Managing the Capital Preservation Phase of the Cycle

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  • 12 mins 23 secs
Obe Ejikeme, Quantitative Equity Analyst at Carmignac, discusses the current market cycle, value investment styles, which sectors he currently favours, unloved UK markets and how long the capital preservation phase lasts.




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PRESENTER: With is outlook for the months ahead I’m joined now by Obe Ejikeme. He’s the Global Equity Quant Analyst at Carmignac. Obi, thanks for joining us. There’s an awful lot going on in the markets right now, but where are we in the cycle?

OBE EJIKEME: Well, it’s kind of strange, I find myself right now, given that we’re coming towards the end of the year, doing a bit of recapping and reminding us and reminding myself of where we’ve come from. Because it’s been quite a significant transformation, not just in how the cycle’s developed but also how the perception of where we are in the cycle has developed with investors. So at the beginning of the year I talked about the peak of the cyclical part of the cycle, so the end of the speculative phase, where we moved into what I call a period of scarce growth - which is where growth expectations remain positive, but people start to discount that going forward the numbers will start to decelerate - to this summer where my models started to point to a phase of the cycle which I call capital preservation. And capital preservation is very similar to scarce growth.

So the growth numbers to start with are actually pretty robust. But what happens going forward is people start to worry and fear that the market will start to discount something which is slightly more severe. And so that’s really been the progression. And I think the translation or the transition of most investors this year has certainly been from speculative behaviour to scarce growth, understanding of that. But I think where most investors haven’t really got to yet is where my models are pointing today, which is this period of what I call capital preservation.

PRESENTER: So what do you invest in if you’re into capital preservation?

OBE EJIKEME: Well, just by the nature of how it sounds, the way I try to think about these things, it’s more about risk tolerance. So if you’re in a period where equity assets are accelerating, growth is accelerating - so that’s speculative mania - you can take as much risk in the portfolio as you can. What I generally say to investors and to the fund managers and to the team internally that I work with is the levels of risk need to come down now. And that’s partly because if you think about how these things work, cycles tend to be behavioural. And so as we continue down this cycle of indicators that point to growth deceleration decelerating, the amounts of risk that investors will take will reduce. So basically it’s all about what your risk tolerance is. And if it’s relatively low then you need to reduce risk further; if it’s a bit higher, then it’s all within the spectrum that you’re prepared to tolerate.

PRESENTER: How do you judge what risk is? Is this volatility or something rather different?

OBE EJIKEME: So, as an equity investor, I look at two very key characteristics that give me a sense of risk. One of them is a style metric that investors call quality, and the other one is risk or earnings risk. The quality one is one that’s really well understood by most people. So companies with very good balance sheets tend to tick that high quality criteria; companies with distressed balance sheets, too much debt, tend to tick the low quality area. So you tend to want to focus on companies with very strong balance sheets, because debt is always an issue when growth stories tend to decelerate.

The risk component, which is the second style that I think I tend to focus on from an equity perspective, looking at fundamental risk is quite key now. Because what tends to happen when you enter capital preservation is you shift from an environment where analysts tend to upgrade earnings to downgrading of earnings. And it’s the downgrading of earnings that shifts the outlook for potential earnings of a company. And so if you’re in the highest risk end it’s often the stocks which have analysts who are far too optimistic about the outlook, and haven’t discounted that growth will slow. So a lower risk stock is generally one where expectations are very well known, and they’re very predictable over two to three years.

PRESENTER: Isn’t quality pretty expensive right now, because people have been talking about buying quality for several years now?

OBE EJIKEME: Well it’s a battle that I think even the last time we spoke we had the same discussion, and it’s one that constantly comes back. There are two issues with quality. There’s the structural issue. So this is the post financial crisis era where growth is relatively low, debt levels are too high, and so as a result we’re structurally bound to buying higher quality assets. And that’s the one side of the story which keeps them more expensive. The second part of it is the cyclical.

So, as I’ve just mentioned, as you go into a downgrade cycle, what’s key right now is that you own companies that are less susceptible to seeing big cuts to earnings. And higher quality companies with very strong balance sheets are of that type of nature. They tend to be able to manage their earning streams a lot better. Versus a cheaper company, which is typically classed as lower quality, where their earnings are very dependent on the world around us and general macro activity. And it’s that general macro activity slowing that causes their earnings to go down, therefore it’s very difficult to value those companies.

PRESENTER: What’s your take on value as an investment style, and what’s the difference between value and a value trap, particularly given some of the changes we’re seeing in technology and how that’s undermining traditional business models?

OBE EJIKEME: Value, just from a simplistic sense, is when investors look for companies that are basically mispriced. So a cheap company, whether it’s looking at a price to earnings ratio, or a price to book ratio, those are two classic measures of valuation, often at the lows of cycles they tend to be mispriced, and so they’re undervalued for where their earnings are going in the future. And your point about value traps is very important, and this is why value investing is very tricky right now, because we don’t really know where those earnings are heading. And if they are cyclical, then the risk is they’re going to be heading lower, therefore those stocks are not cheap enough.

Now, the point about the internet and how it’s affecting some of the retail names, they look to be value traps today. There’s a structural change going on in the market, and so again I always say with value you really need to be careful that you understand what the catalyst is to make those companies rerate. And in this environment right now it’s a very difficult environment to buy what people refer to as value stocks.

PRESENTER: Let’s bring some of this together right now, in terms of sectors, which are the ones that you favour at this point in the cycle?

OBE EJIKEME: Sector-wise, no big change over the last three to six months, in that I’m still a big fan of the high quality growth areas of the market, especially after a period where they’ve just had a bit of a derating. Not just cyclically but structurally, so areas like technology and healthcare, these are sectors that I think will continue to do well. What I think is a bit unusual about where we are in the cycle today is that some of the more classically defensive areas of the market haven’t really participated to the upside as much as we’d expect. So I’m all about how will this cycle end and what will the recovery look like, well before we get to the point where we can talk about a recovery in the cycle, the areas that are next to really participate in the upside will be the most defensive areas of the market. And the only reason I talk about that is because they’re not priced for that yet, they haven’t really moved yet, and there’s a big opportunity there to play that thematic if that plays out.

PRESENTER: Have you got some example of those?

OBE EJIKEME: So your classical sectors. So I mentioned healthcare, but consumer staples, unloved because of some of the structural changes that are going on. But the reality is when investors turn very defensive and they shun cyclical assets, they tend to hold up a little bit better. Utilities, telecoms, again not classic great earning stories, but this is all about which parts of the market will hold up the best if earnings start to come down in the areas of the market which are more geared to the cycle.

PRESENTER: What’s your take on financials right now?

OBE EJIKEME: Well financials is a tricky one. Obviously you have different types of financial stocks. So we have some of the quality stocks that we have in regions of Scandinavia, in Europe. But then you have also parts of the European market as an example where we have some structural issues that haven’t really been fixed. As a general rule, if you look at sectors overall, the financials are the most geared to economic growth and economic activity, i.e. when cycles slow down they tend to underperform the market the most. So for me I’m generally inclined to stay away from financial assets today, until there’s a sign that we’ve reached some sort of cyclical trough that tells you that their earnings have found a low and it’s time to get back in.

PRESENTER: There’s a lot of political uncertainty out there right now, do your models ignore political uncertainty, and if not how do you factor it in?

OBE EJIKEME: Well I try my best to ignore the political uncertainty, and we’ve had lots of them this year. Whether it’s trade wars, whether it’s the Italian elections, tariffs and so on, all these things I put into the part of the cycle which I call the banana skins, all the short term. And I do that because they don’t really have a big shift or big change on the direction of the cycle; they just have a big impact on how bad the cycle will be, or how good it will be on the upturn. And so right now I don’t really focus on it, it just tells me that if you have these troublesome events into a period where there’s already uncertainty, it may increase the risks that investors start to de-risk more aggressively than they would have done originally.

PRESENTER: And looking out across markets, which ones do you favour? And could you start with the UK because a lot of people think it’s, is it unloved for a reason, or is it just getting a bit of an unfair battering?

OBE EJIKEME: Yes, I mean if you look at any survey that looks at positioning of fund managers today, the UK is one of the most unloved parts of the market. And we’ve seen this before in periods where you have political and economic uncertainty that investors essentially, the risk managers are tapping him on the shoulder and they’re basically told to stay away from those investments until the skies are clear. If I look at the UK macro data, it’s not too dissimilar to the other regions of the world in showing some sort of deceleration, scarce growth/capital preservation.

So to me it tells me that if I’m going to invest in the UK, I need to be very careful about the investments I make. Especially because also you have to remember that the UK stock market is not always a reflection of the UK economy so that gives you an extra bit of juice to think about. In terms of broader markets, the US is always considered the safest market in the world. It’s got the highest quality assets, it’s got the most predictable earning streams; hence why it tends to outperform the most when cycles are decelerating and investors are de-risking. I don’t think that trend is going to change.

What we just need to be very careful of is again how does this all end? The end game is classically where the riskiest parts of the market suffer first, and we’ve seen that this year, whether it’s emerging markets, Europe and so on, and investors pile into the safest assets. The only thing that would concern me about investing in the US would be it just hasn’t participated on the downside yet. But that’s really the end game rather than where we are today.

PRESENTER: How long does the capital preservation phase typically last for, and what comes after it?

OBE EJIKEME: Well, so the broader cycle, broader business cycles, which have become more common since the financial crisis, and I think central banks can basically take the blame for some of that. But that’s 18 months to two years on the upside, and 18 months to two years on the downside. And if each cycle downturn is essentially split in half, 18 months to two years gives you about nine months of what I would call capital preservation. So any time between Q1 and Q2 next year we could finally potentially reach a cyclical low, which would allow investors to get back into what I call the recovery phase of the market. But the only reason we talk so much about this capital preservation and why it’s important is because this tends to be the period where investors suffer the biggest losses, and so getting this phase of the cycle right is very key to your ability to participate in the recovery that follows.

PRESENTER: We have to leave it there. Obe Ejikeme, thank you.

OBE EJIKEME: Thank you.