David Morris: Huge Gaps Between Profits and Prices

by: IndexUniverse

David Morris is chief executive of London-based Global Wealth Allocation Ltd., an asset management and research firm with around $3 billion in assets under management. He began his career by serving in economic development for the Canadian government in East Africa. In 1980, he took over as treasury manager for Xerox's Canadian operations. Then, six years later, he became treasurer for Campbell Soup in Canada. Morris later started a pension consultancy business. In 1992, he founded GWA.

Morris is probably best known for developing a series of 20 indexes that are sold worldwide in partnership with the FTSE Group. The benchmarks, which were created in 1996, are "wealth-weighted." GWA takes standard FTSE indexes and weights components based on three valuation measures: net profit, cash flow and book value.

IndexUniverse's Murray Coleman recently caught up with the economist-turned-index-developer to discuss his views on global corporate profits and market pricing of those assets.

IndexUniverse.com: Why do you focus on net profits and two other valuation metrics in creating indexes?

Morris: I didn't grow up, so to speak, as a fund manager. My education is as an economist and my work experience prior to GWA was as a treasurer in corporate finance. Most of my background has been focused on analyzing how corporations run their balance sheets—not modern portfolio theory. I look at how all of the tools, machines and equipment in society—the stock of capital—is used to produce a flow of goods and services. That is on a country-by-country, regional and global basis.

IU: What does your research tell you about current market conditions?

Morris: The limit to growth in the market, of course, is the amount of wealth being created at any given time. If we measure wealth consistent with economic macro theory, then we can look at the wealth in markets and compare that to current pricing levels. For example, in metals we're seeing a collapse in share prices underpinning the basic materials sector.

IU: Has that collapse been matched by a similar deterioration in the corporate profits?

Morris: No, global market prices for basic materials producers indicate that investors expect future wealth creation to decline materially by 35% or more in that sector. But the probabilities favor a recovery of prices rather than a further deterioration of wealth creation.

IU: What brings you to that conclusion?

Morris: We've just been told the Chinese are accumulating strategic materials now at a phenomenal rate. That will support the market pricing for metals. In effect, demand in China should put a floor on metals pricing going forward.

IU: So this is a significant new dynamic coming into play for basic materials and metals manufacturers?

Morris: Yes, considering that the bubble in metals prices that burst in 2007 was driven pretty much by economic development in China. For the decade ended in 2004, China's demand drove lead prices, for example, up almost five times greater than in the past decade. And copper prices expanded by over six times the previous decade's highest levels.

IU: When China's economic activity slowed in 2007, then demand and world metals prices dropped?

Morris: Yes, and they dropped by a large amount. Even though copper prices have rallied by 38% since December [2008], the market still doesn't seem to believe that demand has rebounded enough. But as we've just learned from recently released first-quarter [2009] data, China has purchased something like 20-25% of the world's total copper production. In that same time, copper prices went up about 45%.

IU: What do you see taking place in the financial sector?

Morris: Stock prices in developed markets for financials have dropped about 70% since July 2007. It's interesting to note that we've seen an almost identical deterioration in the sector's net profits and cash flow. In nonfinancials among developed markets, we've seen the same 70% erosion in prices. However, we haven't seen a similar deterioration in earnings. That indicates investors are punishing nonfinancials as much as financials. Today's market pricing is suggesting that investors expect another 50%-plus erosion in nonfinancial corporate profits from current levels. That would put corporate profits about at a level where they were a decade ago.

IU: How much have nonfinancial profits actually fallen?

Morris: Across global developed markets, nonfinancial prices have dropped about 15% off their peak levels. So broadly speaking, there's a huge gap between market pricing and actual corporate profits in those segments. More specifically, it appears that investors are punishing basic materials manufacturers especially hard.

IU: But you consider nonfinancial stocks to be priced fairly now, don't you?

Morris: Yes, and the 55% gap between how much prices have dropped for nonfinancials so far and the actual falloff in corporate profits signify the future for investors. In other words, that 55% gap represents the potential upside in nonfinancials going forward. But that's based on an assumption that no other significant material events will occur to cause a major contraction in corporate profits. But if that does happen, at this point, the downside seems limited because the market has already taken a 55% greater hit than actual earnings and cash flow measurements would justify.

IU: The majority of downside risk for investors globally will continue to come in financial sectors then, won't it?

Morris: Yes, going forward there could be some real nasty surprises. But that's likely to hurt financial balance sheets much more than nonfinancials, considering that financials have fallen by so much at this point. And the limit to that risk is the positive yield curve that is benefiting banks right now.

IU: How do you see bond yields impacting the profit picture for banks across the developed world?

Morris: With 90-day Treasuries yielding around 11 basis points today, and 30-year Treasuries yielding about 400 basis points, financial institutions can borrow at short-term rates—that is, take deposits—while lending at longer-term rates. So they've got a built-in profit margin right now in the lending business.

IU: But banks are being criticized for not lending enough, aren't they?

Morris: We keep reading that. But the total assets in the world banking system are just under [U.S.] $60 trillion. So even if bank lending shrinks a little, that positive yield curve is still working with an enormous base of assets.

IU: So as long as yield curves remain positive, that will act as a floor to losses in the financial sector?

Morris: Yes, that would seem to be the case. Remember that when the credit crisis began in the summer of 2007, the yield curve was inverted almost everywhere in the world. You can debate the merits of Ben Bernanke's short reign as chairman of the U.S. Federal Reserve's board. But give him credit—he did manage to get the yield curve to turn positive in the span of a little more than 18 months. Consider that in June 2007, 90-day Treasury notes were yielding 480 basis points, and 30-Year Treasury notes were around 505 basis points. So that put a huge squeeze on bank profits. That situation has been turned around and will prove to be a significant factor in the performance of financials as a whole in coming quarters.

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