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Asset Allocation Insights – Investors Benefit From Riskier Asset Classes


Risk taking is in, but is risk underpriced again?

►The seesaw continues with risk assets doing particularly well this past week

►US large caps performed best – up 2.9% for the week, but International Developed equities were only slightly

►Bond strategies delivered positive returns last week as well but significantly below those of more risky asset classes

►On a YTD basis, US small caps lead the pack by a slight margin – up 15.5%

►In the context of balanced 60/40 strategies US strategies and international strategies performed in line with each other (both up 1.9%)

►Aggressive focused multi-asset class strategies out-performed less risky options

►Within equities, Growth has slightly out-performed Value in 2019 and over the last year Growth also remains solidly ahead

►Thus far in 2019 more aggressive multi-asset strategies have outperformed less risky portfolios

Currencies:

►A rare down week for the USD as expectations for growth in the US slow down and the Fed remains on hold

►For 2019 we still expect the USD to depreciate slightly

►A depreciating USD will boost international asset returns – we expect this effect to persist in 2019

►A big question mark for this coming week is what happens to Brexit (yet again) – sterling is being massively tossed around depending on political prospects

►Interestingly, the pound has held up admirably during this period of uncertainty and is now in a Break Out phase

►The Yen is now in a Break Down phase as investors have regained their desire for risk

►In general, FX volatility has increased substantially in the last couple of months

Commodities:

►After a bad prior week, ag commodities rebounded strongly with wheat, the most beaten down of the group, up over 6%

►The tension in the grain complex is mostly supply driven but soybeans also are being affected by trade negotiations with China

►Commodity indices have moved into an Improving phase as oil markets have found some stability

►Gas was down slightly last week and remains in a Down Trend magnified by weak seasonality

►Copper kept its gains from the previous week as global growth only slows down slightly

►Gold and Silver were flat last week and are showing divergent patterns – gold being stronger than silver

►While inflationary expectations remain low, commodity prices are an excellent hedge should things change

This Coming Week:

►While risky assets have recovered we still think that risk is being shunned at the moment – investors seem uncomfortable making bold bets

►While not comfortable, US investors should consider allocating more money to non-US stocks due to their lower valuations and potentially a depreciating USD

►The strong USD will not persist much stronger as the FED appears close to the end in terms of interest rate hikes

►The Value/Growth discussion is being overshadowed by sector rotation but on a risk-adjusted basis we believe that higher allocations to Value are warranted

►We are also watching out for any jump in inflationary expectations (which have been trending down)

►Tariffs are inflationary and will be reflected in higher consumer prices eventually

►Our biggest concerns revolve around a slowing global economy – The IMF recently lowered 2019 growth numbers to 3.5%

►We still see a risk on/off market this year making it difficult for short-term investors – probably best to extend horizons

__________________________________________________________________________________

To read our full weekly report please click here

 

ic J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

______________________________________________________________________________

 

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

Asset Allocation Insights – Investors Forget About Risk


Risk Loving is in but for how long?

►The comeback for holders of risky assets was interrupted this week as growth concerns returned

►EM, Commodities and Reits had poor weeks as commodity prices suffered again and interest rates increased in the US

►On a YTD basis US small caps lead the pack by a wide margin – up 18.1%

►In the context of balanced 60/40 strategies US strategies out-performed strategies more globally focused

►Aggressive focused multi-asset class strategies out-performed less risky options

►Within equities, Growth has slightly out-performed Value in 2019 and over the last year Growth also remains solidly ahead

►Thus far in 2019 more aggressive multi-asset strategies have outperformed

Currencies:

►Flat week fort the USD

►For 2019 we still expect the USD to depreciate slightly

►A depreciating USD will boost international asset returns – we expect this effect to persist in 2019

►A big question mark for this coming week is what happens to Brexit (yet again) – sterling is being massively tossed around depending on political prospects

►The Yen is now in a Break Down phase as investors have regained their desire for risk

►In general, FX volatility has increased substantially in the last couple of months

Commodities:

►Commodity indices have moved into an Improving phase as oil markets have found some stability

►Gas was up big last as it became less oversold

►Copper moved down slightly after a big spike up the previous week – still very growth oriented

►Gold and Silver were slightly down last week and are showing divergent patterns

►While inflationary expectations remain low, commodity prices are an excellent hedge should things change

This Coming Week:

►While risky assets have recovered we still think that risk is being shunned at the moment – investors seem uncomfortable making bod bets

►While not comfortable, US investors should allocate more money to non-US stocks due to their lower valuations and a depreciating USD

►The strong USD will not persist much stronger as the FED appears close to the end in terms of interest rate hikes

►The Value/Growth discussion is being overshadowed by sector rotation but on a risk-adjusted basis we believe that higher allocations to Value are warranted

►We are also watching out for any jump in inflationary expectations (which have been trending down)

►Tariffs are inflationary and will be reflected in higher consumer prices eventually

►Our biggest concerns revolve around a slowing global economy – The IMF recently lowered 2019 growth numbers to 3.5%

►We still see a risk on/off market this year making it difficult for short-term investors – probably best to extend horizons

__________________________________________________________________________________

To read our full weekly report please click here

ic J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

______________________________________________________________________________

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

Asset Allocation Insights – Lower Growth Hits Equities


Taking a Breather Due to Lower Potential Growth

►The comeback for holders of risky assets was interrupted this week as growth concerns took over the agenda

►US assets managed to eke out gains with REITS especially having a good week

►EM and International equities had down weeks both in local currency as well as in USD terms

►On a YTD basis US Small Cap and REITS are in the lead – up 11.8%

►Commodity indices had a poor week as energy prices suffered large losses this past week

►In the context of balanced 60/40 strategies US strategies out-performed strategies more globally focused

►Aggressive, domestically focused multi-asset class strategies under-performed less risky options

►Within equities, Growth has slightly under-performed Value in 2019 but over the last year Growth remains solidly ahead

►Thus far in 2019 more aggressive multi-asset strategies have outperformed

Currencies:

►The USD had a strong week, up over 1%, despite ongoing budget discussions in Washington and a pause by the Fed in raising rates

►For 2019 we still expect the USD to depreciate slightly

►A depreciating USD will boost international asset returns – we expect this effect to persist in 2019

►A big question mark for this coming week is what happens to Brexit (yet again) – sterling is being massively tossed around depending on political prospects

►The Yen is now in an Up Trend phase as investors remain risk averse and the Yen is usually considered the “safe” trade

►RResource-oriented currencies experienced losses last week relative to the USD  as oil and gas prices trended down

►In general, FX volatility has increased substantially in the last couple of months

Commodities:

►Commodity indices continue in a Down Trend even as oil markets have found some stability

►Oil and gas were down big last week due to warmer weather in the US and oversupply conditions

►Soybean prices should be firming up as a trade deal with China gets some traction

►Gold and Silver while slightly down last week are becoming a hedge for nervous equity investors

►However, we still view US Treasuries as the best hedging option for equity risk

This Coming Week:

►While risky assets have recovered we still think that risk is being shunned at the moment

►While not comfortable, US investors should allocate more money to non-US stocks due to their lower valuations and a depreciating USD

►The strong USD will not persist much stronger as the FED appears close to the end in terms of interest rate hikes

►The Value/Growth discussion is being overshadowed by sector rotation but on a risk-adjusted basis we believe that higher allocations to Value are warranted

►We are also watching out for any jump in inflationary expectations (which have been trending down)

►Tariffs are inflationary and will be reflected in higher consumer prices eventually

►Our biggest concerns revolve around a slowing global economy – The IMF recently lowered 2019 growth numbers to 3.5%

►We still see a risk on/off market this year making it difficult for short-term investors – probably best to extend horizons

►In general, investors seem very pessimistic making contrarian plays interesting from a tactical perspective

Earnings season in the US is in full swing

__________________________________________________________________________________

To read our full weekly report please click here

ic J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

______________________________________________________________________________

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

Asset Allocation Insights – Risky Assets Continue Their Ciomeback


Partying Like it is 2017 Again

►The comeback for holders of risky assets such as equities, real estate, and commodities continues

►EM equities perform the best of our major asset classes – up 2.3% for the week and over 9% over the last 3 months

►Developed international equities also had a huge week – up 1.7% and 5% for 2019 thus far

►Commodity indices also made a nice comeback boosted by higher oil prices – up 9.4% for the year already

►Aggressive, domestically focused multi-asset class strategies out-performed less risky options

►In 2018 lower risk asset allocation strategies   outperformed especially if allocations involved international equities but the story is reversed thus far this year

►Within equities, Growth has slightly under-performed Value in 2019 but over the last year Growth remains solidly ahead

►Over the last year, only Cash and US Reits exhibit positive returns

Currencies:

►The USD is losing some strength as budget discussions in Washington remain unresolved and the Fed has indicated being close to done with rate hikes

►A depreciating USD will boost international asset returns – we expect this effect to persist in 2019

►A big question mark for this coming week is what happens to Brexit (yet again) but sterling is showing strength

►The Yen is now in a Break Out phase as investors remain risk averse and the Yen is usually considered the “safe” trade

►Resource-oriented currencies experienced losses last week relative to the USD despite firmer commodity prices

In general, FX volatility has increased substantially in the last couple of months

Commodities:

►Commodity indices continue in a Down Trend even as oil markets showed continued gains last week

►Grain prices have also continued their upward path from the lows of last summer

►Gold and Silver are in the Break Out phase as investors have flocked to them as a hedge against equity volatility

►However, we still view US Treasuries as the best hedging option for equity risk

This Coming Week:

►While risky assets recovered last week we still think that risk is being shunned at the moment

►While not comfortable, US investors should allocate more money to non-US stocks due to their lower valuations and a depreciating USD

►The strong USD will not persist much stronger as the FED appears close to the end in terms of interest rate hikes

►The Value/Growth discussion is being overshadowed by sector rotation but on a risk-adjusted basis we believe that higher allocations to Value are warranted

►We are also watching out for any jump in inflationary expectations (which have been trending down)

►Tariffs are inflationary and will be reflected in higher consumer prices eventually

►Our biggest concerns revolve around a slowing global economy – The IMF recently lowered 2019 growth numbers to 3.5%

►We still see a risk on/off market this year making it difficult for short-term investors – probably best to extend horizons

►In general, investors seem very pessimistic making contrarian plays interesting from a tactical perspective

__________________________________________________________________________________

To read our full weekly report please click here

ic J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

______________________________________________________________________________

Global Focus Capital
Global Focus Capital

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

Asset Allocation Insights – A Relief Rally With No Legs


Breathing a Sigh of Relief For Now

►A huge comeback for holders of risky assets such as equities, real estate,  and commodities

►US small caps perform the best of our major asset classes – up 4.8% for the week but still down 6% over the last 3 months

►REITS also had a huge week after a poor last couple of weeks – up 4.5% and 3.2% for 2019 thus far

►Commodity indices also made a nice comeback boosted by higher oil prices – up 7.5% for the year already

►Aggressive, domestically focused multi-asset class strategies out-performed less risky options

►In 2018 lower risk asset allocation strategies   outperformed especially if allocations involved international equities but the story is reversed thus far this year

►Within equities, Growth has slightly under-performed Value but over the last year Growth remains solidly ahead

►Over the last year, Cash remains the best performing of the major asset classes

Currencies:

►The USD is losing some strength as budget discussions in Washington remain unresolved and the Fed has indicated being close to done with rate hikes

►A depreciating USD will boost international asset returns

►A big question mark for this coming week is what happens to Brexit (Tuesday vote)

►The Yen is now in a Break Out phase as investors remain very risk-averse and the Yen is usually considered the “safe” trade

►Resource-oriented currencies experienced the biggest gains last week relative to the USD as commodity prices have stabilized

►In general, FX volatility has increased substantially in the last couple of months

Commodities:

►Commodity indices continue in a Down Trend even as oil markets showed some nice gains last week

►On the flipside, grain prices went down slightly last week but have recovered from the lows of last summer

►Sugar and coffee prices recovered along with the Brazilian Real – these 2 commodities are very sensitive to the currency

►Gold and Silver are in the Break Out phase as investors have flocked to them as a hedge against equity volatility

►However, we still view US Treasuries as the best hedging option for equity risk

This Coming Week:

►While risky assets recovered last week we still think that risk is being shunned at the moment

►While not comfortable, US investors should allocate more money to non-US stocks due to their lower valuations

►The strong USD will not persist much stronger as the FED appears close to the end in terms of interest rate hikes

►The Value/Growth discussion is being overshadowed by sector rotation but on a risk-adjusted basis we believe that higher allocations to Value are warranted

►We are also watching out for any jump in inflationary expectations (which have been trending down)

►Tariffs are inflationary and will be reflected in higher consumer prices eventually

►Our biggest concerns revolve around blowing out interest rate spreads and a slowing global economy

►Leverage on the balance sheet of companies should be cross-checked for sustainability

►We still see a risk on/off market this year making it difficult for short-term investors – probably best to extend horizons

►In general, investors seem very pessimistic making contrarian plays interesting from a tactical perspective

►In this environment of fear, it is best to allocate capital to specific assets rather than asset classes

__________________________________________________________________________________

To read our full weekly report please click here

ic J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

___________________________________________________________________________________

Global Focus Capital
Global Focus Capital

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

Asset Allocation Insights – Bad and Getting Worse for Equity Investors

Investors Shun Equities

  • A slow week with a bit of cheer for equity investors
  • US small caps recover the most – up 1% for the week but still down 21% over the last three months
  • REITS gave back some gains last week (down 1.7%) and are now also in negative territory for 2018
  • Commodity indices remain driven by lower oil prices with no sign of resurgent inflation
  • Aggressive, domestically focused multi-asset class strategies out-performed less risky options
  • YTD lower risk asset allocation strategies have outperformed especially if allocations involved international equities
  • Within equities, Growth slightly under-performed Value but Growth remains solidly ahead for the year
  • Cash remains the best performing of the major asset classes for the year

Currencies:

  • The USD is losing some strength as budget discussions in Washington remain unresolved and the Fed has indicated being close to done with rate hikes
  • A depreciating USD will boost international asset returns
  • The British Pound continued depreciating due to major uncertainty regarding BREXIT early in 2019
  • The Yen is now in a Break Out phase as investors remain very risk-averse and the Yen is usually considered the “safe” trade
  • Resource-oriented currencies experienced the biggest losses last week relative to the USD as commodity prices remain in a Down Trend
  • In general, FX volatility has increased substantially in the last couple of months

Commodities:

  • Commodity indices continue in a Down Trend as oil markets had another down leg
  • On the flipside, grain prices have been recovering since the summer
  • Natural gas prices were down over 8% due to warmer predicted weather and lower levels of fuel switching than anticipated
  • Gold and Silver had good weeks as investors have become more risk averse and the Fed has indicated only 2 more rate hikes for 2019
  • However, we still view US Treasuries as the best hedging option for equity risk

This Coming Week:

  • The year of risk-off continues with little to offer us hope that risky assets will recover soon – there may be a spike in January but risk is being shunned at the moment
  • While not comfortable, US investors should allocate more money to non-US stocks due to their lower valuations
  • The strong USD will not persist much stronger as the FED appears close to the end in terms of interest rate hikes
  • The Value/Growth discussion is being overshadowed by sector rotation but on a risk-adjusted basis we believe that higher allocations to Value are warranted
  • We are also watching out for any jump in inflationary expectations (which have been trending down). Tariffs are inflationary and will be reflected in higher consumer prices eventually
  • EM equities, in particular, are recovering. We still believe that an allocation is warranted. Our biggest concerns revolve around blowing out interest rate spreads and a slowing global economy
  • Leverage on the balance sheet of companies should be cross-checked for sustainability
  • We still see a risk on/off market next year making it difficult for short-term investors – probably best to extend horizons

__________________________________________________________________________________

To read our full weekly report please click here

Eric J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

___________________________________________________________________________________

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

Asset Allocation Insights – Risk Is Off The Table

Investors Want No Part Of Risk

  • Another tough week for risky assets with no end in sight
  • US small caps take yet another down leg and are now down 7% for the year
  • REITS gave back some gains last week but remain our best key asset class for 2018 – up 4.1%
  • Commodity indices remain driven by lower oil prices with no sign of resurgent inflation
  • Aggressive, domestically focused multi-asset class strategies under-performed less risky options
  • YTD lower risk asset allocation strategies have outperformed especially if the allocations involved international equities
  • Within equities, Growth outperformed Value as Energy and Financials experienced large loses

Currencies:

  • The USD appreciated yet again last week and remains in a significant Up Trend
  • The British Pound continued depreciating due to major uncertainty regarding whether BREXIT will pass Parliament
  • The Yen continues in a Down Trend especially in light of lower economic growth in Japan
  • In general, FX volatility has increased substantially in the last couple of months

Commodities:

  • Commodity indices continue in a Down Trend as oil markets had another down leg
  • On the flipside, grain prices have been recovering since the summer but surprisingly soybeans were down despite increased Chinese purchases
  • Natural gas prices were down over 16% due to warmer predicted weather and lower levels of fuel switching than anticipated
  • Gold and Silver were slightly down last week but their technical picture has improved recently as risky assets continue cratering
    • We still view US Treasuries as best hedging option for stocks

This Coming Week:

  • The year of risk-off continues with little to offer us hope that risky assets will recover soon
  • While not comfortable, US investors should allocate more money to non-US stocks due to their lower valuations
  • The strong USD will not persist much stronger as the FED appears close to the end in terms of interest rate hikes
  • The Value/Growth discussion is being overshadowed by sector rotation but on a risk-adjusted basis we believe that higher allocations to Value are warranted
  • We are also watching out for any jump in inflationary expectations (which have been trending down)
    • Tariffs are inflationary and will be reflected in higher consumer prices eventually
  • EM equities, in particular, are recovering but will end up in the red this year
    • We still believe that an allocation is warranted
    • Our biggest concerns revolve around blowing out interest rate spreads and a slowing global economy
  • Leverage on the balance sheet of companies should be cross-checked for sustainability
  • We still see a risk on/off market next year making it difficult for short-term investors – probably best to extend horizons

__________________________________________________________________________________

To read our full weekly report please click here

Eric J. Weigel

Global Focus Capital LLC

eweigel@gf-cap.com

___________________________________________________________________________________

Publications:

Weekly Asset Allocation Review – Free

Weekly Equity Themes Review – Free

The Equity Observer (Monthly) – Subscription Required

The Asset Allocation Advisor (Monthly) – Subscription Required

 

Never let all the political chatter get in the way of the bull

Global equity markets keep moving ahead despite the massive political noise. After falling in the middle of the pack last year, US equity markets remain in the pole position this year.

Some notable developments last week:

  • The US lagged international developed and emerging markets as the US dollar took a bit of a breather
  • Tech for once did not lead the markets. In fact, it was the worst performing sector. Facebook was the main contributing factor.
  • Value and yield strategies rebounded strongly.
  • Mega caps outperformed in the US.
  • Most stocks were down last week but the cap weighting of broad indices made things look better. The S& P 500 was up 61 bp while the Russell 2000 was down almost 2%.

What we are watching this week:

  • Lots of earnings in the US (Notables: Apple, Pfizer, Caterpillar, Tesla, Eaton)
  • Risk Aversion – expect the RAI to jump into the Neutral Zone. Investors keep under-pricing risk
  • Market Internals – expected to remain “balanced”. The technical do not support a bear market
  • Q: What will US markets do after the strong 4.1% GDP growth? Will the long rate stand up?
  • Will the US dollar give up some ground? The policy of super easy money seems to be coming to an end in JP and Europe
  • Will Facebook rebound?

Interested in reading our full report?

Subscribe to our free weekly Equity Observer to get the report delivered to your email.

Eric J. Weigel

Global Focus Capital LLC

Key Asset Allocation Insights – Weekly Review

The Week In Review

  • Asset allocation strategies came under attack last week as global capital markets saw the period of extreme calm come to an end
  • Between the “memo”, earnings week and Super Bowl preparations there was a lot going on
  • None of the key asset classes that we use in our asset allocation process escaped the increase in investor risk aversion. Volatility really spiked up on Friday
  • The Fed did not hike rates at Janet Yellen’s last meeting as Chair but did raise the specter of inflation
    We have been in the camp that believes that investors have been underpricing inflation risk
  • Three huge US companies (JP Morgan, Berkshire Hathaway, and Amazon) are planning to launch their own health care network. Nobody has found the cost-containment magic. Maybe self-insuring and pooling “healthy” employees is the way to go

Key Asset Classes:

Last week saw the best performing asset classes of last year take the biggest hit

Asset classes across the board suffered losses. Diversification only lessened the blow

 

 

 

Emerging markets still remain in an UP TREND but profit-taking may have set in

Interest sensitive asset classes are firmly entrenched in Down Trends

 

 

Currencies:

The USD keeps depreciating and the Trump administration seems to favor this trend

A weak USD should provide a boost to commodity prices

A weak USD also makes imports more expensive further boosting inflationary pressures

In my view, USD depreciation is a function of political turmoil in DC

Higher short-term rates in the US provide a floor to the USD – don’t expect massive USD depreciation

Commodities:

In a week where news outlets told us that investors once again became fearful of inflationary pressures, commodities did not fare well

I am a bit skeptical that the reason the equity market got clobbered was a realization that inflation was a problem

I still think that inflation risk is underpriced by investors, but the stress in the equity market seems unrelated to commodity prices

 

Investor Risk Aversion:

Our most recent Risk Aversion Index reading returned to the Normal Zone

On a 4 week moving average basis, the reading is still in the Euphoria Zone

Prior weeks readings have been extraordinarily low indicting great investor complacency

 

We expect a risk on/off market in 2018 – Friday might have been the start of more normal risk levels

Chart of the Week:

Inflationary expectations are ratcheting up

Wage growth is the most cited reason, followed by a strong US economy

A weak USD is also at work

 

 

 

What We See This Week:

  • A bit more fear – I see a lot more risk on/off in 2018
  • Further profit taking – I think that investors know that 2017 was a gift from above
  • Taking some money off the table may be a smart move especially given valuation levels
    The money is likely to be deployed in cash, not bonds
  • Continued distaste for bonds as an asset class
  • Some recovery among healthcare stocks in the US – the JP Morgan, Berkshire Hathaway and Amazon venture will take time to crystallize
  • Lots of earnings – big companies reporting( Disney, Gilead, Tesla, Mondelez, GM, Allergan, Humana, Prudential, Cerner, Cummings, …)

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

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DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Migration Patterns in Company Profitability

ROE's Tend to be Pretty Stable

ROE’s Tend to be Pretty Stable

Firm profitability is a characteristic highly sought out by investors in private market transactions.  In public markets firm profitability tends to be frequently lumped together among “quality” factors.

Over the years I have always thought that “quality” is very much in the eye of the beholder while profitability as a concept can be measured in an unambiguous manner and stand on its own feet.

That is why in our stock selection and top-down sector and country allocation models we treat profitability as a separate conceptual category.

After all what more powerful combination can one have for long-term value creation than a company that is growing and doing so in a profitable way.  Some of the best known stocks in the world such as Apple and Google are living proof that a combination of growth and profitability is highly rewarding for long-term investors.

While market-wide ROE’s tend to be pretty stable across time we would expect some variability caused by the business cycle, the degree of leverage in the system, changes in the cost of money and tax rates among others.  The above chart shows the year-to-year median ROE along with points along the 3rd and 1st quartiles.  The average calendar year ROE in our global sample is 11.2 with a standard deviation of 2.1.

The conventional wisdom holds that in a competitive economy it is virtually impossible to remain a highly profitable company over the long-term.

In the case of a frictionless free market system, companies should all gravitate long-term to an economy-wide level of profitability.  The idea is that companies that are currently below a normal level of profitability will restructure and/or change their business strategy thus hopefully improving profitability.  Conversely, companies with above average levels of profitability will face increased competitive forces and revert back over time to a normal level of profitability.

In a free market open economy company profitability will exhibit a mean reverting pattern.  That is in theory. In the real world of partially competitive markets we would still expect to see mean reverting levels of profitability but with a lot more noise. We would also expect to see stronger mean reverting patterns over longer holding periods while in the short-term we would expect to see minimal competitive re-alignment.

In this note we present some high level findings on how Return on Equity (ROE), a common measure of firm profitability, evolves over time. ROE is calculated as Net Income / Shareholder Equity. For some background on what motivated our interest in profitability factors please take a look at a recent video Eric J. Weigel – The Manual of Ideas Interview available on YouTube.

What does the data show in terms of how companies migrate between profitability stages?

ROE MIGRATION MATRIX

Note: Decile 1 contains the highest ROE stocks in our balanced panel global equity sample

Some high level conclusions:

  • ROEs do not fluctuate that much over time and there is a high persistence in relative universe profitability rankings. We call this the “status quo” effect
    • Mean reversion in ROE (estimated over a five year window) is best found in the middle portion (Deciles 4-6) of the profitability spectrum
  • The highest ROE stocks tend to, over the subsequent five years, remain in the higher portions of our sample profitability at a greater rate than expected.
    • Buying a high ROE stock and five years down the road ending up with a company in the bottom end of profitability occurs with a frequency less than expected by pure chance
    • Deciles 2 and 3 appear to be the place for finding companies with high sustainable levels of relative profitability
  • The greatest rate of improvement in relative profitability rankings occurs in Decile 10 comprising those companies with the lowest ROEs, but the rate of improvement fails to beat expectations. Going long Decile 10 stocks is fraught with significant risk of disappointment
  • A contrarian investor investing in low relative ROE stocks such as those in Deciles 7-9 is taking a bet with unfavorable odds of success. The improvement rate of these ROE laggards tends to fall below expectations

As a final note, our view is that stock picking is a multi-dimensional endeavor balancing among others valuation, profitability, and growth concepts.  The behavior of any one factor should always be viewed in the context of the current capital market environment.  Our current view on the attractiveness of stock factors augurs well for favorable returns to stocks with high sustainable levels of company profitability.

To read the full report please click here Migration Patterns In Company Profitability

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

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