|
© Copyright 2000 Rogers Media. The following article first appeared in the February 2000 edition of
BENEFITS CANADA magazine.
World View Q4
Fourth quarter 1999 offered up unprecedented valuations and unbridled optimism. What in the world
will happen next?
By John Hock and Paul Easterbrook
Following a favourable year for global equity investors in 1999, opportunities abound as we enter the new
millennium. Global equities, as measured by the Morgan Stanley Capital International (MSCI) World Index,
gained 25% (in U.S. dollars) during 1999.
However, masked beneath the strong market returns is a profound narrowness in which a small number of large
cap stocks (primarily in the technology and telecommunication sectors) generated the overwhelming majority
of many stock markets' returns. This narrow market leadership does not appear to be sustainable given the
existing stock valuations and growth prospects for many of these companies.
Accordingly, the re-emergence of fundamental considerations will result in a normalization of the extreme
valuation disparities that have emerged globally. Although earnings momentum remains strong for many
telecommunications companies, timely opportunities also exist in many European cyclical companies, and
Asian financial stocks.
The combination of attractive valuations and earnings momentum that is emerging in Asia and Japan is
particularly encouraging--economies there appear to have bottomed. Opportunities in Europe remain
plentiful. Meanwhile, the two-tiered nature of North American equities presents unique risks and
opportunities. Aside from the lofty valuations of many large cap growth companies, compelling investment
opportunities are arising increasingly among mid-cap companies, as well as firms that temporarily
disappoint Wall Street's growth expectations.
A GLOBAL VIEW
It is increasingly important to observe the investment land-scape from a global industry perspective. Three
key global themes have emerged: the public's enthusiasm for technology companies; the rapid development of
telecommunications; and the recovery in overly depressed commodity-sensitive industries and capital goods
sectors.
Although most commodity prices remain below normal levels, the recovery from overly depressed levels in
late 1998 and early 1999 has coincided with strong gains in many commodity-sensitive stocks. Although
profit taking is justified in many industry participants, there is reason to be encouraged about further
upside in selective situations based upon: depressed valuations; improving earnings prospects; improving
supply-side dynamics; and strengthening global demand.
Similar considerations, particularly the recovering economic condition in core European countries, presents
opportunities within the cyclical industry groups of Europe.
Much of the concentration of global equity performance during 1999, as well as the meteoric rise of
Internet stock prices, is predicated upon a perceived paradigm shift to the so-called new economy. This
shift, which brings with it the rapid introduction of new technologies, is advancing our efficiency and
productivity at an unprecedented pace.
The new economy is real, but there is a disconnect between many companies' valuations and their ability to
generate future economic profits. The Internet companies appear most vulnerable. Although some of these
companies deserve premium valuations, and some may ultimately generate earnings that warrant their
valuations, the vast majority are completely unjustified.
The extraordinary power of the Internet is clear, but it is important to recognize the behaviour of stock
prices during prior introductions of new technologies. In 1919 for example, there were more than 1,000
automobile companies in the United States. There are three today, one of which is headquartered in Germany.
Many of the market's favourite Internet stocks have no barriers to entry, and they are encountering
increasing and aggressive competition from formidable foes.
It would appear that the greatest economic beneficiaries of the new economy are consumers (both individual
and business technology consumers). Consider your experiences in buying personal computers or hand-held
organizers in recent years.
Lawrence Bossidy, chairman of Honeywell International, says he expects 50% of his firm's business
transactions to be conducted over the World Wide Web within three to five years. That could trim as much as
US$1 billion in costs.
Cars are being sold made-to-order on the Internet. Jack Welch, chairman of General Electric, is demanding
that suppliers transact via the Internet if they want to do business with GE. The benefits of technology
will be far reaching, but it appears the market is mispricing the various economic beneficiaries of the new
economy.
The telecommunications industry has been in vogue, and deservedly so. As the plumbing for the
Internet, the industry is undergoing rapid transformation. In the process it is providing valuable
products and generating tangible cash flow. Although valuations have become stretched in certain areas, and
stocks might be overdue for a temporary setback, there is every reason to remain committed to core telecom
stocks globally. The rapid development of wireless and data communication, as well as industry
consolidation and the integration of telecommunication, the Internet and media industries combine to
provide an exciting investment landscape.
RISK AND REWARD
Key risks to global equities include perceptions toward inflation and interest rates; U.S. Federal Reserve
Board chairman Alan Greenspan's policy; and the degree to which personal consumption and the broad markets
respond to any correction in highly inflated sectors.
In addition to these considerations, Japan's economic recovery remains the wildcard for Asia. Meanwhile,
prospects for synchronized European growth remain on investors' minds.
The high current valuations of many top performing stocks leave minimal margin for disappointment, either
through company-specific factors (i.e. earnings growth) or macroeconomic factors (i.e. interest rates).
Complicating matters is a rising probability that disappointment will occur.
Fortunately, global investors are afforded an enormous and diverse field of investment opportunities from
which to choose. Although a relatively small number of companies have appreciated to vulnerable levels,
where fundamentals do not support their stock prices, a large number of dynamic and fundamentally
attractive companies are trading at reasonable prices. The Pacific Rim, including Japan, appears to offer
the most interesting investment opportunities for long-term investors. Opportunities in the U.S. and Europe
exist as well, but chasing last year's winners is not likely to be the most rewarding investment process.
NORTH AMERICA:
UNDERWEIGHT
Fundamental value-oriented investors have faced a difficult environment in recent years. Stock price
performance has ignored traditional measures of valuation, as evidenced by the feeding frenzy that has
emerged among technology and Internet companies.
A study by Michael Goldstein, investment strategist at Sanford Bernstein & Co., identified that one of
the most successful investment strategies during the last year was simply to follow the price momentum
trend, buying those stocks that had been the best performing stocks during the prior month. That is
regardless of fundamentals or valuations.
The sustainability of this trend is questionable. Although the rapid growth in sales and earnings among
many Nasdaq 100 companies has overshadowed investors' attention to valuations, the momentum of this growth
could slow. This is true particularly relative to the magnitude of upward earnings revisions and momentum
that is emerging among certain out-of-favour sectors, as well as in many overseas markets. As investors
increasingly look beyond their national boundaries, many of the existing valuation disparities will adjust
appropriately--to the benefit of fundamental value investors.
Continued high stock valuations, in the face of potentially rising interest rates, suggest that a degree of
vulnerability exists for the broad U.S. markets--particularly the high price-to-earnings (P/E) multiple
stocks that led the market in 1999.
With North American equities trading at 30-times P/E, and many of the market's favourites trading at more
than twice that level, there are more interesting opportunities overseas.
While the S&P 500 staged a dramatic recovery during the fourth quarter, extreme divergences within the
market continued. One-half of Nasdaq stocks are more than 40% below their previous highs, and there are
similar trends within the broad New York Stock Exchange composite. This divergence is presenting heightened
risk for some stocks, while presenting opportunities for patient investors who are in either out-of-favour
sectors or stocks that have temporarily disappointed.
JAPAN: OVERWEIGHT
Japanese stocks are at an exciting inflection point as we enter the new millennium. On one hand, U.S.
equities are trading at six-times book value in the seventh year of an economic expansion with peak
corporate profitability (17% average return on equity). On the other, Japanese stocks are trading at
two-times book on average, at what appears to be the trough of a 10-year recession. Average corporate
return on equity is approximately 2%.
Value has gradually evolved in Japan. But the catalysts for this value have only recently emerged. Mergers
and acquisition (M&A) activity increased 343% in 1999--to US$78 billion. That is primarily in response
to deregulation and rising foreign interest.
Cross-border M&A activity has amounted to US$24.2 billion, thus presenting enormous and unprecedented
pressure on Japanese companies to focus on global competitiveness and profitability. The country's
corporate and balance sheet restructuring opportunities are encouraging.
NEC and Hitachi are two important holdings. Although recent performance may have gotten ahead of itself
temporarily, the long-term appeal remains intact. Both companies are asset rich, with diverse business
portfolios. However, they suffer from deficient profitability.
New and changing management directives, combined with tangible signs of restructuring, could increase
profitability five-fold for these companies during the next three to five years. There is significant room
for upside surprise.
Look also to domestic-oriented companies with excessive net cash or latent assets on the balance sheet. The
emergence of M&A, share buybacks, special dividends and improved financial management should result in
value creation for investors during the next several years.
Financial sector reform continues to present attractive opportunities for long-term investors. The
government's recapitalization program arrived long overdue, but it has spawned rapid development in the
banking sector. Consolidation has proceeded at a swift pace, and the stock market recovery has provided a
further boost to the banks, given their substantial share ownership.
The mergers between Sumitomo Bank and Sakura Bank, as well as Daichi Kangyo, Fuji Bank and IBJ, are
creating two of the world's 10 largest banks. The acquisition of Long Term Credit Bank by Ripplewood, a
U.S. private equity boutique, further reflects the rapid and meaningful evolution of the Japanese banking
sector. It will accelerate the introduction of Western banking practices in Japan.
Improved capital conditions will allow the banks to benefit from an entry into higher margin businesses
(consumer lending, asset management, etc.), and at the same time enjoy efficiency gains as necessary
investments in technology are implemented. Another potential industry driver is the growth in Japan's
securitization markets, which could add an additional boost to banks' return on equity expansion. The
leveraged structure of banks' balance sheets, combined with the leveraged structure of Japan's economy,
will likely result in a volatile trajectory. However, the strong performance in 1999 among many banks
(gaining more than 100%) places the quality sector participants in the early stages of a secular recovery.
ASIA EX-JAPAN: OVERWEIGHT
Valuations remain compelling, earnings growth continues to strengthen and earnings revisions remain on the
upside. Although the region is not immune to adverse interest rate movements, and local sovereign risk must
be considered, the region's economic fundamentals are appealing.
Recovery prospects are increasingly being discounted in parts of Asia, as evidenced by this year's strong
performance of many Korean stocks. The SK Telecom was up 563% in 1999, Samsung Electronics rose 228% and
Pohang Iron & Steel increased 94% (measured in U.S. dollars).
However, opportunities in Malaysia, Thailand and Taiwan appear to be in the early to mid stages of their
respective recoveries. Following a year of economic decline in 1998, the region's economies could register
7% to 8% growth during 1999 and 2000.
The recovery, restructuring and de-leveraging movement is well on its way in the region. The banking sector
remains fragile in many of the region's emerging economies, but the combination of recapitalization efforts
and falling provisioning levels could underpin favourable performance among industry leaders.
Asia's largest country, China, recently made landmark agreements concerning entry into the World Trade
Organization. This will provide additional support to Asia's foundation, as the massive economy
increasingly opens up for trade.
Australia and New Zealand offer attractive opportunities as well. Both stocks, and the respective
currencies, appear undervalued. Recovering economies in Asia combined with improving commodity prices
provide a favourable backdrop for Australian and New Zealand equities.
EUROPE: NEUTRAL WEIGHTING
Developments in Europe continue to follow a path of fits and starts. Nationalistic government intervention
in recent cross-border M&A attempts provides evidence that Europe has not yet fully emerged as a single
union for the exchange of goods, services, labour and capital. Although progress on this front will take
time, the pace at which companies are adopting globally competitive standards varies greatly.
This presents additional risk and opportunities. The global investment community will increasingly
scrutinize the European Monetary Union as the European Central Bank (ECB) pursues a centralized and common
monetary policy.
The ECB faces a formidable challenge--how does one institution direct monetary policy for a union in which
the constituent economies are at different stages in their respective economic cycles? Effectively,
monetary policy is too tight where it should be loose, and too loose where it should be tighter.
France, Germany and Italy, whose economies should register anemic growth during 1999, could benefit greatly
from looser monetary policy. But such a policy could further fuel inflationary concerns in the Iberian
Peninsula, where 1999 growth rates could exceed 3.5% to 4%.
The absence of true labour mobility leaves the market without one of its critical balancing mechanisms.
Perhaps these contradicting needs, combined with the robust economic conditions in the U.S., explain much
of the weakness in the euro relative to the U.S. dollar during 1999.
Although Europe is facing many challenges, the likelihood of economic recovery in France and Germany is
encouraging. A recovery in the euro versus the U.S. dollar is also possible.
Like the U.S. experience, recent performance in European equity markets has been concentrated in a select
group of large-cap growth stocks. On average, markets appear fairly valued--based upon long-term earning
prospects. However, there is a dichotomy within Europe that does present interesting opportunities for
investors who look beyond the narrow leadership of 1999.
Many cyclicals appear particularly well positioned, and the strong momentum behind telecoms could continue.
Although the disappointing performance in the financials may continue early into 2000 as interest rate
concerns hover over the sector, value is emerging among insurance companies and banks.
Higher risk/higher reward opportunities exist in Eastern Europe, especially in Hungary and Poland.
Attractive stock prices there, combined with leveraged upside participation in a European economic
recovery, present a unique opportunity.
LATIN AMERICA: OVERWEIGHT
Gaining 35.8% during the fourth quarter of 1999, the MSCI Latin America Index was the best performing
region in the world. Falling risk premiums and improved prospects for economic recovery in Argentina,
Brazil and Chile contribute to a favourable outlook for the region.
Mexico's economy continues to grow at a moderate rate (estimated at 3% in 1999), benefiting from the
strength of its largest trading partner, the U.S. Macro-considerations, particularly the direction of
commodity prices and U.S. interest rates, will have a meaningful impact on the region's performance during
the coming year.
Although progress is being made, the funding needs of the region's substantial current account deficit will
subject capital markets to volatility derived from U.S. interest rates. Complicating matters further is the
significant role that commodity exports play in the regional economy. The optimistic outlook for commodity
prices further supports the overweight interest in Latin American equities.
Keep an eye on upcoming elections in Mexico and Brazil too. They could result in rising near-term
volatility, possibly presenting timely opportunities for patient investors.
John D. Hock, CFA, MBA, is senior vice-president, portfolio manager and a member of the Investment Strategy
Committee with Hansberger Global Investors Inc. in Fort Lauderdale, Fla. Paul Easterbrook is senior
vice-president with Hansberger Global Investors Inc. in Burlington, Ont.
|
News
News
