20 January 2016

BRIGETTE LECKIE

The US economy has done the bulk of the heavy lifting this growth cycle, and investors have been accordingly rewarded.

The S&P 500 Index is up 244 per cent from the March 2009 lows, and these compare with 185 per cent for global equities and 142 per cent for the ASX 200.

More recently, however, the US equity market has become regarded by many as being fully valued or potentially overvalued. Furthermore, 2015 was a year of poor equity returns, earnings weakness, and disappointing economic data flow.

Perhaps unsurprisingly, we are increasingly seeing investors speculate that the US equity market is on the cusp of a sizeable correction this year. Why would an Australian investor have exposure to this market, which seems already reasonably priced, despite these potential pitfalls?

1 - Unnamed

SOME RED FLAGS

There is no denying there are red flags emerging for both the US and other global equity markets, and these risks are well documented. Research, however, has repeatedly shown that correctly guessing the timing of market falls is difficult, and that it is rarely a good idea to liquidate equity portfolios.

How, then, should investors respond to these concerns? The correct course of action is not to change the total amount of equities held, but rather to change their composition, and how they are managed. Stress tests should be conducted to ensure that portfolios are robust enough to withstand (or ideally even prosper from) sizeable bouts of volatility, and to adjust to the fast pace of technological change that we believe will pervade absolutely every industry.

Looking at fundamentals alone, the S&P 500 looks unimpressive and perhaps a bit concerning – earnings growth has been negative, profit margins are also declining (albeit from elevated levels), and firms remain reluctant to invest in capital spending, resulting in an aging capital base.

At the sector level the story has been somewhat brighter. Healthcare, consumer services and technology have performed well in recent years, and are useful in diversifying the sector exposure of Australian equities, where these sectors are massively under-represented. This diversification is not the only consideration when deciding where to allocate capital – valuation (and within this, future growth prospects) also matters.

THE BRIGHT SIDE

Critically for investors, where we do see specific valuation opportunities in US equities are in selective stock investments in the S&P 500, and in the small-cap and micro-cap indices, as opposed to general index investment, or sector-specific investment.

A key view of ours is that technological change is pervading all areas of economic life, and no industry will be left unchanged.

The so-called "Uber-isation" is happening everywhere, and the winners will be companies that either instigate change or quickly adjust to it: those companies to which change and disruption are positives rather than negatives.  It is difficult to overstate the effects that this paradigm shift will have on the equity markets, and viewed through this prism, the S&P is the "old world", giving way to the new.

The rate at which the old world has and will continue to decay is shown by the chart. As the chart shows, the composition of the S&P 500 has changed over time as companies enter and exit the index.

Around 80 per cent of the companies currently in the S&P 500 were in the index in 2011 but this dropped to 50 per cent in 2006 and to a mere 30 per cent in 1991.

LESS SURVIVORS IN THE FUTURE

Going forward, we expect to see many more "exiters" and less "survivors" – and over a shorter time period.  On our projections, around half the companies currently listed in the S&P 500 could be gone by 2021 - "killed" by the technological change that will leave no sector unscathed.

Reinforcing this message, investors have profited nicely from the "survivors" over a 10-15 year period, and we expect this to be significantly more pronounced going forward. An investment in the S&P 500 from 2001 to 2015 delivered a return of 106 per cent. An investment in the S&P Survivors over the same period delivered a return of 201 per cent.

Equity markets are likely to be choppy in 2016 and beyond, but this does not mean investors should stay in the harbour. Both in the current environment, and as a matter of general policy, we prefer equities to cash. The challenge is to position portfolios for the changes underway.

We think this is best done with selected stock exposure to the S&P 500 via active management, and also to the small- and micro-cap markets, where real economic growth will be occurring and where significant mis-pricings are still possible.

 

Brigette Leckie is chief investment officer at Koda Capital.

 

Read more at afr.com