Global Equity Observer
  •  
Apr 2019
In Search of a Late-Cycle Buffer
 

Global Equity Observer

In Search of a Late-Cycle Buffer


Apr 2019

 
 

2019 has some worrying echoes of 1999. Markets are up strongly despite soggy earnings, initial public offering-frenzy is back on CNBC as Lyft starts the wave of unicorns heading to market before the music stops and, perhaps most alarmingly, Goldman Sachs has abolished business dress. Even the Backstreet Boys are back. This may be more anecdotal than scientific, but it is all starting to feel rather late cycle and, therefore, arguably a good time to deploy a late-cycle buffer, if one is not in place already.

 
 
 
‘‘
After Q1 2019, we are now concerned about both multiples and earnings"
 
 

Applying a bit more rigor, at the start of 2018 we were worried about the elevated level of market multiples. By the end of 2018, which saw a combination of a sharp de-rating and strong earnings rises, our primary worry had shifted over to earnings. After first-quarter (Q1) 2019, which saw double-digit returns despite a global economic slowdown, we are now anxious about both multiples and earnings. We like to say that the good news is that there are only two ways to lose money in equities… if the earnings go away or if the multiple goes away. The bad news right now is that both are under threat.

The multiples are a concern as they have bounced back to September levels, with the MSCI World Index back above 15x the next 12 months’ earnings2 as Q1 2019 has reversed the Q4 de-rating. It is true that some of the fears that stalked Q4 have faded, thanks to the seeming U-turn from the U.S. Federal Reserve and the more positive mood music from the U.S.-China trade talks, but the experience of last year’s two market swoons suggests that there is significant downside multiple risk, even without any cyclical earnings shock.

As for earnings, our underlying anxiety is that they may be unsustainably high, particularly in the U.S. Margins are near peak levels, as are profits’ share of gross domestic product and the level of earnings per share-boosting leverage. Earnings are also drifting down while the market surges up. The 2019 MSCI World Index earnings estimates are off 6.5% since the start of Q4 2018 and 4.0% down year-to-date.3 In the U.S., where quarterly data is available, earnings are actually expected to be down around 3% year-on-year in Q1.4 The interesting point is the source of the U.S. earnings drop. Revenues are still healthy, up around 5% on the year,5 but the margins are falling. Costs are rising in the U.S., notably for labour, and many companies are having trouble passing them on. The National Association of Business Economics reported that 58% of respondents were facing higher labour costs, but that only 19% had been able to increase prices, presumably the 19% with the strongest pricing power. The market, as per usual, assumes that things will improve. By Q4 2019, consensus has U.S. earnings up nearly 10% year-on-year, as against the Q1 2019 fall.6 Our fear is that this may be over-optimistic, either due to the late-cycle margin pressure, or the even-later-cycle economic downturn.

 
 
 
‘‘
If we are indeed late cycle, then a portfolio of compounders seems a reasonable place to hide"
 
 

If we are indeed late cycle and, therefore, vulnerable to late-cycle margin pressure followed by an economic downturn, then a portfolio of compounders seems a reasonable place to hide. We believe compounders have sustainable high returns supported by powerful intangible assets. Importantly, we also require strong pricing power, recurring revenues and limited operational and financial leverage. The pricing power, generally fed by powerful brands and networks, allows companies to protect their margins when costs rise, while the recurring revenues, from repeat purchases or long-term contracts, support the level of sales. The combination of robust sales and robust margins should help drive robust profits, particularly if there is limited operational or financial leverage.

While of course past performance doesn’t guarantee future outcomes, we believe the impact of the 2008-09 global financial crisis supports our thesis that compounders can be a late-cycle buffer. Our flagship global equity strategy, Global Franchise, actually saw its earnings rise over the course of the crisis, while the market saw a 40% fall. In addition, the earnings for the core sectors of our global portfolios today (consumer staples, software & IT services within information technology, and health care) which combined are over 80% of our global portfolios, held up far better than their more cyclical peers, as shown in the chart below.

 
NTM Forward EPS Change During Financial Crisis Drawdown (Oct 2007 - Feb 2009)
 
in-search-of-a-late-cycle-safety-net-chart-1
 
 
 

Source: FactSet. Data as of February 28, 2019. Chart shown for illustrative purposes only.

 


 
 

On forward price-to-free cash flow, our favoured valuation metric, our global portfolios trade on only an 18-22% premium to the far lower-quality MSCI World Index, despite the far higher return on capital, gross margins and margin stability.[1] We would argue that this is actually an overstatement of any real premium, given the market’s chronic failure to deliver the expected forward cash flows and earnings and the habit of tucking any unpleasant news ‘below the line.’

Our global products look to compound wealth over the long term, by owning high-quality companies that compound their earnings steadily at reasonable valuations. They look to keep the lights on, rather than shooting them out, and have been described as a get rich slowly scheme. We would assert that compounders should be owned across the cycle… but in particular if the cycle may be coming to an end.

 
 

RISK CONSIDERATIONS

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. Changes in the worldwide economy, consumer spending, competition, demographics and consumer preferences, government regulation and economic conditions may adversely affect global franchise companies and may negatively impact the strategy to a greater extent than if the strategy's assets were invested in a wider variety of companies. In general, equity securities' values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. Option writing strategy. Writing call options involves the risk that the Portfolio may be required to sell the underlying security or instrument (or settle in cash an amount of equal value) at a disadvantageous price or below the market price of such underlying security or instrument, at the time the option is exercised. As the writer of a call option, the Portfolio forgoes, during the option's life, the opportunity to profit from increases in the market value of the underlying security or instrument covering the option above the sum of the premium and the exercise price, but retains the risk of loss should the price of the underlying security or instrument decline. Additionally, the Portfolio's call option writing strategy may not fully protect it against declines in the value of the market. There are special risks associated with uncovered option writing which expose the Portfolio to potentially significant loss.

 
william.lock
 
Head of International Equity Team
 
bruno.paulson
 
Managing Director
 
dirk.hoffmannbecking
 
Executive Director
 
 

1 Source: FactSet. Data as of March 31, 2019.

2 Source: FactSet. Data as of March 31, 2019.

3 Source: FactSet. Data as of March 31, 2019.

4  Source: Refinitiv. Data as of March 31, 2019.

5 Source: FactSet. Data as of March 31, 2019.

6 Source: FactSet. Data as of March 31, 2019.

INDEX INFORMATION

The MSCI World Index is a free float adjusted market capitalization weighted index that is designed to measure the global equity market performance of developed markets. The term "free float" represents the portion of shares outstanding that are deemed to be available for purchase in the public equity markets by investors. The performance of the Index is listed in U.S. dollars and assumes reinvestment of net dividends. The index is unmanaged and does not include any expenses, fees or sales charges. It is not possible to invest directly in an index.

DEFINITIONS

Earnings per share is the portion of a company’s profit allocated to each outstanding share of common stock. Gross domestic product (GDP) is a broad measurement of a nation’s overall economic activity. GDP is the monetary value of all the finished goods and services produced within a country's borders in a specific time period.

DISTRIBUTION

This communication is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

Ireland: Morgan Stanley Investment Management (Ireland) Limited. Registered Office: The Observatory, 7-11 Sir John Rogerson’s, Quay, Dublin 2, Ireland. Registered in Ireland under company number 616662. Regulated by the Central Bank of Ireland. United Kingdom: Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA. Dubai: Morgan Stanley Investment Management Limited (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158). Germany: Morgan Stanley Investment Management Limited Niederlassung Deutschland Junghofstrasse 13-15 60311 Frankfurt Deutschland (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Italy: Morgan Stanley Investment Management Limited, Milan Branch (Sede Secondaria di Milano) is a branch of Morgan Stanley Investment Management Limited, a company registered in the UK, authorised and regulated by the Financial Conduct Authority (FCA), and whose registered office is at 25 Cabot Square, Canary Wharf, London, E14 4QA. Morgan Stanley Investment Management Limited Milan Branch (Sede Secondaria di Milano) with seat in Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy, is registered in Italy with company number and VAT number 08829360968. The Netherlands: Morgan Stanley Investment Management, Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. Telephone: 31 2-0462-1300. Morgan Stanley Investment Management is a branch office of Morgan Stanley Investment Management Limited. Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Switzerland: Morgan Stanley & Co. International plc, London, Zurich Branch Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered with the Register of Commerce Zurich CHE-115.415.770. Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland, Telephone +41 (0) 44 588 1000. Facsimile Fax: +41(0) 44 588 1074.

U.S.

A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2.

Please consider the investment objectives, risks, charges and expenses of the funds carefully before investing. The prospectuses contain this and other information about the funds. To obtain a prospectus please download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.

Morgan Stanley Distribution, Inc. serves as the distributor for Morgan Stanley funds.

NOT FDIC INSURED |OFFER NO BANK GUARANTEE | MAY LOSE VALUE |NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A DEPOSIT

Hong Kong: This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This document should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. This material has not been reviewed by the Monetary Authority of Singapore. Australia: This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.

Japan: For professional investors, this document is circulated or distributed for informational purposes only. For those who are not professional investors, this document is provided in relation to Morgan Stanley Investment Management (Japan) Co., Ltd. (“MSIMJ”)’s business with respect to discretionary investment management agreements (“IMA”) and investment advisory agreements (“IAA”). This is not for the purpose of a recommendation or solicitation of transactions or offers any particular financial instruments. Under an IMA, with respect to management of assets of a client, the client prescribes basic management policies in advance and commissions MSIMJ to make all investment decisions based on an analysis of the value, etc. of the securities, and MSIMJ accepts such commission. The client shall delegate to MSIMJ the authorities necessary for making investment. MSIMJ exercises the delegated authorities based on investment decisions of MSIMJ, and the client shall not make individual instructions. All investment profits and losses belong to the clients; principal is not guaranteed. Please consider the investment objectives and nature of risks before investing. As an investment advisory fee for an IAA or an IMA, the amount of assets subject to the contract multiplied by a certain rate (the upper limit is 2.16% per annum (including tax)) shall be incurred in proportion to the contract period. For some strategies, a contingency fee may be incurred in addition to the fee mentioned above. Indirect charges also may be incurred, such as brokerage commissions for incorporated securities. Since these charges and expenses are different depending on a contract and other factors, MSIMJ cannot present the rates, upper limits, etc. in advance. All clients should read the Documents Provided Prior to the Conclusion of a Contract carefully before executing an agreement. This document is disseminated in Japan by MSIMJ, Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: the Japan Securities Dealers Association, The Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association.

IMPORTANT INFORMATION

EMEA: This marketing communication has been issued by Morgan Stanley Investment Management (Ireland) Limited (“MSIM Ireland”). Registered Office: The Observatory, 7-11 Sir John Rogerson’s Quay, Dublin 2, Ireland. Registered in Ireland under company number 616662. Regulated by the Central Bank of Ireland.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the strategy’s / product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.

A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing.

This material is a general communication, which is not impartial and has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

Except as otherwise indicated herein, the views and opinions expressed herein are those of the portfolio management team, are based on matters as they exist as of the date of preparation and not as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date hereof.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

MSIM has not authorised financial intermediaries to use and to distribute this document, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without MSIM’s express written consent.

All information contained herein is proprietary and is protected under copyright law.

CRC 2497089 Exp. 4/30/2020

 

It is important that users read the Terms of Use before proceeding as it explains certain legal and regulatory restrictions applicable to the dissemination of information pertaining to Morgan Stanley Investment Management's investment products.

The services described on this website may not be available in all jurisdictions or to all persons. For further details, please see our Terms of Use.

Not FDIC Insured—Offer No Bank Guarantee—May Lose Value
Not Insured By Any Federal Government Agency—Not A Deposit

Privacy & Cookies    •    Terms of Use

©  Morgan Stanley. All rights reserved.

Morgan Stanley Distribution, Inc. Member FINRA/SIPC.