- Having global bond and equity markets in total disagreement is not unique to the second quarter, but the magnitude of cross-market dissonance has been increasing.
- There are several scenarios where the pricing embedded in both bond and equity markets could prove to be spectacularly wrong.
- With no evidence of inflation and some mounting signs of a global slowdown, we have worked hard to diversify the cyclical exposure in the portfolio so it can be much less dependent on macro forecasts and more robust to a broad range of potential outcomes.
Market Overview and Outlook
One of the biggest paradoxes in financial markets is that investors are forced to accept irreducible uncertainty about the future, and yet we collectively cling to forecasts in a desperate attempt to reduce the irreducible. Basically, when it comes to the future, no one knows, but everyone wants to know. Dealing with this paradox leads most people down a path of either stubborn denial of uncertainty, or grudging acceptance. Investors should choose the acceptance route. Our expectations-driven investment process helps turn the uncertainty of the future into an advantage. To illustrate, this letter will walk through a few steps, starting with a macro forecasting exercise and then drilling into portfolio construction and some individual stock examples.
Evaluating forecasts is always challenging, even in hindsight, as most forecasters are skilled in the art of using vague probabilistic terms that makes the forecast “appear” correct across a broad range of outcomes. However, let’s pretend there was a perfect second-quarter forecast that got all the Trump tweets right, knew the trade war was going to intensify, global growth was going to slow, and fears of a recession were going to increase to such a degree that Fed easing was back on the table. If you had this perfect forecast, there would still be the challenge of predicting market outcomes, and how easy would that be?
There would certainly be some forecasting logic to support the second quarter’s global plunge in interest rates, but maybe not to the degree that has priced a new record $13 trillion in bonds at negative yields (Exhibit 1). Combine that global abundance of bonds that guarantee a long-term loss with the continued inversion of the U.S. Treasury yield curve, and the world’s sovereign debt markets have priced in a very high probability of recession. How does that extreme embedded expectation reconcile itself with U.S. equity indexes at record highs, and very benign credit spreads? Even with global central banks’ artificially low rates acting as liquidity-driven rocket fuel for almost all asset prices, we struggle to see how even the world’s greatest forecast could cut through the noise and fit a macro and market forecast into a cohesive package.
Exhibit 1: Outstanding Global Negative Yielding Debt at an All-Time High
Having global bond and equity markets in total disagreement is not unique to the second quarter, but the magnitude of cross-market dissonance has been increasing (Exhibit 2). Why? We suspect it’s a powerful feedback loop between capital flows and price momentum. During the second quarter, capital flows to bonds versus equities reached record levels. This added a tremendous amount of fuel to bond markets already supported by the major central banks, especially with resurrected hopes the U.S. Federal Reserve is getting back in the easing game. The capital flows that did target equities were guided by the deep feedback channels that have come to favor what has worked over this market cycle, specifically U.S. tech stocks. As a result, tech ended up as the best-performing sector year to date, but it wasn’t due to fundamentals. According to Bernstein research, the 12-month outlook for revenue and earnings growth is worse for tech than the overall U.S. market. Despite these fundamental headwinds, tech valuation multiples have expanded over 40% so far in 2019, versus a still-healthy 20% multiple expansion for the overall market, with the tech sector now trading at a 15-year high versus the broader market.
Exhibit 2: Stock and Bond Investors Disagree
This divorce from underlying fundamental reality is why feedback loops ultimately lead to excess and then dramatic reversals. The current challenge for investors, however, is the massive divergence in what feedback has priced into these two major asset classes. Bonds are increasingly priced for a recession and little else; a recession would ultimately crush tech stocks, which remain cyclical despite current narratives focused on cycle-escaping secular growth. There are also scenarios where the pricing embedded in both markets could prove to be spectacularly wrong.
The Value of Diversifying Cyclical Exposure
A core goal of our investment process is to invert the forecasting challenge and build diverse portfolios that are not reliant on a narrow or extreme set of scenarios. In some ways achieving greater diversification than the indexes has never been easier, given the shift away from active management. With so much capital concentrated in the major U.S. equity indexes, passive exposure has become increasingly less diversifying. More and more people are skewed to U.S. assets, and particularly U.S. tech. If anything, this feedback process is accelerating, but it is also dependent on extrapolation and is increasingly vulnerable to change.
The gift for active managers, if you make what has been a difficult choice to diverge from the index, is that there are myriad ways to create much more diverse portfolios vis-à-vis the index. Greater diversity makes a portfolio much less dependent on macro forecasts and more robust to a broad range of potential outcomes. We think we have achieved this diversification goal, and it has been achieved without sacrificing a valuation or fundamental advantage versus the index. As we highlighted in last quarter’s update, we continue to enjoy a portfolio with better earnings estimate revisions than the broader market. This has also translated into a higher starting cash dividend yield than the market, with better growth prospects. What’s the catch?
"Expensive stocks are getting more expensive and cheap stocks are getting cheaper, and in a classic sign of feedback the divergence is accelerating."
Well, one of the great divergences in the market is the now-extreme valuation difference between growth and value stocks at a broad level. Expensive stocks are getting more expensive and cheap stocks are getting cheaper, and in a classic sign of feedback the divergence is accelerating (Exhibit 3). As this process has continued many value stocks are already reflecting a recession. As a result, the market is paying us a nice premium to take on the macro risk from cyclical stocks in the form of attractive free cash flow yields, good existing returns, clean balance sheets and capital returns through buybacks and dividends that are well above the market.
Exhibit 3: Value Stocks Are Cheap Relative to Growth, but Discount Isn’t Justified by Fundamentals
One of the best ways to capture this value premium is in the financials sector, which remains our biggest overweight. Investors remain wary of financials given their near-death experience during the Great Financial Crisis (GFC), but regulated U.S. financials stocks have gone from too little capital during the GFC to excess capital. This excess capital is being paid out through dividends and buybacks that are generating at or above a 10% total yield for many of our holdings. This yield is in the top decile of the broader U.S. equity market and is a massive compounding advantage in a world with over $13 trillion in negative yielding debt. In many ways, the regulatory response of the GFC has paid big benefits for financials shareholders, and regulatory risk has moved on to the much beloved tech sector.
An added benefit of financials is that the stocks embed a free option on what we think would be the biggest surprise for markets: a policy mistake that leads to higher sovereign interest rates. Financials stocks would be one of the few and the biggest beneficiaries of a shift in the macro environment to higher rates. To be clear, this would be the ultimate surprise as there is no evidence of risks being built into so-called risk-free sovereign yields and no sign of inflation inflecting higher; and interest rates have just gone the other way in a dramatic fashion. However, we think policy risk that could drive such a change is rising dramatically. We have an executive branch that is trying to politicize the Fed, coupled with an increased belief that debt can be monetized to support fiscal expansion. If anything, the longer inflation stays dormant and term premiums built into interest rates remain negative, the more policy will shift away from the initial conditions that give us the policy flexibility we enjoy today: the extreme political independence of the Volcker Fed.
Risks that can be conceptualized but not observed in any data are always the greatest risks for investors. The current observed data support a healthy fear of deflation, and that risk is accordingly dearly priced in almost all assets. On the other side, what we consider the tail risk of higher rates is all theory and in no current data, but we are rapidly establishing new ground on the policy front. The risks of the unobserved, however, are what market turning points are made of. At turning points markets have proven to be non-ergodic, which is a fancy way of saying that observed past probabilities no longer apply to future outcomes. One of the great historic examples was that a root cause of the GFC was that housing prices had never declined in aggregate, until they did. The result was a record amount of capital destruction on, ironically, AAA-rated assets. As market cycles age, the assets that are most cherished are often the most dangerous, even when they are considered the safest assets. With indexes losing diversification and “safe” bond yields once again approaching record-low levels, we think policy risk could prove to be this cycle’s non-ergodic match.
"Risks that can be conceptualized but not observed in any data are always the greatest risks for investors."
However, with no evidence of inflation and some mounting signs of a global slowdown, we have worked hard to diversify the cyclical exposure in the portfolio. The most differentiated way we have tried to do this is through a top 10 position in the royalty gold streamer Royal Gold. The stock enjoys a tight correlation with the price of gold, which has made it a highly diversifying and defensive position. In addition, given the mounting policy risks we are observing, if there is ever a time to own gold we think it’s now.
Besides gold, with defensive stocks in great demand, especially during the second quarter, our challenge has been to buy individual defensive stocks without paying a steep defense valuation premium. We want insurance on the cheap. These opportunities have typically come by buying sustainably high dividend yields in out-of-favor sectors, such as what we did with MLPs in energy. We also will buy a stable defensive business after an unsustainable dividend has been cut to a sustainable level. Buying after a cut has often led to good outperformance, as the market seems to initially underappreciate the improved footing as a company addresses its issues and the long-term prospects for a return to dividend growth. Finally, there are also times when companies in traditional defensive areas, like utilities and staples, fall below business value and we can buy quality when no one wants it. This contrarian approach to defense has worked well for us and has accomplished our goal of diversifying the cyclical value exposure.
One area of defense that has not worked well for us, but may be starting to see better days, is drug stocks. As several large biotech and pharmaceutical stocks declined over the last few years, we built out a large portfolio of positions trading well below our assessment of business value. Unfortunately, the valuation multiples on these stocks declined to a much deeper level than we expected, which has made these stocks anything but defensive. The root cause of the valuation compression has been fears about the underlying business models as drug price inflation has slowed, and there are lingering concerns of a regulatory backlash. Unlike the rest of health care, we think these regulatory and pricing risks are now fully reflected in our holdings, and the stock prices are now embedding long-term value destruction from R&D. Historically, buying R&D when it is heavily discounted by the market has been a good long-term strategy, and was a major factor in the announced strategic acquisition of two of our holdings, Celgene and Allergan, so far in 2019. Even at substantial deal premiums, both stocks are still trading well below market valuation multiples and our assessment of long-term value. Thus, we think these will prove to be good deals, as the acquirers are getting cash flows at a discount and R&D optionality for free. Most importantly, these deals should stabilize sector valuations, and allow some of the defensive characteristics of these stocks to come through for the portfolio.
Consistent with the diversification strategy we discussed above, our new investments this quarter were split between two high dividend yield stocks and two heavily discounted cyclical value stocks.
- Starting on the yield side, we invested in tobacco stock, Altria. Unlike most staple stocks, Altria is cheap at 10x earnings and a 6.6% cash dividend yield, as the market has real concerns about its business model from lower-risk nicotine products. However, we think the erosion in the traditional combustible cigarette market will be slower than what the stock embeds. In addition, we think Altria is well-positioned for various disruption scenarios, due to its aggressive investments in new market-leading products, including Juul (vaping), IQOS (heat but not burn), and most recently On! (nicotine pouch). As a result, we think Altria stock is much better hedged against change than the market believes, and that continued earnings growth and a compounding dividend will close some of the historically wide discount to the staples group.
- On the high yield front in cyclical sectors, we added Energy Transfer, a $38 billion market cap MLP that owns and operates a diverse portfolio of natural gas, natural gas liquids and crude midstream assets. The stock is trading at a deep discount of over 30% to most of its midstream peers. At this discounted price, the dividend yield of 8.4% does not reflect its growing high-quality and diversified asset base. The discount is due to legacy issues with a complex ownership structure, concerns about governance and excessive leverage. However, substantial changes have been and are being made to address these issues, and declining capital spending will drive ample cash flows to materially reduce debt. With a high and sustainable dividend yield, more than 85% fee-based earnings stream and a very low correlation with the cyclical side of the portfolio, Energy Transfer is a classic example of defense in a value wrapper.
- On the deep-value cyclical side we invested in a recently spun-off life insurance company AXA Equitable Holdings. The life insurance sector is one of the most depressed sectors in the market, as it is seen as extremely vulnerable to macro risks from low interest rates. These macro concerns have resulted in a very depressed valuation for AXA, with the stock trading at 3x forward earnings, adjusted for its 65% ownership of publicly traded asset manager, Alliance Bernstein. The stock is under additional market pressure as its parent company has been selling down the 39% of AXA shares it still owns. We believe that AXA’s interest-rate risk has been greatly reduced from robust reserves, derivative hedging strategies and the ongoing decline in its higher-risk variable annuity book. Despite the macro headwinds, AXA generates a low-double-digit return on equity and generates enough free cash flow to sustain and grow an almost 3% cash dividend while buying back roughly 5% of the stock. These favorable current fundamentals and extremely low valuation gives us a positive carry option if interest rates ever do move higher.
- Finally, we are slowly building a position in Corteva, the global agriculture science leader in seeds and crop protection that was recently spun off from DuPont. The stock has been pressured since the spinoff by a confluence of factors resulting in lower near-term financial results, including a weak corn planting season, unfavorable weather, U.S.-China trade tensions and African Swine Fever. We like the long-term secular growth opportunities and the strong competitive moat of the business. We believe the stock will ultimately outperform as multiple short-term headwinds dissipate, and as post-spin-off operating metrics improve.
One of the first things investors learn about is the virtue of the only free lunch in finance: diversification. As market feedback loops drive the indexes toward concentrated extremes, the opportunity and obligation of active managers is to keep diversification on the menu. Diversification will always be critical as investors can never escape the paradox of uncertainty, and portfolios must maintain a robustness to surprise. Our investment process embraces the reality of irreducible uncertainty, as our long-time goal is to build diverse portfolios with embedded expectations well below what history has delivered and a wide range of potential futures.
The ClearBridge Value Equity Strategy had a positive absolute return for the second quarter, underperforming the benchmark S&P 500 Index. On an absolute basis, the Strategy had gains in six of the 11 sectors in which it was invested during the quarter. The primary contributors to the Strategy‘s performance were the financials and information technology (IT) sectors. The main detractors were the health care and energy sectors.
In relative terms, the Strategy underperformed its benchmark during the quarter primarily due to stock selection decisions. Stock selection in the health care, communication services and consumer discretionary sectors detracted the most from relative returns during the period. Conversely, stock selection in the financials and IT sectors boosted relative results. In allocation, an overweight to the energy sector detracted, while an overweight to the financials sector added to relative performance.
On an individual stock basis, the greatest contributors to absolute returns during the quarter included positions in American International Group, Microsoft, Allergan, Royal Gold, and Qualcomm. Mylan, Alphabet, Encana, Fluor and Capri were the largest detractors from absolute performance.
Besides the new positions discussed above, portfolio activity for the period included sales of ABB and Fluor in the industrials sector and Biogen, Universal Health Services and Merck in the health care sector.