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Investment Outlook October 2020

23rd October, 2020

Introduction

In our mid-year update, we concluded that markets were moving to price in a recovery in economic activity and company earnings. As we head into the final quarter of an extraordinary year, we focus on how companies are faring and what this means for markets.

Persistence pays

Back in June, as equity markets continued to recover and were close to regaining their start-of-year levels, we wrote about the ability of equity markets to look through the deep Covid-induced economic valley and anticipate a recovery. This could explain the disconnect between near-term earnings expectations and the soaring level of equity markets.

Of the four pillars of our proprietary Quality model – Profitability, Persistence, Protection and People – it has been Persistence that has stood out, outperforming the MSCI World Index by 14.23% in the first three quarters of the year. The Persistence factor represents those companies that maintain a solid track record of earnings growth through time. The relative outperformance of this factor illustrates the importance investors are placing on consistency in the current extraordinarily uncertain environment. Beneath the surface, it seems the market is quite discerning about whose earnings are most valuable.  

Earnings recovery

Earnings estimates for companies in the MSCI World Index began a precipitous fall in early March before reaching a bottoming out on May 22nd. The collapse in profit forecasts during this period was over 22% from start-of-year levels. Earnings estimates have recovered somewhat since May but are still 14.7% below pre-Covid-19 levels. The equity market, on the other hand, has recovered almost all of its fall – as of September 30th the MSCI World Index was down just 2.6% year-to-date.

These moves put the market on a P/E multiple of 20x earnings – well above the long-term average of 15x. This suggests that investors expect earnings estimates to continue to climb in the months ahead as the recovery from Covid-19 gathers pace.

The index-level data conceals quite a bit going on below the surface at sector level, which may throw light on the nature of recent market performance. The recovery in equities since the lows of March has been remarkable for the divergence in performance between different sectors of the market. As of 30th September, EUR-based investors have seen the Information Technology sector deliver a 22.2% return, while the beleaguered Energy sector fell by 47.7%. Consumer Discretionary stocks returned 12.6% while Financials fell by 24.9%. Are these performances justified by earnings expectations?

 

MSCI World Sector YTD Perf
%
NTM/LTM
EPS Growth
NTM
P/E
Information Technology 22.0 20.5% 27.1
Consumer Discretionary 12.6 54.2% 30.0
Communication Services 6.4 5.1% 20.7
Health Care 1.8 14.4% 19.7
Materials -0.8 26.6% 18.1
Consumer Staples -3.0 17.3% 23.8
Industrials -7.2 16.5% 17.8
Utilities -8.2 7.0% 16.7
Real Estate -16.2 11.5% 24.2
Financials -24.9 1.0% 12.2
Energy -48.2 -7.2% 21.1
Total -2.6 14.2% 20.0

Source: Bloomberg/DGFM as of 30th September 2020
NTM refers to upcoming 12 months
LTM refers to immediately preceding 12 months

Analysing the data for over 96% of the MSCI World Index constituents reveals earnings growth expectations of 14.2% over the next 12 months compared to the last 12 months. Just as with sector performances, there is a wide dispersion of expectations regarding earnings growth for different sectors. Almost half of the earnings growth expected over the next 12 months comes from just two sectors: Consumer Discretionary and Information Technology. These have also been the best-performing sectors so far this year, rising by 12.6% and 22%, respectively.

There has been much talk of the “narrowness” of this year’s rally; that it is being driven by a small group of tech/internet stocks. However, the reality is that the market is rewarding those companies whose earnings performance has persisted and is avoiding those whose earnings have come under pressure. The largest contributors to technology earnings growth over the next 12 months are forecast to be Apple and Microsoft, which are each expected to deliver c$6.5bn of earnings growth over that timeframe. These companies have grown earnings through the pandemic and the market has been prepared to pay for the robustness of their business models.

The earnings growth currently expected from the Consumer Discretionary sector has a lot of moving parts and potentially carries more cyclical risk. The sector is a mixed bag of auto makers, travel companies, luxury goods companies and non-food retailers. These companies’ earnings have been pummelled by this year’s lockdowns and there appears to be consensus among analysts that these earnings will rebound strongly over the next 12 months. Investors, however, have not bought into the recovery fully. At the moment, with the spectacular exception of Tesla, the market is shunning auto companies. The same goes for many “old world” retailers that have struggled to compete with online retailers such as Amazon.

Cyclical earnings

Financials and Energy stocks have lagged the market in 2020. The Energy sector is the only sector where earnings are expected to fall over the next 12 months. Financial stocks are barely expected to grow at all in the same period as expected losses at banks are forecast to largely offset profits from insurance companies.

Oil investors worry that a Biden victory in November will bring with it a raft of legislation aimed at fossil fuel producers. The Democrats are planning a $1.7tn package funded from higher corporation taxes to drive a clean energy research effort and achieve zero net emissions by 2050. The sector also remains vulnerable to renewed travel restrictions over the winter due to Covid-19. Dividend cuts by Shell and BP earlier this year also rattled income investors who fear more to come from their American counterparts before the end of the year.

Banks have also had their share of dividend issues. European banks were forbidden from paying dividends by their central banks early in the crisis. Those same central banks have added to the pressure by engaging in massive quantitative easing, causing interest rates to fall and hurting bank profitability in the process.  

Banks began moving quickly as the pandemic spread, taking provisions for loan losses during the Q1 and Q2 earnings seasons. More is expected in the coming weeks as the recent resurgence in Covid-19 cases focuses minds once again. It is little wonder investors have shunned the sector.

The rotation

There have been few signs this year that investors are prepared to abandon the certainty that comes with persistent profitability and rotate into sectors that have been left behind. The most recent instance came in early September when the Nasdaq had a rare slip. Analysing the earnings and performance trends this year suggests that it will take an inflection in the earnings of these cyclical sectors to attract investors and broaden the market rally. In all likelihood, that will require the development of a safe and effective Covid-19 vaccine.

At DGFM, our investment process is designed to identify and invest in quality companies which we believe will emerge strongly from the current economic environment. We regard such companies as long-term winners able to demonstrate high quality in their profitability, persistence, protection and people.

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