Ardevora Quarterly Review - Second quarter 2019

Where's the Margin?

We are interested in the behaviour of three groups of people involved in stock markets: company managers, financial analysts and investors. We have a bunch of metrics we use to monitor their behaviour, to help us make judgements about stocks. Occasionally it’s interesting to take a step back from stock picking and see if these metrics, in aggregate, can tell us anything about the behaviour of entire stock markets.

We know 2018 was all about anticipatory anxiety. Stock markets everywhere performed badly as investors worried about economic growth. This was clearly reflected in the surprisingly elastic metric of other investors’ views – valuation. Stocks everywhere ended 2018 with valuations considerably lower than where they started. Fundamentals didn’t change much: most of the poor performance was from valuations compressing, rather than sales, cash flow, earnings or book value falling.

There was also a clear pattern to the emergence of anxiety. By watching analysts’ behaviour we can see where pressure first appears; we can see when and where forecasts started to get missed. 2018 began with optimism over EPS and sales growth. Until mid-year, this optimism was being met. Trouble first appeared in emerging markets; stocks started to miss forecasts in May. Next was Japan, where EPS forecasts generally began missing in June. Europe didn’t feel widespread disappointment until September, and finally the US in December. The path reflected the impact of the trade war. What’s interesting, as you dig deeper into the numbers, is what has happened to stocks’ ability to hit sales targets. Most stocks hit their sales targets up until the very end of 2018. It’s reasonable to infer that EPS misses were not driven by disappointing demand (i.e. sales) but from disappointing margins.

Expectations for sales growth looked quite well founded in 2018; on average they were around 6%, not far from nominal GDP growth. They were a little higher in emerging markets and a little lower in Japan. What, in hindsight, looked unrealistic was the implied assumption of favourable operating leverage and benign costs. In every region, average EPS growth forecasts were running at around twice sales growth.

By the end of 2018, analysts in emerging markets and Japan were showing some modest signs of anxiety over demand: sales growth assumptions had generally drifted down. But they remained sanguine in the US and had actually become more optimistic in Europe (falling into yet another year of “the-worst-is-over” trap). And everywhere, analysts still clung to the belief that EPS would grow much faster than sales.

Stock markets this year have rallied. Outside the US, the rally has been driven almost entirely by investors getting less anxious: valuations have gone up, despite widespread disappointment among analysts. Most companies have missed EPS and sales forecasts (although the US has had the additional kicker of tax reform boosting after-tax profits). This has made for an interesting setup for investor and analyst views now, halfway through 2019. For six months, stocks have gone up, while expectations for EPS and sales have come down.

Most commentators seem nervous about the future. There is an acceptance the trade war is here to stay. Central bankers have shifted back to worrying about economic growth far more than inflation. Bond yields and interest rates have fallen. Expectations for sales growth have continued to drift lower, especially in the US. However the belief in the ability of corporate profit margins to rise appears undiminished. In every region, expectations for EPS growth run well ahead of sales growth; only in Emerging Markets is the ratio less than two.

Beneath the averages, some stocks have moved more than others. Stocks with high growth expectations have continued to perform well, especially in the US. They have generally got more expensive, but they have also managed the rare feat of growing surprisingly (rather than disappointingly) fast, at a time when disappointments have generally dominated. Riskier stocks (more volatile, or harder to predict) have also performed well; they have achieved this despite generally missing forecasts. As a result, many are considerably more expensive than at the start of the year. Lower risk, more defensive stocks have also generally gone up, but their valuations have, by and large, gone up less than “growth” or “value” stocks.

Meanwhile, by the looks of management behaviour, life is getting tougher. Profitability has generally been under pressure everywhere. Most businesses are still struggling to hit EPS and sales forecasts. Debt looks like it’s rising everywhere except Japan. In Japan and emerging markets, cash flow is under pressure from unhelpful shifts in working capital – normally a sign of stress in the supply chain.

Our conclusion is simple. Stocks which have rallied on the hope of improving fundamentals, especially improving profit margins, look vulnerable. There seems to be an embedded assumption that profit margins will relentlessly rise, when all current trends suggest they are more likely to fall. Many of the stocks most exposed sit on valuations inflated this year by hopes of recovery. They may be “cheaper” than faster growing companies (with more control over the path of their margins), but they are a lot more expensive than they were at the start of 2019. Dependable, slower growing, but more predictable stocks have done OK this year, but have had to rely much less on rising valuations to achieve their stock price rises.

As a result we have wound back our exposure to what we call “Investor Bias” stocks. These typically either sell on lower than average valuations or have experienced relatively poor price performance over the last year. We have shifted into stocks with more predictable, higher growth; they have more control over their margins, expectations look realistic, and valuations have not moved much. This seems to be the opposite of current prevailing wisdom. There seems to be this odd perception that “value” is the place to be at the moment and good quality, predictable stocks are dangerously expensive. What’s dangerous, in our view, is a belief that companies without much sales growth can grow their EPS by improving their profit margins over the next couple of years.

 


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This material is for distribution to Professional Clients only, as defined under the Financial Conduct Authority’s (“FCA”) conduct of business rules, and should not be relied upon by any other persons. Issued by Ardevora Asset Management LLP (authorised and regulated by the FCA). Registered office: 6 New Bridge Street, London EC4V 6AB. Registered in England No. OC351772. Past performance is not a guide to future performance. Care has been taken to ensure the accuracy of this document’s content, but no responsibility is accepted for any errors or omissions herein. The views expressed are our own and do not constitute investment or any other advice and are subject to change. In particular, we are not recommending or expressing an opinion on the merits of buying or selling any securities mentioned herein. Ardevora Asset Management LLP is authorised and regulated in the United Kingdom by the FCA, and operates in the United States as an “exempt reporting adviser” in reliance on the exemption in Section 203(m) of the US Investment Advisers Act of 1940.

 

Previous Commentaries

Quarterly Commentary Period ending March 2019
Annual Commentary Period ending December 2018
Quarterly Commentary Period ending September 2018
Quarterly Commentary Period ending June 2018
Quarterly Commentary Period ending March 2018

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