Guide to Global Equities Principal Sponsor
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Your ticket to a world of investment opportunities Macquarie Professional Series
Join over 7,200 Australian advisers and access a carefully selected suite of global equities solutions from world-class fund managers, with Macquarie Professional Series.
We identify gaps in the local investment landscape, before scouring the world to find solutions that satisfy our rigorous research and screening process. Offering a range of specialist investment styles designed to meet the needs of local investors, Macquarie Professional Series is your ticket to a world of investment opportunities.
macquarie.com/advisers/managed-funds This information has been prepared by Macquarie Investment Management Australia Limited (ABN 55 092 552 611 AFSL 238321) the issuer and responsible entity of the Funds referred to in this document. This is general information only and does not take account of investment objectives, financial situation or needs of any person. It should not be relied upon in determining whether to invest in a Fund. In deciding whether to acquire or continue to hold an investment in the Fund, an investor should consider the Fundâ€™s product disclosure statement. The product disclosure statement is available on our website at macquarie. com.au/pds or by contacting us on 1800 814 523. Other than Macquarie Bank Limited (MBL), none of the entities noted in this document are authorised deposit-taking institutions for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these entities do not represent deposits or other liabilities of MBL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of these entities, unless noted otherwise.
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Editorial International equities, volatility and strategies
elcome to Money Management’s Guide to Global Equities which is based in large measure on our Investment Analysts Forecast webinar held in late January just ahead of the market volatility which subsequently impacted February and is still a factor in March. Interestingly, our keynote presenter at the Analyst Forecast forum, Stephen van Eyk, accurately predicted the correction which marked February, while Insight Investment’s Adam Kibble noted the degree to which his company was positioned to take account of an end to the “Goldilocks” market. China, as always, remains a critical factor and Premium China Fund’s Jonathan Wu has sought to place some context around that nation’s policy decisions and their long-run impact on global equities. The bottom line appears to be that the first six months of 2018 will be impacted by continuing, albeit sporadic volatility requiring advisers and investors to look to the fundamentals and the reality that, backed by some astute fund selection, international equities exposure ought to remain a fundamental part of any well-balanced investment portfolio. But the question for advisers and their clients is how to position themselves with respect to international equities exposures in volatile times. Thus, it appears that much can be said for van Eyk’s analysis that long/short funds will perform through 2018, and that index funds should be closely scrutinised to determine their level of concentration risk. Importantly, the assessments of van Eyk, Kibble and Wu will be put to the test in August, when their forecasts are reviewed at Money Management’s Future of Wealth Management conference on the Gold Coast.
Mike Taylor Managing editor
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Macquarie: Choosing the best global equities manager for your clients
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Franklin Templeton Investments: An Overlooked Opportunity— Why Global MidCaps Make Sense
Nikko Asset Management: Back to the future: Finding tomorrow’s quality, today
Impact of China GUIDE TO GLOBAL EQUITIES | MONEY MANAGEMENT | 7
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Knowing when Goldilocks has left the room Insight Investment’s Adam Kibble explains his company’s rationale for keeping an eye on when Goldilocks leaves the room.
f the number of concerns that clients ask us about, the number one seems to be how long can the equity markets continue to perform with valuations so stretched and the current bull market entering its ninth year. There is no single answer, but to address the issue I generally explain why Insights’ Multi-Asset team has been positioned overweight risky assets over the past year and then I outline the indicators we are watching closest that we believe will trigger a shift in our asset allocation to a more defensive stance. A range of indicators and recent developments are helping to underpin the view that the global economy remains in the midst of a healthy, increasingly synchronised, upswing. We expect strong growth in the US and Europe. What does this mean for our asset allocation in our Multi-strategy funds? • We are pro-risk assets with a higher than average allocation to global equities which should perform well, while yields are likely to move upwards.
• We remained focused on traditional market returns (market beta) as alternative hedge fund style strategies, or alpha strategies, are more challenging when volatility is low and growth is more synchronised across regions. Key recent supportive factors are: • The recently passed US tax bill is corporate friendly – the International Monetary Fund (IMF) recently upgraded their growth forecasts specifically mentioning the US tax changes. • The European Central Bank (ECB) have upgraded their 2018 growth forecasts from 1.8 per cent 2.3 per cent, and • The Federal Open Market Commission (FOMC) has generally been more positive in its growth outlook. In addition, the underlying macroeconomic data also supports this stance. • Financial conditions remain supportive for businesses: Chart 1 shows Insight’s proprietary Financial conditions index (in blue) and how looser financial conditions lead
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Strategy to stronger GDP growth (in red). Despite gently rising yields current financial conditions are pointing to stronger growth.
Chart 2 shows Insight’s cyclical momentum index (in blue) this has also been increasing; our momentum index tends to lead global industrial production (in red). This also suggests a global growth slowdown is not a near term concern.
Global growth remains in acceleration mode: Individual country Purchasing Managers Indices (PMIs), in particular, provide support for risk assets. Global aggregate manufacturing PMI has been at its highest level in
the current market bull run, and the majority of individual country PMIs are in acceleration mode, that is above 50 and rising. The preliminary January Purchasing managers’ indices were released for Japan and the Eurozone in early February which pointed to minimal deterioration in the growth outlook and the two most recent surveys from Germany, the ZEW and IFO surveys both reported stronger-than-expected current conditions. Chart 5 shows the performance of different asset classes with the US ISM purchasing managers’ index is in the upper right quadrant – ie acceleration mode. For asset allocation purposes this is the best time to be overweight risk assets in preference to defensive assets with returns from the S&P averaging a 14.3 per cent per annum return when US ISM index is above 50 and accelerating, compared to four per cent for US treasuries. The current episode started in August 2016 and is 16 months in duration, which is above the average of 12 months duration since 1972, so it is starting to look extended. Yet, equity market returns in the current 16 month episode do not yet look excessive at 23 per cent compared to past experience So what about the potential bogyman! Key inﬂation numbers continued to point to limited inﬂationary pressures and continue to surprise on the downside of expectations. Analysts tend to work on the assumption that higher growth leads to higher inﬂation with a lag. Although there are not yet any concrete signs of higher inﬂation, we also expect US inﬂation to trend a little higher over the next 18 months – if this eventuates, then markets shouldn’t be shocked – it is why the Fed is already tightening policy. Continued on page 10 GUIDE TO GLOBAL EQUITIES | MONEY MANAGEMENT | 9
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Strategy Continued from page 9 To understand why inf lation has remained low despite the robust growth you need to look a little deeper – for example one reason inf lation has so far been contained is inf lation-friendly labour market developments. In particular, labour force participation rates for older workers and females are increasing globally. There remains spare capacity with female workers. For example, the participation rate in the US for females peaked at 60 per cent in 2000; it is currently below 57 per cent. More broadly, more f lexible working arrangements and developments in technology are enticing people back to part-time work or encouraging self-employment through f lexible contracting arrangements. These developments increase the available pool of workers and this is a contributing factor to keeping the growth in wages below 2.5 per cent for the US, Europe and Japan. So globally, inﬂation remains contained. Chart 7 shows the latest yearly core inﬂation readings in blue against each Central bank’s target rate or target range in red. In all case (with the exception of the Brexit impact on the UK) inﬂation remains below targets and some central banks are in the process of removing monetary accommodation. The US in particular is heading towards a neutral policy setting.
In summary, the current growth and inﬂation outlook are supportive of continued overweight positioning to risk assets despite stretched equity market valuations, particularly in the US , ongoing low volatility which may have prompted systematic strategies to build up levered positioning and the central banks tightening monetary policy, although at a very gradual pace. So, the key question is what are we focused on to provide warning signs that this “Goldilocks” environment is coming to an end: • Less supportive macroeconomic data is key– particularly a potential early warning from the Purchasing managers indices • Downside surprise in corporate earnings growth • Understanding where we are in the investment cycle which can highlight potential warning signs in market dynamics, and • Central Bank policy and the risk of a policy mistake Clearly, we regard the Purchasing managers indices as a particularly good lead indicator for global growth – a shift from the acceleration zone into the moderating zone (above 50 but slowing) will be a cause for concern. Why? A shift of the ISM to the moderating regime is less supportive for risk assets. Chart 11 compares returns from the different asset classes when the US ISM regime is still above 50, but moderating. Whilst in this regime the S&P average returns have been 3.5 per cent per annum, compared to 14.3 per cent in the acceleration regime, and clearly fixed income is a better place to invest if we have seen the peak in growth. A sustained shift to moderating
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Strategy regime will see a shift to a more defensive stance. In terms of earnings growth, with valuations stretched earnings growth is essential to maintain equity market upside momentum. So, we are focused on corporate earnings growth.
The current US earnings season has so far not disappointed and continues to be positive sign reinforcing the outlook from our leading macro indicators. With around 30 per cent of the S&P 500 reporting so far, US earnings growth stands at 12 per cent. The earnings per share beat ratio currently stands at 79 per cent. Importantly this has been driven by the revenue side, not cost cutting. So far this season revenue growth is at eight per cent, with the revenue beat ratio currently at 72 per cent, which is signiﬁcantly higher than average. So, earnings growth remains supportive for equity valuations. Turning our attention away from the macroeconomic data and earnings data. What are the equity market related indictors that we are focused on for warning signs? Current market dynamics are consistent with the trading characteristics you typically see towards the end of a market cycle. At the end of the cycle we expect to see:
• • •
Equity prices are still rising With low volatility, and correlation between stock performance is also low This chart shows the interplay between prices, volatility and correlation over the investment cycle. Typically, volatility (in blue) peaks during an equity market downturn, but starts to decline well before the low in prices. Correlation between equity prices (the purple line) peaks after the volatility peak but remains high for an extended period as equities are sold indiscriminately into the “panic” low. After the price low and during the price rebound, correlation remains high, as all stocks are purchased as sentiment changes from the panic sell to “everything is now cheap”. Correlation starts to decline much later in the cycle as the market becomes more discerning and rewards individual stocks for superior earnings performance. This is where we are now – towards the end of the current bull market cycle. The key question is how close?
Financial asset volatility is low. In-fact S&P equity volatility as measured by the VIX index is at historical lows. This is mostly indicative of the supportive macro environment as we have Continued on page 12 GUIDE TO GLOBAL EQUITIES | MONEY MANAGEMENT | 11
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Strategy Continued from page 11 discussed. Indeed, low volatility is not necessarily a forerunner of poor equity performance. The danger is that low volatility can lead to complacency and the build-up of leverage positions. At this stage we can detect little evidence that leverage is extended compared to previous equity peaks. However, fund manager surveys do suggest managers are overweight equities relative to ﬁ xed income and bears watching. Implied correlations of stocks in the S&P 500 have fallen below 40 per cent for the first time since 2007, this is shown in blue on this chart. As mentioned, this is indicative of late cycle dynamics, as less and less stocks contribute to the index rising, we commonly hear that the market lacks breadth. A pick-up in correlation is also a concern from here.
So what can cause a sustained increase in volatility and a rise in correlation? • An economic downturn • Surprise events. By definition, surprise events are difficult to predict – mostly with respect to the timing. For example, a serious escalation in hostility between the US and North Korea would not necessarily be a surprise event, however it’s the timing of the event that makes it a surprise for
markets and makes positioning a portfolio to take advantage of that event for very difficult. By their nature economic downturns are a little easier to predict with respect to their timing. Economic downturns tend to occur, as central banks overtighten monetary policy due to a policy mistake or in response to higher than expected inf lation. Equity markets to suffer a market downturn as the market anticipates the effects of higher interest rates on corporate earnings. So we are focused on developments and changes in the pace of central bank policy and the potential for a policy error. With the exception of Japan, Central Banks have stopped or have started to reduce their quantitative easing policy. We have already passed the peak in asset purchases and the net total is projected to decline further in 2018 as the Federal Reserve won’t be replacing maturing assets. So in summary: the environment remains supportive for growth assets – so we retain our overweight equity position. But this “Goldilocks” environment will not last forever. We are very watchful and are focused on: • The macro data remaining supportive – Purchasing managers indices shifting to moderating regime is a key indicator for us. • Corporate earnings - with high valuations maintaining earnings growth is essential. • Understanding where we are in the investment cycle and keeping an eye on potential sustained increases in equity market volatility and stock correlations and finally, • The potential for a central bank policy error by raising rates to far leading to expectations of an economic downturn.
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Products Strategy “This ‘Goldilocks’ environment will not last forever. We are very watchful and are focused .” – Adam Kibble, Insight Investment
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Choosing the best global equities manager for your clients
hile the Australian equity market certainly performed strongly over the past five years returning 10.20%pa to the end of 2017*, international equities enjoyed returns of 18.40%pa over the same period**, as well as providing investors with access to a more diverse opportunity set. So while it’s clear overlooking international markets can put your clients at risk of missing out on a world of opportunities, what can be less clear is how to choose the best global equities manager to suit their individual needs and values. Just as each of your clients is different, so too are global equities managers. In our connected world, there is certainly a plethora of means for you to research global equities mangers to match your clients’ investment goals, risk profiles and preferences – should you have the time. An alternative approach to consider is leveraging the research and due diligence of Macquarie Professional Series – we scour the world to find global equities solutions from worldclass fund managers, to offer access to a range of specialist investment styles designed to meet the needs of local investors. Below is a helpful guide summarising a range of popular approaches to global equities investing.
A focus on long-term growth and managing downside risk
Some managers have an ability to think differently, invest beyond the constraints of a benchmark, with an outstanding track record, distinctive culture, and strong leadership. These managers typically invest in quality growth companies that share common features: market leadership, high levels of profitability and cash generation, conservative balance sheets, and robust governance structures. Walter Scott & Partners Limited based in Edinburgh, Scotland, is one such manager. They have one of the longest track records in global equity investing, and their approach is researchdriven, high conviction, defensive and long-term.
Preserving wealth via low volatility investing
Some managers seek to offer access to equity market growth opportunities while better managing volatility, and helping to protect client portfolios in the event of a fall in global equity markets. Analytic Investors, LLC (Analytic) based in Los Angeles, California pioneered this approach. Since 2004 Analytic has been at the forefront of low volatility global equities investment strategies,
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offering quantitatively-driven solutions globally. They use proprietary analysis to examine risk and returns to develop a portfolio of companies they expect will modestly outperform the market, mainly by avoiding the full downside when markets fall.
Capitalising on qualitative and quantitative research
Some managers take a unique approach and combine fundamental research with quantitative techniques to capitalise on opportunities across small, mid and large-caps as well as emerging and developed market companies. Arrowstreet Capital, Limited Partnership based in Boston, Massachusetts subscribes to this approach and merges investment intuition of their experienced team with rigorous quantitative research and sophisticated forecasting models. They offer investors broad exposure and the potential to access diversified sources of returns.
A bias towards market leaders with strong intangible assets
Some managers focus on value and downside protection by offering exposure to some of the world’s leading international companies with a strong competitive advantage, robust long-term track records and strong management teams. Independent Franchise Partners LLP based in London, UK is one such manager. They identify companies whose primary competitive advantage is supported by possession of a dominant intangible asset such as a brand, patent, intellectual
property or licence. The defensive characteristics of these stocks help to generate stable profits, and potentially protect clients’ wealth in difficult markets.
Investing off the beaten track to uncover hidden gems
Some managers are comfortable taking a contrarian approach – seeking to capitalise when others are fearful. Polaris Capital Management (LLC) based in Boston, USA is a specialist value investor seeking to capitalise on undervalued companies in periods where short-term investor behaviour creates volatility and pricing discrepancies. They have no biases to any particular industry or country, and instead seek pockets of value in developed and emerging markets, as well as large, mid, and small cap companies. It’s clear that just like your clients, global equities managers are different. Some hold household names while others seek less well known opportunities. Some emphasise efficiency through big data, and others focus on face-to-face research. Some think of risk relative to a benchmark and others consider risk in more absolute terms. Some focus on a single style of investing, while others incorporate multiple ideas. Assessing these approaches and asking yourself how well they resonate may be a useful approach in helping you to choose the best global equities manager for your clients.
* S&P/ASX 200 Total Return Index. ** MSCI World ex Australia Net Return Index. Other than Macquarie Bank Limited (MBL), none of the entities noted in this document are authorised deposit-taking institutions for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these entities do not represent deposits or other liabilities of MBL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of these entities, unless noted otherwise.
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Putting the market’s volatility into context
Market veteran Stephen van Eyk predicted the onset of the volatility which has beset markets since late January, this is the presentation he delivered to Money Management’s Investment Analyst Outlook forum
oday we will look at: • Why has market volatility been so subdued? Is it false security? • Why did growth pick up in 2017 when monetary policy is having no impact on major economies? • Are interest rates likely to rise and are bond funds safe? • At 22x future earnings on the S&P, are stock market valuations justified? • What are the major factors behind the strong company earnings growth over the past five years? Will they continue? You don’t need me to tell you the markets were good in 2017, or that growth picked up. In this paper I am more interested in why, and whether it will continue in 2018. When I started out in research I thought I ought to read some books on forecasting and
one that made a lasting impression on me was called “Winning on Wall Street”. Rule No. 1 in this book was “don’t fight the Federal Reserve” and rule No. 2 was “don’t forget Rule No. 1”. This rule has held true spectacularly well since 2008. In fact, in the last 10 years the amount of liquidity added by the Federal Reserve is roughly equivalent to the increase in US Household net worth – amazing! Public institutions globally have been relieved of worrying about inf lation targets since traded goods prices have fallen every year thanks to China’s expansion into global trade. With nothing else to do, authorities added rising markets and low volatility to their list of targets since the early 2000s. Central banks have particularly targeted low volatility in bond markets and that is exactly what we have got. Steady capital value, yield only returns. Investors have become used to this implied low downside risk, unlimited upside in markets. Valuations don’t appear to mean much. Although the Federal Reserve (Fed) stopped adding liquidity in 2015/16, they have been careful to keep things steady. Continued on page 18
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Your ticket to a world of investment opportunities Macquarie Professional Series Access a carefully selected suite of global equities solutions from world-class fund managers, with Macquarie Professional Series. Access a carefully selected suite
Offering a range of specialist investment styles designed to meet the needs of local investors, we’re your ticket to a world of a investment opportunities. Offering range of specialist investment
of global equities solutions from world-class fund managers, with Macquarie Professional Series.
styles designed to meet the needs of local investors, we’re your ticket to a world of investment opportunities.
macquarie.com/advisers/managed-funds This information has been prepared by Macquarie Investment Management Australia Limited (ABN 55 092 552 611 AFSL 238321) the issuer and responsible entity of the Funds referred to in this document. This is general information only and does not take account of investment objectives, financial situation or needs of any person. It should not be relied upon in determining whether to invest in a Fund. In deciding whether to acquire or continue to hold an investment in the Fund, an investor should consider the Fund’s product disclosure statement. The product disclosure statement is available on our website at macquarie. com.au/pds or by contacting us on 1800 814 523. Other than Macquarie Bank Limited (MBL), none of the entities noted in this document are authorised deposit-taking institutions for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these entities do not represent deposits or other liabilities of MBL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of these entities, unless noted otherwise.
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Outlook Continued from page 16
Zweig would have been bailing out of the US market in 2017, as the Fed balance sheet started to shrink slowly. However, the European Central Bank (ECB), the Bank of Japan (BOJ) and People’s Bank of China (PBOC) not only made up for the Fed’s stagnation, but nearly reached 2008 levels of excess global liquidity in 2017. With the Fed having already locked in balance sheet reductions of over $400 billion for 2018, and the PBOC undertaking similar liquidity reductions, global liquidity will decline in 2018 significantly. A falling velocity of money has rendered monetary policy ineffective in creating growth in the real economy. GDP = M2 x Velocity of Money It would appear bond purchases by the Fed in its QE programme merely led to increased reserves at the major investment banks that they then lent to hedge funds gearing into the markets. Two questions, therefore, remain to be answered. Firstly, if monetary policy has become useless at creating growth and the government expenditure multiplier has also crashed, why did growth pick up globally in 2017? Secondly, how have companies managed to
make near record profits in stagnating economies and how sustainable are they? The X Factor event in creating growth was the Chinese authority’s decision to limit the export of capital into overseas markets in 2017. Chinese citizens were already grossly overweight in cash compared to other emerging markets (EMs) after the 2016 liquidity boom. Once they were not allowed to diversify their portfolios overseas, they simply lowered their savings rate and spent it.
Australian commodity exports were the ﬁrst to rise, followed by gold, handbags, bitcoin, cars and so on – anything that could be a store of value. Within a relatively closed system like China, booming liquidity and spending usually leads to inﬂation. China’s Producer Prices rose by around 6 per cent in 2017, and surveys of Producer Price expectations are rising further. Food prices have been down reducing the CPI, allowing more disposable income to be spent.
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Outlook However, it is the reason Chinese authorities chose to make their currency only partially convertible into other currencies that is really interesting. Sure, they were running down reserves with the f lood of capital finding its way into over-seas markets, but, more importantly, their banks suffered declining deposits. For a country where growth is dependent on credit (credit growth is 5 x GDP growth at the moment), a lack of deposits means banks must borrow money to be able to lend it. Chinese banks have been forced to borrow from the PBOC as well as substantially increasing in their bond issuance in both domestic and overseas markets during 2016 and 2017 due to falling deposits. Thus, the restriction on capital leaving the country was essential to Chinese growth. However, the spending spree of consumers who have lowered their savings rate and deposits has meant falling deposits anyway – just at a much slower rate than exporting capital. China wants to be a consumer economy, it has just come at a much faster rate in 2017 than expected. This unexpected factor X has been great for global trade growth and ﬁnancial markets, but has left China with a possible inﬂation headache in 2018. Chinese exporters are likely to raise their prices in 2018 in a bid to become more profitable, since authorities have cut back credit to some of the corporate sector. Higher import prices are only passed on to consumers with a lag. Wholesalers generally absorb higher costs by reducing their margin if they believe the rise is temporary. US wholesale profits declined in 2017. Eventually higher prices are passed on to retailers and consumers. Between 2012 and 2016 both durables and
non-durable goods prices (traded goods) have been falling at the same time. Having 40 per cent of your inﬂation rate falling by 3-4 per cent pa leaves a lot of room for services inﬂation (domestic) to rise before a 2 per cent inﬂation target becomes a problem. This has been the situation since 2008 and has led to very loose monetary policy, rising markets and low volatility.
However, late 2017 is the first time in a while where Services Inf lation and Non-durables inf lation are both rising together by 3 per cent pa. If traded durables rise by 5-6 per cent in 2018 due to higher import costs, overall inf lation could hit 3.5 per cent or higher. Or at least at some stage financial markets will worry about inf lation rising, causing volatility.
With US corporate debt at record highs, and margins on corporate and high yield paper at Continued on page 22 GUIDE TO GLOBAL EQUITIES | MONEY MANAGEMENT | 19
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An Overlooked Opportunity— Why Global Mid-Caps Make Sense
istorically, global mid-cap stocks, or those with market capitalisations between US$2 billion and US$15 billion, have outperformed their large-cap counterparts. Over the 10-year period through 31 December 2017 for example, the MSCI World Mid Cap Index returned 15.8% on an annualised basis, while the MSCI World Index returned 14.2%1. Mid-cap names in many cases were successful small-cap companies that survived the early stages of their growth to become more established. While an economic rationale for strong relative and absolute mid-cap performance exists, over the past few years, mega-caps and large-caps drove the market’s advance and outperformed their mid-cap peers as companies’ fundamentals have mattered less to investors in an era of ultralow interest rates and abundant liquidity. The historically strong performance of mid-caps has the potential to reassert itself as interest rates begin to rise, excess liquidity dries up and economic growth begins to gain traction globally. As that occurs, expensive mega-caps could struggle as corporate fundamentals, such as earnings growth, free cash flow and profitability matter more for investors when
evaluating stocks for their portfolios. If we take the technology sector, the prevalence of a number of secular trends such as increased mobile penetration, the growth of the “on-demand” economy, cybersecurity, artificial intelligence and the growing adoption of cloud-based computing have supported faster growth across a wide swath of the sector. Shopify, a Canadian ecommerce platform and services company is one such example. In 2016, expectations for revenue growth for 2017 were forecast to be 45%. Instead, Shopify has been growing in excess of 70% year-on-year on a quarterly basis. As a result, expectations for the year and 2019 have increased dramatically. We believe robust merchant growth and increase in the total value of goods sold by each merchant on Shopify’s site has been picking up, leading to more optimistic growth forecasts. We believe the current environment calls for taking a concentrated, unconstrained approach to investing and anticipate that over the longer term global mid-caps possessing strong growth and quality characteristics should outperform. To find out more visit franklintempleton.com.au/globalequity
Source: FactSet, MSCI
Franklin Templeton accepts no liability whatsoever for any direct or indirect consequential loss arising from the use of this commentary or any information, opinion or estimate herein. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance.
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Since 5 Years Inception % p.a. % p.a. 19.1 11.1 18.4 0.7
Discover more at www.franklintempleton.com.au/globalequity
Past performance is not an indicator or a guarantee of future performance. *Returns are for the W class unit net of management fees. Sales charges and other commissions, taxes and other relevant costs paid by the investor are not included in the calculations. Inception date: 1 October 2008. Franklin Templeton Investments Australia Limited (ABN 87 006 972 247) (Australian Financial Services License Holder No. 225328) issues this publication for information purposes only and not investment or financial product advice. It expresses no views as to the suitability of the services or other matters described herein to the individual circumstances, objectives, financial situation or needs of any recipient. You should assess whether the information is appropriate for you and consider obtaining independent taxation, legal, financial or other professional advice before making an investment decision. Investments entail risks, the value of investments and the income from them can go down as well as up and investors should be aware they might not get back the full value invested. A Product Disclosure Statement (PDS) for theÂ Fund is available at www.franklintempleton.com.au or by calling 1800 673 776. ÂŠ 2018 Franklin Templeton Investments. All rights reserved.
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Outlook Continued from page 19 their lows due to rising proﬁts in 2017, the eﬀect of rising inﬂation and interest rates on bond funds would not be positive. This external factor would see the Fed abandon its low volatility target. Since 1960 the average spread between the US 10-year yield above the inf lation rate has been 2.4 per cent. Currently it is 0.15 per cent, because there has been a negative supply of bonds and thus excess demand globally. Since banks make money on their loan spread, expected rising interest rates often leads to a surge in ﬁnancials relative to the market index. Financials have been rising strongly since September. Bond funds basically returned yield with no capital gains or losses in 2017, but may do worse in 2018 as rates rise and spreads widen. Those funds which have been careless about the leverage of the issuers will suﬀer most. How vulnerable is the stock market to rate rises or profit declines? The following charts compare the current rise in the market to the last 24 months of previous boom/bust cycles.
The P/E ratio of the S&P 500 Index based on trailing 12 months earnings (black line) has not moved over the last two years. The average increase in valuations in the previous boom/bust cycles (red line) was nearly 30 per cent as the end neared. The big difference has been the growth in Earnings per share (EPS) in the current cycle (black line), the second highest since WW2.
This is a surprising result, since companies are older and larger, and IPOs have dropped substantially over the past 20 years. This is probably due to the ready availability of credit to non-listed companies. Company listing, it appears, is the exit strategy for the original founders once maximum growth has been achieved. How have essentially older companies, which would normally be slower growing, managed to achieve such massive proﬁt rises over the past ﬁve years in a moderate growth environment. Operating Proﬁts have been soaring due to the following: • Depreciation write offs have fallen. • Wages have continued to stagnate. • Interest costs have remained low despite rising corporate debt. • Effective tax rates for global companies (tax
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Outlook havens) have dropped to 24 per cent, limiting the effect of Trump’s new lower rates. • Operating expenses have plunged due to technology. The big hidden factor has been the huge drop in Operating Expenses as a percentage of sales. Technology has led to a huge decline in the “cost of distance” and interaction. Moving people, goods and information has got really cheap. Large global companies have beneﬁtted because of the distances involved. Operating expenses as a percentage of sales for the S&P has dropped over 10 percentage points – a huge amount of extra proﬁt for a large global company. It appears that booming company proﬁtability (and stock markets) has been more about decreasing expenses than increasing demand until the second half of 2017. However, the surge in the second half of 2017 was also due to the pick up in world growth emanating from surging imports into China. The fall in the Chinese savings rate was a surprise factor oﬀsetting liquidity tightening in China. Just as economic growth boomed, proﬁtability has started to decline rapidly back to the mean. This could be exposed if China slows, and world growth declines. Valuations are in rare territory with Price/DCF based Fair Value two standard deviations above the mean.
Also, the value assigned to future growth is one standard deviation above the mean, after being below market value in 2011/12. Obviously, there is a deep belief in the market that strong profit growth will continue well into the future. This has created a lot of risk, with margins starting to decline.
Turning to Valuation Quintiles in the global market, in the lead up to the 2008 downturn the gap between the top quintile and bottom quintile was closing – all boats were rising with the tide. When the crash hit, being in the top quintile stocks did not help returns. In the recovery between 2008 and 2014, the gap opened up with the leading stocks doing well. For long/short funds a widening gap means strong returns, especially when gearing comes into play. Between 2014 and late 2017 the gap has stayed largely the same, and long/short funds generally struggled. This was until the top quintile jumped in the second half of 2017 and long/short funds recovered strongly. Continued on page 24 GUIDE TO GLOBAL EQUITIES | MONEY MANAGEMENT | 23
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Outlook Continued from page 23
• • •
• The other interesting thing about Long/ Short funds over the past five years is that their long portfolios generally outperformed the index by big margins. Often their short portfolios wiped out the gains when weak stocks were pushed up with the markets.
Global bond funds are vulnerable to increasing spreads and rising rates in early
2018 – capital losses are likely. Global stock markets are over-valued relying on strong future growth when company profitability is falling. Long/Short funds should perform well in 2018. Index funds will be concentrated in overvalued stocks. Australia will suffer from reduced demand for commodities later in the year – the $A is vulnerable. Asian emerging markets will continue to provide the best avenue to access China’s growth in the short run. Global stock markets will suffer setbacks in 2018 – if one is early, it shouldn’t be too bad. Later declines could be more significant and damaging – volatility is rising.
Stock markets suffered significant declines the day after this presentation was delivered.
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LOOK AT YOUR CURRENT DEALER GROUP
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Back to the future: Finding tomorrow’s quality, today With the unwinding of quantitative easing on the horizon and interest rates starting to rise across the globe, a period of change seems inevitable. Nikko Asset Management shares their approach to finding quality companies of tomorrow in this environment.
ikko Asset Management’s Global Equity Team, based in Edinburgh, provides solutions for clients seeking global exposure. Their unique approach — a combination of experience, ‘Future Quality’ and execution — means they’re continually ‘joining the dots’ across geographies, sectors and companies, to find the opportunities that others simply don’t see. The Team’s philosophy is based on the belief that investing in a portfolio of Future Quality companies will lead to outperformance over the long term.
Quality of management: The Team looks for management with a strategic vision, strong internal leadership, disciplined capital allocation and a high standard of corporate governance. Quality of future valuation: The Team seeks companies where the future is not reflected in today’s valuations. Based on this criteria, the Team believes Future Quality companies can ride through the cycle and maximise returns whatever the investment climate.
The characteristics of Future Quality
The Global Equity Team was formed over six years ago and the team of six portfolio managers/ analysts have an average of 20 years industry experience. Their deliberate flat structure fosters individual accountability and collective responsibility. It is designed to take advantage of the diversity of backgrounds and areas of specialisation to ensure the Team can ‘join the dots’ and find the investment opportunities others don’t.
When it comes to identifying Future Quality companies, the Team applies four criteria. Quality of franchise: They believe superior and sustainable returns on capital over the long term will deliver better compound returns. Quality of balance sheet: They prefer to invest in businesses that can finance future organic growth using their own capital resources.
Experience where it counts
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Their detailed bottom-up research approach leads them to fresh, lesser known winners and away from accepted growth stocks where returns are already priced in. This method allows them to delve into the detail and identify businesses ranging from traditional companies, which are reshaping, to younger companies that are delivering tomorrowâ€™s technologies and business models.
Strength in numbers
When it comes to building portfolios, the Team adopts a four-step investment process. Each element of the process is designed to produce optimal outcomes â€“ from idea generation through fundamental research to peer review and, lastly, to portfolio construction. The process is disciplined, accountable and transparent, relying on open debate and robust risk controls to build efficient, high conviction portfolios With over two decades in the market the Team is experienced in the vagaries of markets and can be better prepared for what may come next. No doubt 2018 and beyond will see more geopolitical gyrations, market volatility and likely divergent trends in profitability, making careful stock picking the key to maximising returns in global equity markets. By focussing on Future Quality companies, the Team is well placed to navigate whatever markets throw at them for long-term rewards. This material was prepared and is issued by Nikko AM Limited ABN 99 003 376 252 AFSL No: 237563 (Nikko AM Australia). Nikko AM Australia is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs and figures contained in this material include either past or backdated data, and make no promise of future investment returns. Past performance is not an indicator of future performance. Any economic or market forecasts are not guaranteed. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.
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The China Factor in 2018
Premium China Funds chief investment strategist, Jonathan Wu looks at the impact of China on the investment outlook for 2018 and seeks to place it into context.
n late 2017, Time magazine for the first time in its history published a dual language cover which was in English and Chinese entitled “China Won”. This in itself marks another watershed moment with regards to China’s importance in the global landscape, and for a Western based media outlet to accept that this is the way of the future proves conviction and respect for the world’s largest
economy based on a purchasing power parity basis. There are many reasons as to why “China has Won” and the context iny which the article is written is that while the US has had a very inward focus over the last couple of years (and especially so since Trump took office in January 2017, China has been slowly but carefully using its soft economic power to Continued on page 30
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¹Perfo obtain terly b and d AUD, includ Premi Equity comp Asia F The in Equity matio not ta Retail
Premium Asia Fund & Premium Asia Income Fund
Union of Growth and Income equals Double Happiness
Premium Asia Income Fund The best performing credit fund in Australia over 1, 3 and 5 years¹ Attractive and stable quarterly income of at least 6% p.a. since inception² 6-year track record delivering a total net return of 10.9% p.a. since inception with 5.4% annualised volatility³
Our diﬀerence is that we have achieved 100% success rate in delivering double-digit net returns since inception across our strategies*
www.premiumchinafunds.com.au ¹Performance ranking based on the performance of funds which are categorised under Financial Standard’s Credit sector, based on data obtained from Rainmaker Information as at 31 December 2017. ²Normally, the Fund expects to pay distributions out of its income on a quarterly basis, and out of its net capital gains annually after the end of June; the actual distribution an investor may receive is not guaranteed and dividend history is presented for reference only. ³Source: Link Fund Solutions Pty Ltd, Macquarie Investment Management Limited, in AUD, NAV to NAV, with dividends reinvested. Data as at 31 January 2018. Inception date is 31 August 2011. *Strategies and inception dates include Premium China Fund (28 October 2005), Premium Asia Fund (1 December 2009), Premium Asia Property Fund (4 June 2008) and Premium Asia Income Fund (31 August 2011). Past performance is no indication of future performance. Equity Trustees Limited (“Equity Trustees”) ABN 46 004 031 298, AFSL No. 240975, a subsidiary of EQT Holdings Limited, a publicly listed company on the Australian Stock Exchange (ASX:EQT), is the Responsible Entity and issuer of units in the Premium China Fund, Premium Asia Fund, Premium Asia Property Fund and Premium Asia Income Fund. The information is taken from sources which are believed to be accurate at the time, but neither Premium China Funds Management Pty Ltd, Equity Trustees Limited, nor any of its related parties, directors or employees, provide warranty of accuracy or reliability in relation to information contained herein, or accepts liability to any person who relies on it. The content herein does not constitute ﬁnancial advice. It does not take into account the investment objectives, ﬁnancial situation or needs of any person. Retail investors should not rely on any information without ﬁrst seeking advice from their ﬁnancial adviser.
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China Continued from page 28 woo other countries in a joint initiative to re-shape the logistical world for the 21st century and beyond. This initiative is aptly named the “One Belt One Road” initiative. By including countries spanning right across Asia, the Middle East and Europe, China is bringing prosperity to all who sees the light. The second reason is due to the faltering US dollar. While, yes, we saw the US dollar soar during the last Global Financial Crisis even though it was the country who started it, it was seen as the most liquid safe haven currency in the world. Note that if we look back into recent history, it took approximately 56 years after the US economy exceeded the size of the United Kingdom’s before its currency was seen as more superior and globally accepted. In the same way, China’s currency which has had its global acceptance reach new highs each year (seen through many European Union (EU) countries now stocking the RMB as part of its foreign currency reserves). The only weakness of the Chinese RMB is that its still relatively closed, which has consequences with regards to liquidity, but other than that and as they open it up more, its power and acceptance will increase.
China GDP Growth vs Share Market Performance One of the traps that investors and advisers alike continue to fall into is that there is this bizarre belief that GDP growth and share market performance have a correlated relationship. This is simply not true. There have been studies done
over the past 30 years that show in many cases an inverse relationship or no relationship at all. China is a very clear example of this, where the correlation between GDP growth and the MSCI China Index in 2010 hit a high of approximately 0.8, and then came tumbling back down to -0.2 in June 2015, and has since gone back up (as opposed to recovered) to around 0.4 by June 2017 and again then has come back down again. What pattern can be drawn from this? None at all. Ultimately, share market returns are driven by underlying company earnings (in some situations this can lag, but over the longer term, rational investors need to revert back to earnings, not sentiment). What China has currently going for it is strong earnings growth. After two terrible years in 2015/16 where the MSCI China constituents registered negative earnings growth, 2017 had an excellent year averaging just under 24 per cent earnings growth. Forecasting out this year, it looks to be high teens which is still exceptionally strong in both absolute and comparable terms in Western markets.
Markt hits new highs, but what about valuations?
We keep seeing the familiar headline over the last ﬁve years that the US market keeps hitting new highs, and has fully recovered from the Continued on page 32
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¹Sour at 31 Premi perfor Equity comp Asia F The in Equity matio not ta Retail
Premium Asia Fund & Premium Asia Income Fund We’re drumming up high income potential while making noises about Asia’s growth
Premium Asia Fund Annualised net returns of 12.8% p.a. since inception¹ One of largest investment teams on-the-ground in Asia In-depth 360-degree review of companies with 2500+ company visits per year
Our diﬀerence is that we have achieved 100% success rate in delivering double-digit net returns since inception across our strategies*
www.premiumchinafunds.com.au ¹Source: Link Fund Solutions Pty Ltd, Macquarie Investment Management Limited, in AUD, NAV to NAV, with dividends reinvested. Data as at 31 January 2018. Inception date is 1 December 2009. *Strategies and inception dates include Premium China Fund (28 October 2005), Premium Asia Fund (1 December 2009), Premium Asia Property Fund (4 June 2008) and Premium Asia Income Fund (31 August 2011). Past performance is no indication of future performance. Equity Trustees Limited (“Equity Trustees”) ABN 46 004 031 298, AFSL No. 240975, a subsidiary of EQT Holdings Limited, a publicly listed company on the Australian Stock Exchange (ASX:EQT), is the Responsible Entity and issuer of units in the Premium China Fund, Premium Asia Fund, Premium Asia Property Fund and Premium Asia Income Fund. The information is taken from sources which are believed to be accurate at the time, but neither Premium China Funds Management Pty Ltd, Equity Trustees Limited, nor any of its related parties, directors or employees, provide warranty of accuracy or reliability in relation to information contained herein, or accepts liability to any person who relies on it. The content herein does not constitute ﬁnancial advice. It does not take into account the investment objectives, ﬁnancial situation or needs of any person. Retail investors should not rely on any information without ﬁrst seeking advice from their ﬁnancial adviser.
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China Continued from page 30 impacts of the global ﬁnancial crisis. But no one has been concerned about this? At the same time Hong Kong’s markets have been lagging, and only recently hit its new highs. The key diﬀerence though is that even though it breached the highest point of around 33,000 points in December 2007, the valuations are still very attractive. When you compare the HSI’s P/E from October 2007 to now, it is far cheaper (21.4x then compared to 13.9x now), while comparing P/B’s, it is less than half of that now as it was in October 2007 (3.2x vs 1.4x now). The MSCI China is even more attractive with both P/E and P/B currently at less than half of that compared to October 2007. We therefore make a hypothesis in that even assuming no P/E expansion for the coming 12 months, with EPS levels in the mid-teens, this should result in reasonable returns but at the same time due to the global rate hike situation, will result in some level of volatility in order to get there.
Global allocations to China are still low Global Emerging Market fund managers are very much underweight in China. Over the last ﬁve years, these managers have invested somewhere between -1.5 per cent to -ﬁve per cent active
weight against benchmark to China (the ﬁve year average is around -three per cent active weight). While this is concerning, over time this is sure to change. If current P/E’s are reasonable, what will happen when investors wake up to the fact that there is still attractive equity markets to invest into which are ignored by global investors as well as still presenting themselves with attractive valuations? We have already seen this start to happen with monies ﬂowing from mainland China into Hong Kong. This is simply due to the fact that institutions in the mainland have to ﬁnd alternative sources of investments after reaching their caps on investment into A shares. Given Hong Kong is so close, and the companies are so familiar, this makes it an easy destination for these monies, which is a trend which will last into the medium term.
Case Study: Tencent
Tencent has now become Asia’s largest company by market cap which has now surpassed $700bn AUD. It is the primary communication platform in China, so you could say it is equivalent to Whatsapp but on steroids. The group has 768 million active users. One must understand that Whatsapp is simply a communication platform, whereas Tencent is a communication platform with complimentary services including mobile payment, digital currency and social media. In other words, imagine Whatsapp, Facebook and Paypal all wrapped into one single app. Their two most recent exponential growth spurts came in the form ﬁrstly of red packets. Given Chinese New Year has just passed us, (welcome to the year of the dog) one of the traditions is for red packets (monies given by older relatives to younger ones Continued on page 36
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Products “It’s the role of advisers and researchers to search for the best investment ideas for investors, no matter what jurisdiction or asset class.” – Jonathan Wu, Premium China Fund
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Please note the value of investments is not guaranteed. Investors may not get back the full amount invested. Issued by Insight Investment Australia Pty Ltd (ABN 69 076 812 381, AFS License No. 230541) located at Level 2, 1-7 Bligh Street, Sydney, NSW 2000. This material is general information only, it is intended for wholesale investors only, it is not intended for, nor should it be relied upon by, retail investors. Insight Investment Management (Global) Limited is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 in respect of the financial services; and is authorised and regulated by the Financial Conduct Authority (FCA) under UK laws, which differ from Australian laws.
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Please note the value of investments is not guaranteed. Investors may not get back the full amount invested. Issued by Insight Investment Australia Pty Ltd (ABN 69 076 812 381, AFS License No. 230541) located at Level 2, 1-7 Bligh Street, Sydney, NSW 2000. This material is general information only, it is intended for wholesale investors only, it is not intended for, nor should it be relied upon by, retail investors. Insight Investment Management (Global) Limited is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 in respect of the financial services; and is authorised and regulated by the Financial Conduct Authority (FCA) under UK laws, which differ from Australian laws. MMGuide_2809_26-40.indd 35
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Continued from page 32 to wish them good fortune for the coming year) to be distributed during the ﬁrst seven or so days of the new year. But given many people in China cannot make it back to their hometown during the holidays, Tencent in 2014 created digital red packets, which eﬀectively rendered them a bank. As of today, WeChat Pay has over 300 million users with linked bank accounts. This is eﬀectively the holy grail of digital transactions. In 2015, Chinese mobile transactions were already in excess of $235bn USD (which surpasses the US).
Their second key growth spurt has been its acquisition of Supercell who is the creator of the world famous gaming platforms namely Clash of Clans and Clash Royale series. They have around 200 million users of which 10 million are daily
active users. By utilising this new distribution platform Tencent has been able to penetrate their existing services into western markets, which has thus far been generally untapped.
Where to from here? With China in a commanding position in global aﬀairs, they will continue to use their soft economic power to assist the world in growing prosperity for all via the one belt, one road initiative. This is a positive for the world given the US’s rather internal stance. With this new shift in geopolitical landscape, China (and the rest of broader Asia) should provide more optimal long-term risk adjusted returns especially given both valuations and earnings growth are more attractive. It’s the role of advisers and researchers to search for the best investment ideas for investors, no matter what jurisdiction or asset class. If one just wants to follow the herd and invest into opportunities only familiar to them, this will not bode well for investors going forward. The key issue right now is that everyone in the asset management industry have lived in a world with falling long term bond yields over the last 30+ years, and the associated asset allocation mindset. Now that this 30+ year bond bull market has ended, how much will investors have to loose before portfolios are shifted using new world rationale thinking?
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