Investors only. This document does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments; nor does it constitute an offer to purchase securities to any person in the United States or to any US Person as such term is defined under the US Securities Exchange Act of 1933. It pays no regard to the investment objectives or financial needs of any recipient. No action should be taken or omitted to be taken based on this document. Tax treatment depends on personal circumstances and may change. This document is not advice on legal, taxation or investment matters so investors must rely on their own examination of such matters or seek advice. Before making any investment (new or continuous), please consult a professional and/or investment adviser as to its suitability. Any opinions expressed may change. The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. Any investments overseas may be affected by currency exchange rates. Investments in emerging markets tend to be more volatile than those in mature markets and the value of an investment can move sharply down or up. Investing in smaller/medium sized companies may carry higher risks than investing in larger companies. Past performance is not a reliable indicator of future results and targets are not guaranteed. All figures, unless otherwise indicated, are sourced from Hermes. For more information please read any relevant Offering Documents or contact Hermes. The main entities operating under the name Hermes are: Hermes Investment Management Limited (“HIML”); Hermes Alternative Investment Management Limited (“HAIML”); Hermes European Equities Limited (“HEEL”); Hermes Real Estate Investment Management Limited (“HREIML”); Hermes Equity Ownership Limited (“HEOS”); Hermes GPE LLP (“Hermes GPE”); Hermes GPE (USA) Inc (“Hermes GPE USA”) and Hermes GPE (Singapore) Pte. Limited (“HGPE Singapore”). All are separately authorised and regulated by the Financial Conduct Authority except for HREIML, HEOS, Hermes GPE USA and HGPE Singapore. HIML currently carries on all regulated activities associated with HREIML. HIML, HEEL and Hermes GPE USA are all registered investment advisers with the United States Securities and Exchange Commission (“SEC”). HGPE Singapore is regulated by the Monetary Authority of Singapore. Issued and approved by Hermes Investment Management Limited which is authorised and regulated by the Financial Conduct Authority. Registered address: Lloyds Chambers, 1 Portsoken Street, London E1 8HZ. Telephone calls may be recorded for training and monitoring purposes. Potential investors in the United Kingdom are advised that compensation will not be available under the United Kingdom Financial Services Compensation Scheme. CM155491 T4636 09/16
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Excellence. Responsibility. Innovation.
Hermes Investment Management Hermes Investment Management is focused on delivering superior, sustainable, risk-adjusted returns – responsibly. Hermes aims to deliver long-term outperformance through active management. Our investment professionals manage equity, fixed income, real estate and alternative portfolios on behalf of a global clientele of institutions and wholesale investors. We are also one of the market leaders in responsible investment advisory services.
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