Downward Earnings Revisions Are Slowing, But Cost-Cutting Alone Can't Reverse The Tide
By Clas Olsson, CIO, Senior Portfolio Manager. Posted on Expert Investment Views: Invesco US Blog.
When active managers talk about high conviction, that doesn't only mean we have confidence in the securities we buy - it also means we're willing to be patient and wait for the right opportunities to come along. In the first quarter, Invesco International Growth Fund didn't add a single new stock to our portfolio because we didn't see any new opportunities that met our criteria for EQV: Earnings, Quality and Valuation.
In the longer-term, however, there are a few positive glimmers that may light the way toward future opportunities. Below, I discuss what the team is seeing on an EQV basis.
Earnings: Downward revisions slowing
The difficult earnings scenario we've experienced over the last few years continues, as the global earnings growth forecast for 2016 has been consistently revised downward from 13% in April 2015 to only 3% currently.1 We're seeing negative revisions in all regions, including the US, Japan and Europe.
The good news - and everyone is looking for some out there - is that we've seen analysts trimming their earnings estimates at a slower pace than before. But unless there's a pickup in top-line growth, it's hard to see where upward earnings revisions would come from, considering that cost saving has run its course, merger and acquisition activity is at a record high, and leverage has increased, which limits the potential for stock buybacks.
The areas with the largest potential for upward revisions, in my view, are the commodity sectors in countries such as Brazil and Russia, which we believe stand to benefit from stronger commodity prices and currencies that have depreciated significantly over the past few years. We've already seen some of this during 2016, accompanied by currency appreciation and a strong market rally.
Quality: Returns continue to drag
Looking at quality characteristics, which consider the financial strength of a company, we've seen returns on equity (ROE) trending down on a global basis since 2012 without any signs of improvement. As with earnings revisions, we think ROE improvement is unlikely to happen before a top-line recovery.
Valuation: Dispersion indicates opportunity
Because earnings and cash flows have been significantly revised down over the last few quarters, valuations are no more attractive today than they were two quarters ago. But there are areas where we see significant valuation dispersion, which usually indicates opportunities. Two of those areas are emerging markets and Asia. But we've seen that this dispersion (which refers to the wide range of valuations seen among companies within a market) is also almost entirely driven by the sharp fall in the financials sector, which comes with the risk of being at an early stage of a negative credit cycle.
Looking at valuations, we see that:
- From a price-to-earnings (P/E) perspective over the next 12 months, the US now trades at a 30% premium versus other world markets - the highest since 2012.2
- From a price-to-book (P/B) perspective, the US trades at an 80% premium - a 15-year high - versus an average of 40%.2
- Looking at projected earnings over the next 12 months, developed markets are at a P/E premium of about 40% and a P/B premium of 47% versus emerging markets, levels not seen since the early 2000s.2
- Defensive stocks are also at a multi-year high versus cyclicals, trading outside the US at a 100% premium based on P/B ratio.2
Currency volatility continues
Currency volatility in 2016 - a continuation of what we've seen in previous years - has been driven by weakness in the dollar versus emerging market currencies such as the Brazilian real, the Russian ruble and the Malaysian ringgit (all up over 10% in the first quarter of 2016)3 as well as the yen and the euro. We're often asked how our international strategies manage this volatility. And our answer hasn't changed over 23 years of our strategy: We don't hedge our currency exposure for four main reasons:
- While foreign currency exposure may introduce volatility in the short term, it doesn't have a significant impact on long-term performance, in our view.
- A key benefit international funds can provide to US-based investors is low correlation to the US market. Hedging currency exposure increases correlation, lowering the potential diversification benefit.
- Currency hedging is largely redundant because many foreign companies have global operations with exposure to many different currencies and hedge their own currency exposure directly.
- Hedging is costly and can introduce unwanted leverage to a portfolio.
Learn more about Invesco International Growth Fund.
- Bloomberg L.P., January 2016
- Bloomberg L.P., Invesco, March 2016
- Bloomberg L.P.
Price-to-earnings (P/E) ratio measures a stock's valuation by dividing its share price by its earnings per share.
Price-to-book (P/B) ratio is the market price of a stock divided by the book value per share.
Earnings per share (EPS) refers to a company's total earnings divided by the number of outstanding shares.
A defensive stock is an equity security whose price isn't highly correlated with the larger economic cycle.
A cyclical stock is an equity security whose price is affected by ups and downs in the overall economy.
Valuation is how the market measures the worth of a company or investment.
Return on equity (ROE) is a measure of profitability, calculated as net income as a percentage of shareholders' equity.
Diversification does not guarantee profit or eliminate the risk of loss.
Investing in depositary receipts involves the same risks as direct investments in foreign securities. In addition, the underlying issuers of certain depositary receipts are under no obligation to distribute shareholder communications or pass through any voting rights with respect to the deposited securities to the holders of such receipts. The fund may therefore receive less timely information or have less control than if it invested directly in the foreign issuer.
The value of a derivative instrument depends largely on (and is derived from) the value of an underlying security, currency, commodity, interest rate, index or other asset (each referred to as an underlying asset). In addition to risks relating to the underlying assets, the use of derivatives may include other, possibly greater, risks, including counterparty, leverage and liquidity risks. Counterparty risk is the risk that the counterparty to the derivative contract will default on its obligation to pay the fund the amount owed or otherwise perform under the derivative contract. Derivatives create leverage risk because they do not require payment up front equal to the economic exposure created by owning the derivative. As a result, an adverse change in the value of the underlying asset could result in the fund sustaining a loss that is substantially greater than the amount invested in the derivative, which may make the fund's returns more volatile and increase the risk of loss. Derivative instruments may also be less liquid than more traditional investments, and the fund may be unable to sell or close out its derivative positions at a desirable time or price. This risk may be more acute under adverse market conditions, during which the fund may be most in need of liquidating its derivative positions. Derivatives may also be harder to value, less tax efficient and subject to changing government regulation that could impact the fund's ability to use certain derivatives or their cost. Also, derivatives used for hedging or to gain or limit exposure to a particular market segment may not provide the expected benefits, particularly during adverse market conditions.
Emerging markets (also referred to as developing markets) are generally subject to greater market volatility, political, social and economic instability, uncertain trading markets and more governmental limitations on foreign investment than more developed markets. In addition, emerging markets may be subject to lower trading volume and greater price fluctuations than companies in more developed markets. Securities law and the enforcement of systems of taxation in many emerging market countries may change quickly and unpredictably. Investments in emerging markets securities may also be subject to additional transaction costs, delays in settlement procedures and lack of timely information.
The fund's foreign investments may be adversely affected by political and social instability, changes in economic or taxation policies, difficulty in enforcing obligations, decreased liquidity or increased volatility. Foreign investments also involve the risk of the possible seizure, nationalization or expropriation of the issuer or foreign deposits (in which the fund could lose its entire investments in a certain market) and the possible adoption of foreign governmental restrictions such as exchange controls. Unless the fund has hedged its foreign securities risk, foreign securities risk also involves the risk of negative foreign currency rate fluctuations, which may cause the value of securities denominated in such foreign currency (or other instruments through which the fund has exposure to foreign currencies) to decline in value. Currency exchange rates may fluctuate significantly over short periods of time. Currency hedging strategies, if used, are not always successful.
The fund may from time to time invest a substantial amount of its assets in securities of issuers located in a single country or a limited number of countries. Adverse economic, political or social conditions in those countries may therefore have a significant negative impact on the fund's investment performance.
Growth stocks tend to be more expensive relative to the issuing company's earnings or assets compared with other types of stock. As a result, they tend to be more sensitive to changes in, or investors' expectations of, the issuing company's earnings and can be more volatile.
Investments in certain countries in the European Union are susceptible to high economic risks associated with high levels of debt, such as investments in sovereign debt of Greece, Italy and Spain. Separately, the European Union faces issues involving its membership, structure, procedures and policies. The exit of one or more member states from the European Union would place its currency and banking system in jeopardy. Efforts of the member states to further unify their economic and monetary policies may increase the potential for the downward movement of one member state's market to cause a similar effect on other member states' markets.
The fund is actively managed and depends heavily on the adviser's judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for the fund's portfolio. The fund could experience losses if these judgments prove to be incorrect. Additionally, legislative, regulatory or tax developments may adversely affect management of the fund and, therefore, the ability of the fund to achieve its investment objective.
The market values of the fund's investments, and therefore the value of the fund's shares, will go up and down, sometimes rapidly or unpredictably. Market risk may affect a single issuer, industry or section of the economy, or it may affect the market as a whole. Individual stock prices tend to go up and down more dramatically than those of certain other types of investments, such as bonds. During a general downturn in the financial markets, multiple asset classes may decline in value. When markets perform well, there can be no assurance that specific investments held by the fund will rise in value.
Mid-capitalization companies tend to be more vulnerable to changing market conditions and may have more limited product lines and markets, less experienced management and fewer financial resources than larger companies. These companies' securities may be more volatile and less liquid than those of more established companies, and their returns may vary, sometimes significantly, from the overall securities market.
Preferred securities are subject to issuer-specific and market risks applicable generally to equity securities. Preferred securities also may be subordinated to bonds or other debt instruments, subjecting them to a greater risk of nonpayment, may be less liquid than many other securities, such as common stocks, and generally offer no voting rights with respect to the issuer.
Before investing, carefully read the prospectus and/or summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the products, visit invesco.com/fundprospectus for a prospectus/summary prospectus.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
|NOT FDIC INSURED||MAY LOSE VALUE||NO BANK GUARANTEE|
All data provided by Invesco unless otherwise noted.
Invesco Distributors, Inc. is the US distributor for Invesco Ltd.'s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC, investment adviser. Invesco PowerShares Capital Management LLC (Invesco PowerShares) and Invesco Distributors, Inc., ETF distributor, are indirect, wholly owned subsidiaries of Invesco Ltd.
©2016 Invesco Ltd. All rights reserved.
What's the bottom line on top-line growth? by Invesco