Common Denominator: Productivity

Overnight for those of us in the US, India released GDP numbers for Q1.  The numbers showed a disappointing 4.8% year over year increase.  This represents the fifth straight sub-6% GDP quarter.  While this sounds great vs. the 2% to 2.5% numbers posted in recent recovery years in the US, this continues a worrisome trend for a country that many thought a few years ago would outgrow its neighbor and competitor China and close the economic gap between the two.  From 2005 to early 2011, India was posting consistent 9% to 10% year over year GDP numbers (except for the quarters associated with the global financial crisis, which nailed everyone).  Now, technocrats and politicians are scrambling to figure out a way to regain momentum.  4% to 5% growth isn’t going to do much to pull the legions of citizens that remain impoverished into prosperity.  

Meanwhile, all the way across the Atlantic Ocean, another BRIC country, Brazil, is experiencing a similar conundrum.  Several days ago, Brazil posted another somewhat disappointing year over year GDP number of 1.9%.  While this is slightly better than the 1.4% year over year number posted during Q4:2012, it’s still the sixth straight quarter of sub 2% year over year GDP growth.  Like India, two to three years ago, economists, politicians, and investors were looking to Brazil as the next great emerging economic power.  Fast forward and the main Brazilian stock market index is still approximately 20% off its 2010 highs, faith in government leaders is starting to erode, and the central bank just jacked up benchmark interest rates by 50 bps to combat what they perceive to be as a stagflationary situation.

To borrow a line from the movie Blazing Saddles, “What in the Wide, Wide, World of Sports is going on here!?”  

In these countries, a lot of the easy fruit has been picked in terms of unlocking factors to rapidly increase economic growth.  According to study by the Boston Consulting Group, for instance, 74% of Brazil’s economic growth over the past decade was attributable to increases in the labor force size, while only 26% could be attributed to productivity improvements.  The commodity boom over recent years certainly didn’t hurt either.  India experienced a similar dynamic in the early 2000s as the offshoring phenomenon took hold and multinational corporations entered India to take advantage of an untapped pool of labor eager to work and possessing the skills to handle jobs in call centers and other venues, in many cases because of their familiarity with the English language.  

The proverbial slack in the economic rope has been wrung out.  Now the countries must face their stark productivity and efficiency bottlenecks if they hope to compete effectively going forward.  We know from Intro to Macroeconomics that the “natural rate” of growth for a broad economy increases with shifts in the long run aggregate supply curve.  What factors permanently shift a curve?  It all has to do with inputs and/or productivity.  As seen early on in the process in places like Brazil and India, unlocking the availability of inputs such as labor and capital that were previously unavailable or underutilized pushes economic growth.  In these cases, unlocking labor capital seems to have made a big difference early on.  As economies advance, however, general productivity becomes more important.  Countries must educate populations to compete effectively in an increasingly complex world.  Positive technological change increases the productive capacity of the economy.  Infrastructure improvements, such as more efficient ports, efficient transportation networks, and high-speed data networks, help increase productive capacity.  Laws must be improved to reduce the complexity associated with starting and maintaining enterprises.  Rule of law and political stability become important factors.  Opening borders to skilled immigrants and imports can also contribute.

Looking at the Brazilian and Indian economies, these countries have a long way to go to unlock their potential and put growth back on track.  

In Brazil’s case, the aforementioned BCG study mentioned four factors that Brazil must address to improve productivity and hence the ability to advance economic growth.  The first is a “talent shortage.”  Problems with the education system have left the overall population in a poor position relative to other countries in terms of their ability to fill increasingly complex jobs.  A Manpower survey cited by BCG pointed out that Brazil ranked second worldwide in terms of companies’ difficulty finding talented employees.  Second, BCG discusses infrastructure deficiencies.  Roads, bridges, ports, and other infrastructure throughout the country are inadequate making it difficult to move agricultural products, for example, cheaply from farms to ports.  Third, investment as a percentage of GDP is very low relative to other emerging countries.  Brazil’s sub 20% investment figure as a % of GDP stands in stark contrast to China and South Korea where investment comes in at 47% and 27% of GDP (though in fairness, plenty of questions are being raised about the quality of China’s recent investment).  Much of Brazil’s economic growth in recent years has been attributable to consumer spending; as such, the country has seen a large increase in credit/debt, a situation perhaps not too unfamiliar to those of us in western developed countries prior to the financial crisis.  Finally, BCG cites an “Underdeveloped Institutional Framework.”  In other words, doing business in Brazil is complex, costly, and inefficient.  The judicial system is inefficient and snail-paced.  Tax structure is complex.  

India faces problems that are strikingly similar.  While India’s investment as a % of GDP is quite a bit higher than Brazil’s at 30% of GDP, it’s widely acknowledged that India’s infrastructure across the country is woefully inadequate.  Roads are spotty.  Perishable goods routinely rot in storage and never make it to markets.  India’s power infrastructure is creaky.  Last summer, India was crippled by a series of power blackouts which affected over 600 million people across the country.  According to most anecdotes, these represented the largest blackouts in history.  Labor productivity in India is far behind many developed and developing countries.  Another BCG study on India shows that manufacturing as a % of GDP has remained around 15% of GDP more or less for the past 20 years, mostly due to low labor productivity.  Manufacturing as a percentage of GDP is lower than all other BRICS countries, and lower than nearly all of the major developed economic powerhouses.  Labor productivity is the lowest among all the BRICS nations, and growing at the slowest pace.  While India’s top engineering schools produce world-class students, overall the Indian educational system has proved incapable of producing the quality talent required to meet demand.  The caste system, unique to India, also plays a role in this phenomenon.  Finally, India’s fragmented and notoriously “messy” democratic government has proven a major hindrance to growth in productivity.  Introduction of crucial reforms is consistently a three steps forward, two steps back proposition.  The back and forth in recent years over opening the country to external retail competition is a perfect example of the complex interaction between what’s best for the country economically and what’s best politically for the top parties and politicians. 

Not all is doom and gloom.  Many in these countries realize these problems are out there and are keen on addressing them.  Until the problems are addressed, however, through comprehensive national political programs, India and Brazil are going to continue to underwhelm on the economic growth front.  As it stands now, it’s not surprising that markets have remained flat to down over the past three years in these two countries, and that emerging market stock indices, dominated by companies in the BRIC nations, have been underperforming significantly of late.

Long Term Valuation Update

It’s been a few months since we’ve provided a valuation update for various global indices.  In past updates, we’ve stuck exclusively to longer-term 10-year Shiller P/E levels.  In this update, we’ve added two other fundamental valuation metrics to provide some additional color: trailing EV/EBITDA and Price to Book.  Across the board, the numbers generally come to the same conclusion: US and Japanese markets in the developed world, and India in the emerging world, are currently trading rich to the broader EAFE and emerging market indices.  As we’ve warned in the past, keep in mind that longer-term valuation metrics such as these aren’t necessarily good short or intermediate term timing indicators, but have provided strong, statistically significant long-term returns predictions.  

Let’s start with Shiller CAPE P/Es using earnings and index data provided by Bloomberg:

Source: Bloomberg

Nearly all major European indices are currently trading below longer-term averages.  Of course, Europe has been stuck in recession for several quarters and has experienced several major market hiccups over the past three years, all factors serving to compress market multiples.  If Europe can continue to slowly rebuild market confidence and stabilize its broader economic situation, there is the opportunity for decent long-term outperformance in European markets relative to developed Asian or US markets, especially in the periphery countries (and France).  Speaking of developed Asia, Japan with its massive rally over the past six months has leaped to the top of this valuation table, as well as the other valuation tables we’ll present below.  Certainly, economic prospects and confidence have brightened in Japan in recent months as fiscal and monetary authorities have finally taken an aggressive and consistent approach to solving growth woes; however, markets seem to have gotten ahead of themselves.  This week’s volatility in Japanese markets may be an early sign that markets are due for some consolidation.  Finally, emerging markets are trading at a discount to the EAFE and US markets.  India, however, stands out as particularly overvalued relative to nearly all developed and emerging equity markets, despite the fact that India’s SENSEX index has traded in a range for the past five years.  Russia, on the other hand, remains among the “cheapest” of the emerging market indices, occupying a space near the battered European periphery economies.  Russia has resided in the cheap realm for several years.  Multiples remain compressed as investors believe the Russian government and Russian business entities remain hostile towards shareholder interests.  

On a Price to Book basis, the valuation situation described above remains roughly the same, though Europe has flipped positions with the All Country Asia index.  Still, we see the European periphery countries, plus Russia, occupying the low valuation spots (Greece, Russia, and Italy are trading below book value) while the US, Japan, and India occupy higher spots than the broader indices.  Australia creeps up the list here as well.    

Source: Bloomberg

On an Enterprise Value to EBITDA basis, we see a similar layout to the tables above, though the US comes out a little bit better than it does with the other metrics:

Source: Bloomberg

Considering there are some differences in position among the three metrics, we decided to average the rank for each country across P/E, P/B, and EV/EBITDA.  Simply, the lower average ranks represent higher relative valuation positions.  Here are the results:

Source: Bloomberg

Again, India, Japan, and the US occupy the most expensive spots when it comes to relative valuation.  When all is said and done, Australia also appears to trade at a decent premium to other markets.  Germany and the UK trade at a premium to their European cohorts.  Asia in general trades at a premium to broader European indices.  

All in all, we continue to believe that overseas developed and emerging markets will outperform US markets over the next decade, though in the emerging markets complex it might benefit investors to look at emerging markets outside of the BRIC countries, which (except for Russia) are trading at premiums to other indices.  India’s markets seem particularly vulnerable in coming years considering it comes out as the most expensive and the broader economy has shown a disconcerting inability to grow to potential in the face of a sclerotic political system, infrastructure issues, and other inefficiencies.  

Active Share

In a 2009 paper, two professors at the Yale School of Management, Martijn Cremers and Antti Petajisto, introduced a new way to evaluate mutual funds/asset managers and the potential for future outperformance.  Their metric, called “Active Share”, helped provide another framework to evaluate alpha-generation potential and provided an interesting contribution to the age-old debate within investment management circles concerning “concentrated” vs. “closet indexing” funds and active vs. passive management in general.  

What exactly is Active Share?  The concept behind the formula they created is incredibly simple.  In essence, the formula, which sums the absolute differences in weights between the positions in a portfolio and the positions in the benchmark and divides that number by two, shows the overlap between a portfolio and its benchmark in terms of position weightings.  The professors measure active share on a scale between 0% and 100%.  A fund/portfolio demonstrating an active share of 90%, for instance, only demonstrates 10% overlap with its relevant benchmark, i.e. the managers of the portfolio have taken a very active approach.  An active share of 10% indicates 90% overlap; one would find this level of active share in an index fund, for instance.  

Taking the active share formula, the professors identified five categories of managers based upon their level of active share and the level of tracking error, which is basically the “divergence between the price behavior of a portfolio and the price behavior of a benchmark” over time, according to Investopedia.  (Specifically, tracking error is the standard deviation of the differences in returns (monthly, quarterly, yearly, but usually monthly) between the fund and benchmark.) 

• Diversified/Active Stock Pickers: defined as those with high active share and low tracking error.  In other words, there are numerous stocks in the portfolio, which reduces tracking error, but little overlap with a benchmark in terms of holdings/weighting.
• Concentrated Stock Pickers: defined as those with high active share and high tracking error.  The concentrated stock pickers have far fewer positions and little overlap with the relevant index.
• Factor Timing: these managers focus more on general market factor bets, such as timing the broader market or making broad bets on sector rotation.  They demonstrate low active share but high tracking error.  Performance can deviate wildly from an index as they make bigger macro-market directional bets.
• Closet indexers: these funds demonstrate low to middling active share, generally between 40% and 60%, and low tracking error.
• Index funds: essentially an index fund demonstrates nearly zero active share and miniscule tracking error.  

Their findings on outperformance and underperformance as it relates to the above are quite interesting.  Analyzing a broad database of funds from 1990 to 2003, they found that the high active share funds (exceeding 80%) produced annual outperformance after fees of 1.13% to 1.15%.  Funds falling in the lower active share categories underperformed 1.42% to 1.83% per annum when fees are taken into account.  Interestingly, the Factor Timing funds, those that tend to take bets on market direction on sector rotation, produced the worst outcomes among the low active share bunch and the worst outcomes overall.  

In a follow up paper that added six years to the database, covering the period through the financial crisis, Professor Petajisto provides additional granularity to the outperformance/underperformance debate.  The results are very interesting, especially in light of the debate between concentrated and diversified funds.  First, overall, high active share funds, concentrated and diversified, again were the winners relative to the other categories when viewed in terms of performance relative to benchmark, net of fees.  However, in the follow up study there was only one category of funds that exhibited absolute annual outperformance net of fees: the diversified stock pickers’ category.  Diversified stock pickers generated +1.26% annualized performance over time relative to benchmarks.  This outperformance occurred within all five quintiles of fund size performance as well.  Concentrated funds with a high active share overall produced -0.25% annualized returns relative to benchmarks, though there were differences across fund size quintiles.  Concentrated funds in the middle three size quintiles exhibited positive performance net of fees relative to benchmarks; performance was still lower than that of the high active share diversified stock pickers in the middle three quintiles.  Funds making factor bets were the worst overall, confirming the data in the original paper; factor bet funds produced annual net relative performance of -1.29%.  Similarly, closet indexing funds produced negative net relative performance of -0.92% per annum; basically, the closet indexing firms match the benchmark in gross performance, with nearly all the negative difference attributed to fees.

Going back to the original paper from 2006, there were some interesting findings on the migration of funds from high active share to closet indexing.    From 1980 to 2003, the assets under management held in high active share funds decreased from 58% to 28% while assets held in low active share funds increased from 1.5% to 40.7%.  In other words, over the past few decades, closet indexing has become much more prevalent in the asset management arena, perhaps an explanation for the disappointment many investors have experienced with mutual funds in recent years.  

Like all studies, there is divergence within each category.  There are certainly high active share, diversified managers that underperform and factor bet managers that outperform over long periods of time.  Another issue that complicates active share analysis is the fact that fund holding and benchmark holding data can be hard to come by for many individuals and professionals.  

Nonetheless, the results suggest that investors in general should seek out funds and managers with very high active share (less overlap with the benchmark), who also exhibit lower tracking error.  Highly concentrated firms can deliver outperformance, but the results overall don’t appear as consistent overall.  

Sources:

Cremers, Martijn, and Antti Petajisto.  September 2009.  “How active is your fund manager? A new measure that predicts performance.”  Review of Financial Studies.

Kidd, Deborah.  2013.  “Active Share Adds Value In Search for Alpha.”  CFA Institute Investment Risk and Performance Newsletter.

Investopedia.com.  February 26, 2009.  “Active Share Measures Active Management.” http://www.investopedia.com/articles/mutualfund/07/active-share.asp

Petajisto, Antti.  January 15, 2013.  “Active Share and Mutual Fund Performance.”  Working Paper, New York University Department of Finance. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1685942

The Pain Trade

Equity markets, or markets in anything for that matter, have a manner of moving in such a direction as to maximize the number of fools and the level of frustration among the population of investors.  The “pain trade” is real and it’s been in full effect since last fall.  Markets are melting up again this morning on a reasonably decent employment number in the US, pushing the S&P 500 further into new high territory and eliciting cries of, “Why!” or “What’s so good about these numbers??  The economy stinks!”  or “But, but, the market is massively overvalued!” or “This earnings season have been terrible!”  The reactions are valid to a certain extent.  A 165K non-farm payrolls handle combined with 7.5% unemployment would have generated unimaginable amounts of hand-wringing during an economic boom period like the 1990s if there were some way to transport Twitter and blogs and today’s mass media back to that era.  Nominal GDP in the US is running at a 3.5% to 4.0% clip, very weak by historical standards.  Real GDP in America is barely above stall speed.  Europe remains in recessionary limbo.  China’s GDP is slowing and leaders there are spending time how to navigate a very tricky transition from a capital intensive manufacturing economy to one more services oriented.  Long-term P/E ratios, as we’ve discussed in our chartbook and other blog posts, are significantly stretched in the US and near to slightly above historical median levels in overseas markets.  Based on Bloomberg’s data, this revenue is flat to down year over year for the S&P 500 companies that have reported; earnings growth is barely above zero.  Reading the financial press can be a heartburn inducing exercise.

But, and this is an important “but”, fundamentals are only one part of a story over the short and intermediate term.  Over the long-term or very long-term, fundamentals usually win.  John Maynard Keynes, however, famously pointed out two truths: “In the long run, we are all dead,“ and “The market can stay irrational longer than you can stay solvent.”  Other factors figure prominently in market action.  Liquidity, sentiment, psychology, central bank action, geopolitics, perception, and many more factors are a part of the brew.  We are witnessing this now.  On the sentiment and psychological front, we pointed out two weeks ago that individual investor equity market sentiment figures in the US remained near levels seen at bear market bottoms even though the S&P 500 was probing new highs.  It’s improved slightly since then, but remains in negative territory.  We observed that this was probably an indication that individual and institutional investors are significantly underexposed to equities relative to historical precedent.  Anecdotal evidence backs us up on this.  While flows have improved this year, many billions of dollars have exited equity funds over the past several years, flowing into fixed income and money market products.  Granted, equity ETFs captured a bunch of the flow as well; nonetheless, according to Leuthold Weeden, from 2007 to approximately the end of Q3:2012, ETF inflow combined with equity mutual fund outflow netted to negative $150 billion.  Pension funds and other institutional investment vehicles have exposures to equities now that fall far below levels seen over the past two or three decades.  The pessimism continues, too.  As the Financial Times reported a few weeks ago, “UK Pension Funds reject ‘cult of equity.’”  According to the article, 41% of UK pensions expect to reduce their exposure to UK equities in the next 12 months while 28% plan on reducing their exposure to global equities.  Using data from Pensions & Investments, corporate pension funds equity exposure in the US is at the lowest levels witnessed over the past three decades.  From 1984 to 1994, exposure averaged about 52%.  This increased to near 64% from 1995 to 2000.  The initial stages of the secular bear dented this somewhat, but not much; equity exposures in the period leading up to the 2008 crisis were just south of 60%.  Currently, equity exposures are in the mid-40s range.  Fixed income has swallowed up a good portion of the asset allocation flows.  In a world of 2% yields and underfunded pensions, this has to be a nailbiting period for many institutional managers.  

It’s times like these with markets grinding higher and individuals and institutions underinvested that irrational, performance-chasing behavior can really catch a spark.  We’re not making a prediction that markets are going to go on a parabolic upward rampage here, nor are we saying that we’re about to embark on a 1990s like run with near 20% annualized returns.  On the contrary, we’re still a bit cautious about annualized returns over the next 10 or 15 years relative to the historical record.  Momentum is important, though, and tends to push counter intuitively against the herd, at least in the early to middle stages of a cyclical or secular bull market.  Cracks appear in the damn.  Eventually, institutional managers and individual investors say, “Darn it, I can’t take it anymore, I’m all in!”  Unfortunately, these timing decisions prove regrettable.  Again, as shown above, exposures to equities and sentiment reached their highest levels just before the 2000 and 2007 peaks.  The opposite was true in 2002 and 2009.  Interestingly, disbelief remains rampant today, even after a few years of decent returns, especially in the US.  To reiterate, this could be the kindling that keeps markets grinding higher, contradicting the news flow, and confounding many.  

There are a few quick lessons to draw from the global equity rally over recent quarters:

• Market performance and news flow are almost always disconnected.  Just because headlines scream, “Out! Out! Out!” doesn’t mean markets are ready for the fall.  The opposite is true.  Positive news flow on the new economy, for instance, reached a peak in 1999 and early 2000, just before markets began a secular bear journey.  Memories dim—with 20/20 hindsight, many say they definitely saw the late 2008 collapse coming--but news flow remained sanguine in early to mid-2008 with talk that subprime was “contained” and that the economy was still on track.  The September/October 2008 swoon caught almost all investors completely off guard.  Even the Fed remained optimistic through summer 2008 based on a reading of the Open Market Committee minutes.  Thus, “What Wall St. knows ain’t worth knowing.”  Many experiencing market upside pain now have spent more time worried about backward-looking headlines, and less time understanding Mr. Market.
• It’s helpful to combined technical trading rules with a fundamentals-based investment style.  In a world like the present, with fundamental valuation indicators showing overvaluation, but markets moving higher, a technical sensibility could keep you participating in a trending up market.  Past episodes have shown that poor fundamental environments (such as 2000) combined with a technical breakdown lead to very poor outcomes.  Trading rules can help pull exposures down before the real mess begins.  Similarly, in a situation with a decent valuation environment but a declining market, sensible technical trading rules can keep one out of the market until the clouds lift.  It doesn’t always help.  Some of the whipsaws surrounding the European debt crisis have been painful.  However, the point is to recognize and capture (or avoid) the really big moves.  Bottom line, during larger secular/cyclical moves, injecting a technical sensibility can keep investors out of the pain trade trap.