Change is in the air for global stocks

-- | 05/08/2019

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Glenn Freeman: I'm joined today by Jonas Palmqvist from Alphinity Investment Management. Thanks for your time today.

Jonas Palmqvist: Nice being here. Thank you.

Freeman: I just wanted to speak to you firstly about – so, the investment philosophy that you guys follow there, and I believe there's quite a few differences in the way that you actually construct the portfolio. And one of those things is the way that you look at earnings. Not so much in valuations, but the earnings of companies. Can you just talk us through that?

Palmqvist: Yes. It is actually our core belief that earnings do drive share prices. So, what we seek to do is constantly investing in the earnings leadership in global equities. We are constructing quite a concentrated portfolio based on that. So, we're buying quality companies that we think are undervalued. But what probably differentiates us a little bit is just that very sharp focus on earnings cycles.

Every company in the world goes through earnings cycles. There are long, quite sticky periods when the market, the analysts, the fund managers are chasing the true earnings power of a company north. So, they're underestimating the earnings power. And likewise, there's an earnings downward cycle. Even the highest-quality companies sometimes have too high expectations, and that's the time we try and be out of these stocks. So, we put together a concentrated portfolio, 30 to 40 stocks, and each and every stock in our portfolio have that character of a faster rise of earnings expectations than the rest of the market. And we're quite agnostic where that leads us.

Freeman: So, quite sector agnostic you mean…

Palmqvist: Yes. Sector, region agnostic. The leadership, for example, you're probably aware, in the last 12 months has been quite firmly on the defensive growth, the quality side of the market. But if you back the tape two years, it was more on the cyclical side of the market. And we will follow the leadership on the earnings side, and we will always aim not to overpay for it. And following that cycle makes us quite unconstrained in terms of what type of stock we invest in. But at the same time, we're very disciplined to always have that faster earnings surprise in the portfolio.

Freeman: There would be some pattern even though you are bottom-up in the way that you actually select the types of companies.

Palmqvist: Right now, it's quite interesting because the global earnings cycle turned quite negative a year ago. So, the last 12 months, we've been seeing more earnings cuts than rises. And we've seen this spreading across the globe. Started in Asia, swept across Europe, into the U.S. markets. And the leadership in terms of earnings has been very firmly planted on the growth defensive side and quality side of the market; whereas it's been at the expense of cyclicals and high-risk companies.

So, we've been invested accordingly. More on growth side, quality side of the market. And the one thing we do want to point out right now that there is an emerging risk of a change in this. So, we're not calling it yet. And we're just halfway through our reporting season for the second quarter. And it's safe to say that the current trends are continuing. There are more downgrades than upgrades. And the cyclical side is struggling more. There's still plenty of profit warnings on that side.

Freeman: So, consumer staples, those sorts of…

Palmqvist: Staples are doing better. Healthcare's doing better. Utilities, property, the software side of technology is doing quite well. And earnings are resilient, earnings are growing. Whereas if you step over to chemicals, capital goods, that side of the market – semiconductors, it's been very steep downgrades.

What we're looking at now though is even though we don't have conviction yet on the cyclical side of the market, there is an emerging chance that the cycle changes. So, what typically happens after 12 to 18 months is that everyone is too bearish on one side of the market. And I think the ongoing reporting season is telling us it probably has a bit more to go on the cyclical side in terms of negative revisions. But we are now at a (level) – if you look across the whole global earnings space, we are at a level where historically we have enough analysts being bearish and cutting numbers now. So, it's time to lean forward and do a lot of work on stocks that would work better if this leadership changed from defensive to cyclical. We're not there yet.

Freeman: The markets are talking about at the moment is the Fed has just come out overnight and cut the official interest rate. How does your portfolio change over the longer-term and what prompts that?

Palmqvist: Well, right now, we've actually been in a long period of not changing the portfolio much, because that earnings leadership has been quite consistently on the growth defensive side of the market. And I think what the central bankers have done in the last six months, when they basically capitulated and started talking rate cuts, started talking potentially QE again in Europe, that's just turbocharged that move. So, the leadership has gone even more firmly into the growth side of the markets. That's where the market performance has been.

So, what happened overnight when Fed cut for the first time in 11 years, that helps us maintain the current direction. What we're looking for is a science where the earnings are bottoming out on the cyclical side, like I said, and the Fed hasn't really changed anything in their behavior for us to change our view.

Freeman: At Morningstar, we've been talking a lot about index funds and ETFs. And that's something that's a big growth area that has done very well. If there is a downturn and a lot of these types of funds haven't been tested, I'm talking ETFs in those more bearish markets, it will be interesting to see.

Palmqvist: It's a bit uncharted waters, isn't it? I think we've got as many listed ETFs now in the U.S. as we have listed stocks. It must mean that the same stock is now feeding into multiple, potentially hundreds of ETFs. So, who knows what happens? I'm convinced that active management will do quite well when the market changes. I think there's a clear role for active management long-term. I think liquidity is going to be at the core of anything that happens when markets one day turn more negative. But the way central bankers are going now, it doesn't look like it's happening today.

This report appeared on www.morningstar.com.au 2019 Morningstar Australasia Pty Limited

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