1999 all over

Pascal Blackburne & Luc Synaeghel 2017-06-08

The money currently flowing into the private equity space is quite astounding – and a testimony to how desperate investors have become for returns in a world of zero rates. Not only are they willing to entrust massive amounts to newly established private equity funds, but they are also requesting that their money be put to work fast. The ensuing competition between private equity firms to find investments means not only that target company prices are bid up well above the level suggested by standard valuation tools, but also that proper due diligence is not always performed.

To us, this is worryingly reminiscent of 1999. That too was a time when traditional valuation tools were put aside, giving way to all sorts of fancy criteria – including a dollar value per person employed! And not just in the private equity market. Publicly traded companies also rocketed to “irrationally exuberant” prices led, we all remember, by the “dotcom” sector. But in the ensuing brutal crash, it was private equity that suffered the most. With no liquidity, technical or momentum buffers, private company prices immediately plunged to conservative multiples of operating earnings. The damage inflicted was such that for many years thereafter, private equity managers kept to a careful valuation approach… up until recently.

In the stock market, we have the same feeling of déjà-vu. And while the eventual downside valuation adjustment may again prove less violent than in private equity, there will be additional disturbing factors to contend with this time around. Over the past 8 years, Exchange Traded Funds (ETFs) have amassed more than a trillion US dollars – a demand such that it could only be directed to stocks with sufficient liquidity, i.e. large capitalisation indices. Quantitative hedge funds, working with trading algorithms, have also proliferated, now accounting for over a quarter of trading volume. The resulting indiscriminate and clustered buying makes for rising correlations between stocks, thus few places to hide when the turning point does come.

Of course, foreseeing this turning point is of the order of the impossible – and in the meantime, the upside could still be very significant if vast amounts of money keep pouring in. As such, our investment stance is to have a moderate and flexible exposure to broad equity indices, focusing on the “relatively” cheaper regions, namely Europe and Japan. Alongside that exposure, we look out for attractively valued (disliked) specific investment themes such as bulk shipping or shale oil. A longer-term horizon is obviously required on these niche positions, readily accepting intermediate volatility.

A final mention of currencies, to point out the significant ground lost by the US dollar versus the euro year to date. Assuming the euro-dollar 1.05-1.15 range still holds, the greenback now stands at the cheaper end. With the Federal Reserve poised to continue increasing interest rates, we have adjusted our currency overlay so as to up portfolio exposure to the dollar, from 10% to 20%.

When valuations no longer matter

With equity markets going from strength to strength, portfolio construction is becoming an ever more difficult choice between investing in low/zero yielding bonds or in equities that are broadly overvalued. US equities are the most extreme case, with the S&P 500 index now trading at an 18.5 multiple of consensus forward earnings and the technology-heavy Nasdaq composite index trading at an even richer 23.6 multiple. This return vs. risk conundrum is made worse by the fact that the stock market rally of the past few years has largely been driven by index and quantitative funds – only serving to accentuate the herd effect and to downplay traditional valuation considerations.

As the cheapest means to participate in equity markets, costing sometimes as little as 5 basis points for the most common indices such as the S&P 500 or the Russell 1000, ETFs have been inundated with over USD 1 trillion in new money since the 2009 financial crisis. And just in the first five months of this year, inflows into ETFs have already exceeded 2016 full-year numbers. The money flowing into passive investment vehicles has been such that there has been only one place for it to go: large-cap indices. As a result, over 80% is now invested in companies whose capitalisations exceed USD 10 billion. Liquidity begets liquidity. Also, and perhaps even more importantly, ETFs invest in all the companies that belong to the index being replicated, regardless of their respective valuations. Put differently: buying is indiscriminate.

But beware of the hangover when the trend reverses

Prospering alongside ETFs have been quantitative hedge funds, whose investment decisions rely on complex statistical models. Here again, fundamental analysis plays little role and valuation has little bearing. According to the New York research firm the Tabb Group, quantitative hedge funds now account for 27% of US stock trade volume (up from 14% in 2013) and have thus become almost as important market participants as individual investors. At over USD 930 billion in investments, quantitative funds’ share of the total hedge fund business now exceeds 30%. Tellingly, they collected a further USD 4.6 billion during the first quarter of 2017, while hedge funds overall experienced outflows of USD 5.5 billion.

The combined clout of ETFs and quantitative hedge funds seems to us a very dangerous cocktail. The ride is clearly exhilarating, but beware of the hangover when the trend reverses. And that time will eventually come, however difficult it is to predict.

In the meantime, though, staying on the sidelines of such powerful liquidity, backward-looking and trend-following forces is a costly option for investors. We prefer to keep some exposure, albeit underweight, to broad equity indices. We focus that allocation on the “best of the bad” in terms of valuation and earnings dynamics, namely European and Japanese equities. And we do so with a flexible, short-term approach – standing ready to make tactical adjustments.

Patience is a virtue

Alongside our moderate exposure to broad equity indices, we strive to find niche investment opportunities. By definition, these lie in riskier segments of the market. With an important proviso though: the risk that we look to take is business risk, which we believe will be rewarded by strong (and somewhat market-decorrelated) stock price performance as sector/company prospects improve, rather than valuation risk, which can only lead to stock price disappointment.

Bulk shipping is a case in point. We initiated positions in the last quarter of 2015, when the sector was suffering a major crisis. Vessel oversupply had brought shipping rates down to a 20-year low and bulk carrier companies were bleeding cash. With the most distressed companies forced to sell part of their fleet to meet debt requirements, second-hand vessel prices had in some cases fallen below their scrapping value. We recognised that it might take several years for the overcapacity to fully resorb and freight rates to normalise but, with bulk shipping stocks trading at only a fraction of their book value, we deemed their upside to be very consequent – for the financially strongest companies that is. We did stress, however, that a longer-term approach would be required to reap these benefits. As it were, bulk shipping stocks really started to rally in early 2017 – contributing markedly to our first quarter performance. They have levelled off since, but the underlying investment thesis remains very much in place. We are thus confident that further significant upside lies ahead for patient investors.

If the oil price does not reach USD 60 per barrel in the near future, odds increase that it eventually hits USD 80

Holding to a multi-year exit window is also our approach in the shale oil space. Admittedly, the recent oil price trajectory has not lived up to our expectations. As we wrote last month, oil market participants seem intent at looking at the glass half empty rather than half-full. They have been pinpointing “details” to justify not investing, ignoring the broader positive evidence of ongoing global oil market rebalancing. Even OPEC’s recent decision to extend its oil production cuts for a further 9 months was not enough to revive investor appetite.

In some respects, though, the failure of the oil price to move up now strengthens its longer-term outlook. Decisions to invest in additional production are being delayed, deepening the supply-demand imbalance down the road. In other words, if the oil price does not reach USD 60 per barrel in the near future, odds increase that it eventually hits USD 80.

As the “swing producer”, US shale oil companies stand to reap the benefits of a higher oil price, when and how it eventually materialises. The sector is emerging from a severe crisis. Bankruptcy concerns are gradually abating and faster drilling and enhanced completion methodologies have made for massive efficiency gains in tight oil recovery. We are confident that patient and agile investors will be able to unleash the considerable shale oil stock valuation potential.

Towards a stronger US dollar ?

In past letters, we have regularly reflected on the remarkable stability, or should we say range-bound behaviour, of currency markets – to the point of wondering whether some form of (unofficial) agreement between central banks as to appropriate exchange rates had been found. Take the euro-dollar exchange rate, for instance. Ever since the period of massive euro depreciation ended in January 2015, the euro has fluctuated only between 1.05 and 1.15 versus the greenback.


Euro-dollar exchange rate (since 2015)

Source: Bloomberg

Year-to-date, receding political risk in Europe, as electoral hurdles were cleared one after the other, has pushed the euro-dollar exchange rate towards the upper end of this range. Given the relative monetary policy stances – a progressively more hawkish Federal Reserve versus a still accommodative European Central Bank – we would expect the US dollar to appreciate again during the second half of this year.

We have thus elected to increase our dollar exposure in portfolios from 10% to 20%. We should stress that we have an overlay approach with respect to currencies. By this we mean that we select assets across the globe purely on a conviction basis, and then add foreign exchange hedges in order to achieve the desired currency mix. Right now, holding more dollars seem warranted.