DAA review and ARB
Asset class performance
May was a strong month for most risky asset markets. REITs, after a long period of underperformance, have strung together a strong quarter.
In our direct equity portfolios we are neutral REITs, having adding SCP, DXS and VCX over the past year. In our multi-asset funds we’ve narrowed our underweight at the asset class level, targeting G-REITs, although we are waiting for yields to climb a little higher from here before moving overweight.
Note the graph below is log indexed, starting at zero, and can be read as percentage point increases.
State of play
We await US non farm payrolls overnight, and like others in the market have heard of a whisper number closer to 1m. If we get a print of that magnitude, we’d expect to see taper talk accelerate, spreads to tighten, breakevens and yields to lift and for the US dollar to rise.
But, regardless of the outcome, our longer run view continues: a materially higher US 10 year treasury yield, predicated on the eventual success of average inflation targeting, and a stimulus driven return to the pre-COVID, pre-2019 manufacturing mini-recession level.
Overall, we see credit spreads as far too tight and offer little compensation net of expected defaults.
The views outlined above are supported by initial and continuing claims moving in the right direction, released overnight.
With PMIs in particular remaining buoyant (alongside most global PMI prints).
We’ve talked before about our concerns over the US cyclically adjusted PE, which is, well, very high.
And is high even when we use some mathematical fanciness, recognising the 3rd order polynomial relationship between the natural rate of interest, R*, and potential output G, and using estimates of both to deconstruct a PE multiple into its constituent parts (rates, inflation, growth) to strike a “predicted” Shiller PE multiple.
This method takes into account the negative relationship between the level of rates and valuation multiples, and the positive relationship between the change in rates and valuation multiples.
In other words, accounting for lower rates still tells us valuations are high, higher than we should expect them to be.
Simpler methods that relate the real rate of return on stocks as a valuation indicator likewise suggest that both the US and Australia have gotten ahead of themselves.
And equities are, in general, a very crowded trade at the moment.
And is often a good contrarian indicator, pointing to lower returns moving forwards.
The good news is that equity risk premia (ERP, bottom row) in Europe (Germany, France) and the UK are still much more reasonably priced, and we think slowly tilting away from the US makes good sense, on a DAA basis (whilst noting that it will still have a very large allocation simply due to the enormity of US markets).
A short look at ARB, which was held out several times at the recent Morningstar conference.
We like the stock too, but, let’s walk through the following.
Firstly, it is a phenomenal business. Our quant factors (z-score exposures to each factor and sub factor) show strong loadings to growth, a great balance sheet, good momentum, that’s highly profitable.
Profitable businesses with good growth prospects are usually in our strike zone. The only negative appears on the value factor.
The track record of earnings growth has been excellent, and COVID only saw things get better, as people that couldn’t travel internationally, and couldn’t spend on services, chose to upgrade the car, and, travel domestically, in those new cars.
However, it is abundantly clear to us that those earnings are unsustainable.
Valuations suggest those peak earnings are being capitalised into peak multiples…
…which is true of the whole sector, and again suggests it is less of an idiosyncratic story and more of a generalised over-extrapolation of strong retail sales data.
However the most important one, to us, is what’s embedded in the market price. If we extrapolate the market cap out at a 7% annual return for the next 10 years (as a proxy for a market-like return), and divide this future market cap by a mix of different assumed terminal PEs (a historical average, the current PE, and a general market PE of 20x) we get the various paths that earnings will need to grow at.
And in most cases either this path of earnings is wildly unrealistic, or requires growing from the current highly inflated base.
Despite being a wonderful company, at these prices, it is not one for us.
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