Alternative Investments and Other Wealth Imperatives Conference: Part II

Assuming that GDP growth will facilitate a company’s future earnings growth, is GDP growth a sufficient condition for future performance? From a strategic perspective, should we allocate our portfolio to the countries with the highest GDP growth? Or, should we allocate to the sectors that contributed most to domestic GDP growth? George Iwanicki, Market Director of Global Strategy for J.P. Morgan, does not think so. He points out that economic growth does not necessarily translate into equity market gains. During the late 1990 Asian crisis, high above normal Capex/Sales Ratio undermined corporate earnings growth in spite of superb economic growth. He offers a microeconomic approach to identify the likelihood of an economy's growth leading to sustained corporate earnings growth. His generalized approach can be applied regardless of the geographic location of a company:

• Profits need to “participate” in economic growth. Since the investors buy a company, its prospective earnings, rather than prospective economics, matter the most. Past performance might not necessarily guarantee future success, and changes in economic trends might not necessarily favor those companies that are successful in the current economic environment. The company that is able to quickly adopt to new economic dynamics and experience the maximum EPS growth will be the likely winner. He looks at the improvements on the profitability ratios, such as ROE, for a clue to profitability participation. Higher profit margins, rising asset turnover ratios, improved operating leverage vs. reduced financial leverage, together with a reasonable Capex/sales Ratio would indicate the company’s ability to stay globally competitive as well as financially disciplined.

• Valuations need to be reasonable in risk-adjusted terms. The “Fed Model” will give an investor a guideline to separate overvalued stocks from undervalued stocks. A firm’s forwarding earning yield needs to be a “respectable” amount above its comparable bond yield. In the the U.S this would be the yield on 10-year US Treasury notes, and other countries would use some form of Equity-Weighted Sovereign Bond Yield.

• Exchange Rates need to be at economically viable levels. As globalization intensified financial market integration and risk sharing, currency risk became an integral part of the asset evaluation, especially for companies with international exposure. Currency misalignments could have adverse effects on portfolio performance.

Mr. Iwanicki believes that emerging markets will be “too big to ignore”. High growth prospects, favorable demographics, and improved financial relevance enable emerging markets to offer superior risk-adjusted returns in the long run. The decline in sovereign debt exposure has made them less susceptible to exchange-rate shocks. However, from time to time, emerging market equity values can go overboard on irrationally exuberant expectations. He doesn’t think that the emerging market ETFs, which represents today’s corporate leaders in each target market, can capture the future growth that will likely come from the companies outside the ETF basket.

Both Mr. Iwanicki and Alec Young, International Equity Strategist at Standard & Poors, warned about the high volatility associated with emerging market equities. Furthermore, the emerging market equities no longer offer diversification benefits since the markets worldwide have been highly correlated in recent years. Mr. Young recommended regular portfolio rebalancing, with an eye to keeping Emerging market shares at no more than 20% of total portfolio value.

Conclusion

We just ended one of the most severe recessions in recent history and are transiting into a period of slow recovery. During this period, corporations have to be able to grow their top line revenue instead of relying solely on reducing costs. There is a high degree of uncertainty in future economic developments and earnings growth. However, the near future could offer a rich risk-reward environment. There is no doubt that future economic growth will come from emerging markets. Growth in this area, however, comes with a high degree of risk in economic conditions and earning expectations. For those who want to avoid political risks and cultural unfamiliarity, it might be better to allocate their portfolio into high quality US and global franchises with international exposure.

For those who have access to global information, the following systemic qualitative and quantitative approach with some discretionary justifications will be better suited to determine a portfolio's strategic and tactic allocation:

1. Analyze the business cycles for directional trades in the long run. Allocate assets strategically to the sectors that contribute most to GDP growth.

2. Tactically overweight and underweight assets according to each stage of business cycle development.

3. Identify the business-cycle-related variation in market risk premiums. Discover the valuation spread created by the dispersions among the different countries.

4. Coupled with a microeconomic perspective, determine whether a company is able to capture the economic growth into its EPS growth.

5. It is critical to analyze momentum trends, such as changes in trading volume and technical signals.

6. Since the market consists of irrational agents, sentimental indicators provide a good signal when they are at the extreme level.

Comments

[Old Trader:]

An interesting article, with some good points made on portfolio construction, and rebalancing. I find the suggestion to look beyond a single country ETF to be an interesting and valuable one. It seems that often, a single country ETF will be vastly overweight a particular sector...usually, it seems financials predominate, or in the case of commodity-based economies, firms that deal in extraction of that/those commodities.

Nov 16 11:08 PM

[surfgeezer:]

Couldn't agree more, but with Brazil EWZ and BRF cover pretty well. I also have CPL as I am overweight in Brazil, with no intention of rebalancing out.


On Nov 16 11:08 PM Old Trader wrote:

> An interesting article, with some good points made on portfolio construction,
> and rebalancing. I find the suggestion to look beyond a single country
> ETF to be an interesting and valuable one. It seems that often, a
> single country ETF will be vastly overweight a particular sector...usually,
> it seems financials predominate, or in the case of commodity-based
> economies, firms that deal in extraction of that/those commodities.

Nov 17 09:24 PM