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Monday, 22 September 2014

Decent exposure

Cyclical stocks look like the new value plays

Equity markets across the globe have risen smartly in the last 12 months. Tokyo shares have led the way, rising more than 50 percent since last May. U.S. and European shares are also sporting double digit gains. Purportedly dependable stocks - those thought to be relatively impervious to economic swings - have done best. These non-cyclicals are up by a quarter in Europe and the United States, according to a Breakingviews analysis. Cyclical stocks, meanwhile, have risen by only about 15 percent. Right now, though, investors may have it the wrong way around.

Some of the general stock market optimism comes from hope that the world economy is finally emerging from the post-crisis hangover. The absence of value in other asset classes - notably sovereign debt - has also led investors to focus on equities. Even so, it is reasonable that investors, especially in troubled Europe, would take the low-risk route into equities, snapping up non-cyclical stocks in sectors such as pharmaceuticals, food and household products.

Yet they have pumped up valuations to a point where the logic dissolves. In Europe, non-cyclical stocks now trade on an average price-to-earnings multiple of about 14. Typically less dependable sectors like energy, autos and materials are changing hands at a relatively cheap-looking 11 times on average. There’s a similar divergence globally and an only slightly smaller one in the United States. Thomson Reuters data from the last 20 years suggests that non-cyclicals in the S&P 500 Index typically enjoy a slim valuation premium, but one that’s narrower than the present gap.

There is scant difference between the earnings growth rates achieved by cyclical and non-cyclical stocks, according to the Starmine database. If anything, cyclical stocks have delivered better growth in the past and are expected to generate higher growth in the future. There is also little to choose when it comes to balance sheets - cyclicals aren’t markedly more indebted.

Based on his analysis, Todd Builione, president of JPMorgan-owned hedge fund firm Highbridge Capital Management, said at the SkyBridge Alternatives conference on Wednesday that cyclicals now present a historic opportunity. They may be vulnerable to economic winds, but for now there’s a big discount to compensate investors for that risk.

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