Active Investing in the Age of Disruption. Evan L. Jones

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FIGURE 2.3 Federal Reserve assets and the S&P 500 Index (2001 to November 2019)

Fundamental investing overwhelmed by central bank intervention

For a fundamental investment manager this is evidence that macro news and events are driving markets, not fundamental business results. In the 2020s, the markets can progress down two different paths. The first is a continuation of the 2010s, which will be a struggle for active investing, as we have discussed. The second path would be more ominous, as investors lose confidence in central banks. There seems to be little indication that a third option of growth and normalcy will arise. The path of global economies rebounding significantly allowing central banks to stop their intervention has little supportive data. Central banks have taken on the incredible responsibility of stabilizing and supporting financial markets for the next decade.

A macro-driven market, as the Fed has created through constant intervention, takes the emphasis away from fundamental investing. At the core of any investment strategy that outperforms the market is investing based on future expectations of cash flows produced by a company. A security selection thesis can be articulated by managers in many different ways. Investing in a business may be based on operating margin growth, entering new markets, facing weaker competition, creating a technological advantage, or having an elite management team, but they equate to expecting stronger cash flows in the future than the market expects today. Central bank intervention has materially lowered the relationship of fundamental company security selection and equity performance. Multiples are more volatile than earnings, so if multiples are going to be driven by outside factors, cash flows will have less explanatory effect.

      [In January 2015] Earnings don't move the overall market, it's the Federal Reserve Board… Focus on the central banks and focus on the movement of liquidity… It's liquidity that moves markets.

       —Stanley Druckenmiller, investor

      Diligently studying a company's operations to understand future growth does not add the same value to future equity performance when a central bank dictates the markets and low rates make all stocks go up due to higher valuation multiples. An additional driver of valuation multiples today is technological disruption. Certain sectors of the S&P 500 have been decimated by actual or perceived future disruption and are trading at historically low multiples balancing the historically high multiples of other rate-sensitive sectors. Retailers' valuations have been destroyed by Amazon's success, energy producers have been destroyed by supply gluts created by fracking disruption, and health care services trade at all-time lows due to regulation concerns and technology company threats to the established industry leaders. This confluence of cheap, easy money and disruption is the challenge pressuring active managers. If we focus on S&P 500 sectors that are rate sensitive and have not seen large-scale technological disruption, we can see the massive effect on valuations from low rates.

      When capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error.

       —Howard Marks, investor

Utilities are one of the most rate-sensitive sectors and to date have not been negatively influenced by technological disruption. Figure 2.4 shows price-to-earnings (P/E) multiples in the 2010s. Multiples have grown over 60%. Utilities are historically a cost of capital return sector, where very few investment managers spend much time due to the slow-paced, regulation-influenced business model. Low rates have made it a top-performing sector.

During the same time frame that P/E ratios rose, utilities had incredibly easy access to capital at very low rates due to investor demand for their debt. From 2010 to 2019, the S&P 500 utilities sector created negative-free cash flow every year and increased dividends every year. Figure 2.5 illustrates the upward dividend per share trend and the downward free cash flow trend. All dividends during the last decade were paid for with newly issued debt. The sector now trades at a net debt to cash flow ratio of 6.7 times. This is the highest level of net debt in history, completely supported by low rates and a chase for yield by investors. Utilities are a very stable industry historically, but any disruption caused by renewables and consumers' ability to generate electricity independently to move off the grid will cause a severe down trend given the sector's debt levels.

FIGURE 2.4 S&P 500 utilities sector trailing 12-month P/E ratio (2009 to November 2019)

FIGURE 2.5 S&P 500 utilities sector dividends paid per share and free cash flow per share (2009 to November 2019)

Another rate-sensitive СКАЧАТЬ