How to find dividends during the COVID-19 recession and its aftermath.

There remains much uncertainty regarding the depth, breadth and length of the COVID-19 recession. For example, the Global Economic Policy Uncertainty Index (compiled by academics from Stanford, Chicago, and Northwestern) stands at a record high and almost twice its level during the global financial crisis (GFC).

Bill Priest, CFA, Executive Chairman, co-CIO and portfolio manager at Epoch Investment Partners, discusses the challenges this presents for investors, including understanding how corporate dividend and buyback policies are likely to change during the COVID-19 recession and its aftermath.

One thing we can be certain of is that companies will be tightening their wallets. It appears that EPS growth for the S&P 500 is likely to decline by something in the range of 20% to 35% this year. Earnings visibility is always poor in the midst of a recession and currently the dispersion among consensus estimates is close to the record high set during the GFC.

Regardless of the lack of clarity, it seems the nadir will probably occur in the second quarter, with profits down roughly 100% year-over-year (the 1 standard deviation band around this estimate is uncommonly wide). This is an eye-popping number that would have been all but unimaginable even two months ago.

For context, S&P EPS typically declines by about 20% peak-to-trough during recessions (but was down 45% in the case of the GFC, the worst outcome since the 1930s). While the descent is usually swift and steep, it normally takes two to three years for earnings to climb back to the prior peak. That appears to be a reasonable assumption for this cycle as well, given that we expect a swoosh-shaped recovery (rather than the V optimistically assumed by many forecasters).

Over the long-term, US EPS and DPS (dividends per share) are tied at the hip (they’ve been 97% correlated since 1871), but during recessions, dividends typically decline by only one-third as much as earnings. We expect this recession to be a bit different, with dividends falling by around 25%; that is, roughly one-to-one with earnings.

The consensus sees a small rebound in 2021, with dividend growth averaging 3% to 5% for the remainder of the decade (in line with earnings). This suggests  a somewhat slower recovery than is historically the norm. In previous recessions, dividends normally took 6 to 8 quarters to recover from the trough to the prior high. This time around 12 to 16 quarters strikes us as a more reasonable assumption, reflecting the swoosh-shaped recovery we foresee in earnings. Regardless, since at least 1980, dividend yields have increased during every downturn (Figure 1).

While 2020 is likely not a repeat of 2008 for earnings in the US, it might be for buybacks, which act as an important shock absorber for many sectors. Share repurchases totalled $750 billion last year, but appear set to decline by around 50% this year, followed by a smaller dip in 2021 and then a rebound to trend. This is roughly consistent with the 8-quarter, 67% peak- to-trough decline experienced during the GFC.

Leading the charge have been banks, with America’s eight largest announcing on 15 March that they would suspend buybacks through at least July. While their action on share repurchases was appropriately fast and furious, the big banks have defended their plans to continue paying dividends, unless “an extremely adverse scenario” unfolds. This stance has attracted substantial controversy, partially because banks were central to the financial crisis of 2008 and are still viewed with some suspicion.

Many pundits argue that this time US banks must grasp the opportunity to ensure they are not only part of the solution but are seen to be so. To make the optics even more contentious for domestic lenders, on March 27 the ECB issued its “recommendation” that, at least until 1 October 2020, European banks refrain from both dividends and share buybacks. Similarly, on 1 April, the UK regulator “advised” all major UK banks to suspend dividends and buybacks until the end of 2020.

A final factor weighing on US dividends this year is  government restrictions related to the Coronavirus Aid, Relief and Economic Security Act (CARES). CARES stipulates that any company that borrows money from the federal government may not pay a dividend or repurchase stock until 12 months after the loan is repaid in full. The bill explicitly provisions assistance for airlines, air cargo and aerospace companies, but any company receiving assistance from the Treasury will also be subject to these restrictions.

Turning to Europe, we expect EPS to fall by 30% to 50% in 2020. This is moderately worse than what appears likely for the US, but similar in severity to the continent’s experience during the GFC. Regarding dividends, the consensus foresees a decline of 25% to 50% in 2020, with the wide range being indicative of the acute degree of uncertainty. For example, the lower bound would be hit if bank and energy dividends declined toward zero, while other sectors experienced falls similar to the GFC.

Additionally, and comparable to the US, all major European countries have made access to state financial support this year conditional on companies scrapping dividend payments.

Across the channel, hefty exposure to energy and financials suggest the UK dividend base looks especially vulnerable. According to the Link Group’s UK Dividend Monitor, dividends could decline by 27% to 53% in 2020. However, it also predicts “classic defensive sectors,” such as food retailers, health care and basic consumer goods, will continue paying their dividends.

This too shall pass

The above discussion largely concerns our outlook for the next year or two. Beyond the short-to-medium term, though, we believe the drivers that have led to strong dividend payouts over the last two decades should remain intact.

First, as emphasized in our “Tech Is the New Macro” discussions, the shift from atoms to bits, or asset-heavy to asset-lite business models (more tech and health care and less capital-intensive cyclicals) is, if anything, accelerating. As our DuPont RoE decomposition has demonstrated, this implies higher profit margins and lower capital requirement, freeing up a higher proportion of cash to be distributed to shareholders.

Second, rates are likely to stay lower for even longer, which incentivises companies to maintain lean balance sheets and return excess cash earnings to shareholders. This is consistent with QE’s raison d’etre, which is to discourage holding cash (by investors, corporates or households) in favour of opportunities further out on the risk curve.

Third, if buybacks continue to be vilified by the press and some politicians, then S&P 500 companies could opt for boosting dividends. Total shareholder yield has averaged well over 4% for decades, and we don’t see it declining materially during the 2020s.

Further, we have been in a world of yield starvation for well over a decade now. Bond yields had been driven lower by demographic challenges, benign inflation (reflecting the digitisation of the economy), hyper aggressive central banks and elevated policy uncertainty. With COVID-19, bond yields plummeted yet again to new record lows. We expect this interest rate environment, characterised by sub-2% GDP growth and large government deficits, to persist for many years to come.

The Economist forecasts global payouts to shareholders (dividends and buybacks) to decline by a thumping 36% in 2020. Moreover, the historical experience suggests that, post-recession, a swoosh-shaped recovery is most likely. Further, in previous recessions dividend yields and dividend payout ratios almost always increased, as DPS declined by less than both EPS and market cap.

Although this cycle might be somewhat different, with dividends declining  by roughly the same percentage as earnings, we expect the yield available from equities to remain far superior to that attainable in fixed income markets (Figure 2). And as dividends recover from 2021 onward, it is possible that this gap will expand even further.

In summary: companies will not abandon sound capital allocation policies

• Sustainable growth for any nation requires the efficient allocation of “land, labour, and capital” (the factors of production in economic terminology) among all possible uses. With respect to capital allocation within a business, there are two choices: return excess capital (free cash flow) generated by the business to the business owners or reinvest that capital into the business in order to grow the business.
• Businesses should always reinvest operating cash flow if they can generate a return on investment above their cost of capital. Similarly, businesses should return capital to their owners via dividends if they cannot generate a return equal to their cost of capital. Dividends matter not only for the income paid to shareholders; they are also a conduit for capital to flow where it can be deployed most efficiently.
• Do desperate times call for desperate measures? Many current articles call for comprehensive suspension of dividends and share repurchases. During COVID-19 induced recession, many businesses will cut dividends and buybacks. Those businesses receiving government assistance should not return capital by any means to their shareholders.
• However, there are many firms that possess solid balance sheets and resilient business models and are reassuring investors today of their capital allocation policies. They occur across sectors and within sectors.
• It is important to note that dividends exhibit greater stability than earnings in downturns and have been remarkably stable for decades. This will not change in our view.
• Reports of the death of the dividend have been greatly exaggerated: this is a challenging period, but like previous recession, it will not lead to companies to abandon sound capital allocation policies.
• Businesses run on cash flow and the most successful businesses make wise capital allocations – investing only when a premium over their cost of capital can be earned and returning excess cash flow to investors via dividends when that condition does not exist. Abandoning this policy will ultimately lead to reduced innovation, an increased number of zombie companies, and less wealth for future generations.

As a result of the above points, we believe the companies best positioned for this challenging environment are those that have a demonstrated ability to produce sustainable free cash flow and allocate that cash flow effectively between return of capital options and reinvestment/acquisition opportunities.

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Important information: The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2019 Epoch Investment Partners, Inc.

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The first cold war ended in November 1989 – the new cold war – 2.0 – is occurring between the US and China.

Bill Priest, CEO, co-CIO and portfolio manager of Epoch Investment Partners (Epoch) recently visited Australia to share Epoch’s world view with financial advisers and in particular, the potential impact of Cold War 2.0 on investment markets.

In this article, GSFM shares Bill’s insights, gleaned from an investment career spanning more than 45 years, and discusses how advisers can find the elusive yield in this environment.

There’s a wall of worry facing investors world-wide. Is a recession looming or ‘just’ a slowdown? How will the US-China trade war impact the global economy and what does elevated political uncertainty mean for markets? How will issues such as the continued rise of populism, Brexit or issues in the Middle East impact domestic and global markets?

Cold War 2.0

The first cold war ended in November 1989 – thirty years ago – with the fall of the Berlin wall. The new cold war – 2.0 – is occurring between the US and China. The platform is trade and technology is a key part of it.

Although recent trade negotiations between the US and China produced a welcome truce, coupled with expressions of goodwill to tackle the tougher issues later, it’s likely to be a temporary cease fire. China has violated more World Trade Organisation (WTO) regulations than any other country that’s ever signed up to the WTO – this isn’t likely to end for some time and is feeding the prevailing uncertainty across global markets. Most of the big disputes are unlikely to be resolved before November 2020 (the next US election) or, for that matter, the 2024 election.

The contentious issue of intellectual property (IP) theft helps illustrate why this is the case.

According to the US Trade Representative, Robert Lighthizer, China is close to agreeing to adopt normal best practices for IP, including criminal enforcement of violations with sufficiently stiff penalties. Apparently he believes this is the case because China has produced enough sophisticated technology on its own that safeguarding IP is now in its national interests.

The problem is that Lighthizer himself has repeatedly lamented that China has made false promises to respect IP on countless occasions. Moreover, China’s own government is highly active in stealing IP and industrial espionage. In fact, economic espionage has become a prime directive of the Ministry of State Security (MSS), and the FBI has estimated that 3,000 Chinese companies in the US are covers for MSS activity. Therefore, Epoch believes China’s pledge to tighten IP protection is unlikely to amount to more than window dressing.

It should be clear to everyone by now that this is not just a trade war; indeed, several recent disputes have made it manifestly clear that the clashes between the US and China are much bigger than trade or even tech.

On October 5, Daryl Morey, the general manager of the NBA’s Houston Rockets, ignited a furore in China with a seven-word tweet: “Fight for freedom. Stand with Hong Kong.” Chinese nationalists angrily asserted that Morey was challenging China’s sovereignty over Hong Kong. Chinese broadcasters quickly announced they would not air Rockets games and retail outlets stopped selling Rockets gear. Because China is by far the NBA’s most important international market, NBA executives quickly distanced themselves from the perceived offense.

As The Economist has emphasised, self-censoring to make money in China is a long-standing business practice. The most obvious example is Hollywood, where studios steer clear of any topics that might offend the Chinese Communist Party (CCP). But virtually all foreign businesses operating in China have long self-censored in a more subtle, pernicious way: by never speaking publicly about any issue the CCP deems off-limits (including the three Ts — Taiwan, Tibet and Tiananmen).

China’s fierce reaction to Morey’s tweet is certain to induce more self-censorship by executives in the future.

Since the fall of the Berlin Wall, America’s approach to China has been founded on a belief in convergence. The prevailing view was that integration into the global economy would not just make China wealthier, it would also make it more open, tolerant, democratic and market-oriented. Today, however, dreams of convergence are dead. America has come to see China as a strategic rival—a malevolent actor and duplicitous rule-breaker. How did that happen?

One key catalyst was President Xi’s ascension in 2012. During “the new era” he has exalted and entrenched the state’s leading role in the command economy. He has also developed a sophisticated surveillance state to stifle dissent and tighten the authoritarian screws, squashing delusions of China morphing into a free and open society. Further, its Belt and Road Initiative made it plain that China has no interest in embracing the American-led global order. Rather, it is seeking to radically overhaul it.

Trade is the battle, tech is the war

In addition to the cascading collapse of the Soviet state, something else happened in 1989, and that was Tiananmen Square. With that tragedy a different kind of threat emerged, although its true extent has only become fully appreciated during the last couple years. This realisation has marked the beginning of this new Cold War, one that requires quite a different type of containment policy than the first.

Although Cold War 2.0 is not likely to become a hot war, the stakes are just as important. And the stakes are values, as represented by the US Bill of Rights, which guarantees civil rights and individual liberties — including freedom of speech, press, and religion. It also sets rules for the due process of law, and places clear limitations on the government’s power in judicial and other proceedings. In addition, democratic institutions and comparatively free markets have been key to the vibrancy and success of the US experiment.

However, these values are anathema to China’s autocrats. The CCP under President Xi wields power that is unbounded and unchallenged, without the checks and balances provided by an independent judiciary, autonomous media, free and fair elections, and constitutionally guaranteed rights for individuals and society. In China, the law is best viewed as a spear rather than a shield. And not only has state and bureaucratic power become even more centralised since 2012, but markets are increasingly taking a secondary role to the whims and commands of the CCP.

While China’s political system is for it to choose, it is conspicuously evident that the two superpowers possess vastly different values, economic systems and visions for the global economy. This is why Cold War 2.0 has become a defining reality, and not just for the next couple years, but likely for decades to come. And, at least initially, trade is the platform on which this war will be waged.

Moreover, almost all measures of global integration (including merchandise trade, foreign direct investment and the activities of multinational corporations) are already in retreat or stagnating. In fact, these metrics have been in trouble for the good part of a decade now. This regrettable trend is negative for overall economic efficiency and growth, as well as margins and profits, which raises several challenges for investors.

With the advent of Cold War 2.0, global economic policy uncertainty (figure one) has skyrocketed to a record high (the data-series inception was 1997). This has led to slower global growth, which has resulted in today’s hyperactive central banks riding fast and furious to the rescue.

Three key issues will continue to dominate from the US perspective; market access, IP protection and opaque industrial subsidies. The Chinese government fears containment and has stressed it will not compromise its values. As well as risk surrounding trade, the Cold War 2.0 brings increasing risk of a currency war, which could include restrictions on investment and capital flows.

Capital markets outlook

On the upside, the team at Epoch is not anticipating a global recession. Mixed signals abound, pointing to challenging times ahead. While some economies (such as Germany) may fall into recession, it’s unlikely to be experienced globally.

The US manufacturing index (ISM) suggests manufacturing has declined since the onset of the Cold War 2.0, but that’s only part of the story. The non-ISM (non-manufacturing industries) numbers are more solid (figure two). At the same time, Germany’s business climate index the IFO, a closely followed leading indicator for economic activity, is close to its lowest level since November 2012.

A recession is defined as two consecutive quarters of negative GDP. Negative GDP is comprised of two things: growth in the workforce and growth in productivity. In the US, while productivity growth might be weak, the workforce is still growing – therefore recession in US is unlikely.

Capital expenditure and export growth have both been negatively impacted by the Cold War 2.0. Profit margins for the S&P500 were flat from the 1950s to 1989 – then it took off, at the end of the first cold war. This was when China came into the ‘world’ and the global labour force grew by over one billion people. China brought no money or technology, but a giant labour arbitrage opportunity – this is now coming to an end.

Trade war consequences

There are two significant consequences of the trade war – the end of margin expansion and the end of price discovery.

Margin expansion

Globalisation has faltered. For the three decades following 1989, large and sustained increases in the cross-border flow of goods, services, capital, ideas and people were the most important factor in world affairs. However, today most measures of global integration are in retreat or stagnating.

Manufacturing margins were flat for decades at around 6 percent, but they have doubled since 2000, with four factors explaining most of the expansion (figure 4): labour arbitrage derived from China entering the WTO, the evolution of complex and highly efficient global supply chains, lower corporate tax rates and declining interest rates. While lower taxes may be here to stay, the other three are reversing direction, in large part due to rising trade tensions and the transition to QT. Therefore, Epoch expects profit margins to struggle and market multiples to fall or at best remain flat.

Price discovery is the mechanism by which competing buyers and sellers determine the price of a security. Cold War 2.0 has resulted in slower growth, which, in turn, results in lower interest rates, cheap money and falling bond yields (figure five). The US Federal Reserve is likely to lower rates at least another two times and the European Central Bank (ECB) is talking about it. This is a particular issue for the fixed income market.

Every single German bond has a negative yield today; if you have mortgage debt in Denmark, most are negative – in other words, you’re being paid to stay in your own home. An interest rate environment like this destroys price discovery.

Capitalism doesn’t work without a mechanism that allows competition within prices, so the potential impacts on markets is significant. The disappearance of price discovery is exacerbated by ‘hyperactive’ central banks trying to manage the economy in a way that might ease the trouble in the shorter term but will undoubtedly lead to volatility in the longer term.

The hunt for yield

Although bond yields have been driven lower by record high policy uncertainty, the late-cycle slowdown and hyper-aggressive central banks, dividends and buybacks remain robust, partially reflecting a capital-lite world. As a result, the yield available from equities can be far superior to that currently available in fixed income markets.

For example:

• US SPX: Dividend yield of 2.0% + buyback* yield 3.3%
• Europe SXXP: Dividend yield of 3.8% + buyback* yield 1.1%
• Japan TPX: Dividend yield of 2.5% + buyback* yield 1.2%

*Buyback yield = value of shares repurchased divided by market capitalisation

Source: Bloomberg, Yardeni, Goldman

There are three ways to make money from equities: the dividends, the change in earnings and the change in the P/E multiple. As illustrated in figure six, rolling 10-year return for the S&P 500 Index has broken down between those three components going back to the 1930s. You can see that dividends have been a positive contributor in every 10-year time period, and earnings have contributed positively in all but five of the eighty-two rolling 10-year periods.

You may also note that the contribution from dividends seems to have decreased starting in the early 1990s. That is due to the fact that regulatory changes ten years earlier made share buybacks an attractive (and tax-efficient) alternative to cash dividends, and companies began to make increasing use of this additional method for returning cash to shareholders.

Because buybacks reduce the outstanding share count, they tend to drive up earnings per share, so some of what used to show up in this analysis as the contribution of dividends has been transferred to the earnings contribution.

The confluence of Cold War 2.0 and technology has reduced capex expenditure; this makes tech inherently deflationary and helps to explain why we find ourselves entrenched in a ‘lower for longer’ interest rate environment. Indeed, pervasive digital technologies and their associated economies of scale imply that we are living in a disinflationary, capital-light world.

This implies that, with less cash flow being directed to fund capex, payout ratios are likely to remain high and may even rise further from here. So, even as bond yields have plummeted, stranding us in a world of yield starvation, we expect dividends and buybacks to remain robust. As a result, the yield available from equities can be far superior to that available in fixed income markets.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2019 Epoch Investment Partners, Inc.

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Regardless of geography or sector, investors should focus on companies that have an ability to produce FCF on a sustainable basis and possess superior management with a proven track record.

The current hype about two-sided digital platforms, blitzscaling and winner-takes-most markets has fuelled a surge in IPO listings. It is perhaps unsurprising that this exuberance, especially when combined with inordinate liquidity, record levels of VC activity and multiple fundraising rounds, has often produced stratospheric valuations that are difficult to reconcile with free-cash-flow (FCF) fundamentals.

As discussed in this paper from Epoch Investment Partners, penned by CEO and co-CIO Bill Priest and Managing Director of Global Portfolio Management Kevin Hebner, a growing number of commentators suggest we are repeating the excesses of the dot-com boom – are the unequivocal bears right?

One consequence of the high valuations is that there are now over 360 unicorns* globally, with most in tech-related sectors. Given the soaring number of IPOs, it would seem reasonable to expect this list to be shrinking. However, just the opposite is occurring as the pace of business model innovation is intensifying, ensuring an escalating number of promising start-ups. To illustrate, last year delivered a sizeable herd of new unicorns, 96 according to PitchBook, with 2019 on pace to surpass that number and set a new record.

As a result, a rising tide of doomsayers have warned that we are repeating the excesses of the dot-com boom, citing several specific developments to support their alarmist view. For a start, nominal IPO supply is on track to set an all-time high in 2019, finally surpassing the record set in 1999 (Figure 1).

*Unicorn: A start-up, private company, typically in a tech-related sector, valued at over $1 billion. They have been dubbed “unicorns” because, in many cases, their billion-dollar valuations are thought to be purely mythical.

Silicon Valley has become all about applying its magic formula, all bankrolled by slabs of VC money, to as many sectors as possible. However, one must question whether this model of growth at almost any cost is actually magical, allowing investors to take home previously buried pots of gold, or just mythical, like the much sought after, but illusive, unicorn of lore. This is especially a concern given that the clear majority of IPOs are loss-making. In fact, 81% of recent IPOs are for unprofitable firms, a proportion that ties the record set two decades ago (Figure 2). This is a particular concern for tech IPOs where only 15% of firms are profitable and, in some cases, like Lyft and Uber, the pathway to profitability is anything but clear.

Further, VCs now back almost 80% of tech IPOs, up dramatically from the 1980-2010 average of 57%. Reflecting this trend, last year was a banner year for VC investments into start-ups, with 2019 expected to be just slightly lower.

Similar to the tech bubble, VC exit activity is soaring, setting records for the dollar amounts cashed out. According to PitchBook, 2018 set a record of US$126 billion in total exit value for VCs. With a host of major listings still on the horizon, it is all but assured that total VC exit values will smash this record in 2019. This has led us to wonder: Do these savvy and well-apprised private market investors who are rushing to the door know something their public market counterparts don’t?

While the arguments that say history is repeating itself are compelling, we believe unequivocal bears miss three key points:

First, since the dot-com boom the median age of tech IPOs has risen from 4 to 12 years and the median sales of tech IPOs has increased more than threefold. (Figure 3). One could interpret these developments as evidence that it is becoming even more difficult to become free-cash-flow generative. However, in most cases these are real companies that have developed robust, viable and innovative business models and are exhibiting truly impressive sales growth.

Second, most of the oft-cited excesses appear much less worrisome when expressed relative to market cap (which has roughly doubled since the tech bubble) or in constant USD (to eliminate the impact of inflation). Although it is undeniable that some excesses do exist, they are simply not in the same league as those of the late-1990s and certainly do not pose a systemic risk to equity markets.

Third, cynics who take a black-and-white view, risk tarring all unicorns and IPOs with the same brush. This is a mistake as the historical experience and empirical evidence strongly suggests that some of these companies will develop into dominant platforms and become global champions, thus amply rewarding the patience of their investors.

Fake it ‘til you make it

Aside from the “grow fast or die slow” dogma behind the mad rush into platforms, one reason for the increased prevalence of unprofitable IPOs is the burgeoning importance of biotech. While the percentage of total IPOs represented by the tech sector remains close to its historical average of 30%, biotech’s share has soared to 43%, up six fold from the 1980-2010 average of 7% (Figure 4).

This definitely skews the statistics, as very few biotech IPOs have been profitable. In fact, most biotech IPOs haven’t even generated sales, let alone bottom-line earnings. To be more specific, since 2010 only 3% of biotech IPOs have been profitable (down from 23% previously). This is even worse than tech sector IPOs, where a rather dismal average of 27% have been in the black since 2010 (down from the historical mean of 61%).

Moreover, during the last two years the statistics have been even worse. Among tech IPOs, only 17% were profitable in 2017, followed by an even more discouraging 16% in 2018. However, the corresponding numbers for biotech were rock bottom, at 0% and 0%; that is, not a single biotech IPO posted positive earnings during the last two years. This certainly raises questions about the robustness and validity of the funding model behind all these loss-making private companies.

Venture capital: phishing for phools?

“The skill you need most when raising venture capital is the ability to tell a compelling story.” This quote is a key theme of “Secrets of Sand Hill Road: Venture capital and how to get it”, by Scott Kupor of Andreessen Horowitz. He asserts that VC investors are obsessed with technology differentiation, network effects and the potential for juicy margins. This sounds eminently sensible, but he also demonstrates that even the best VCs aren’t terribly good at avoiding failures: in fact, over 50% of VC investments lose money. Rather, he shows that the entire VC business model is based on the 10% to 20% of investments that turn into home runs. Among other things, this helps to explain why the top VCs (such as Sequoia, Kleiner Perkins and Andreessen Horowitz) hold well-diversified portfolios, typically with investments in 25-40 unicorns, spread across sectors.

A second theme of Mr Kupor’s book is that “lemons ripen early.” That is, he contends a portfolio of start-ups will often have early losses as the teams without product/ market fit quickly run out of money early. However, the successful start-ups, the ones that will become dominant platforms, take time to emerge. It can take 5+ years from a company’s founding to understand its likely growth trajectory. As a result, the goal is a J-curve with the start-up initially showing losses, followed by chunky margins and impressive profitability in the later years. This is why VCs are so infatuated with huge TAMs (total addressable market) and frequently declare that few ideas are big enough.

The VC perspective is important to understand, as they backed 79% of tech IPOs in 2018, up dramatically from the 1980- 2010 average of 57%. (The corresponding percentages for all IPOs were 66% and 35%, respectively.) Reflecting this trend, last year was a banner year for VC investments into start-ups, with 2019 expected to be just slightly lower (Figure 5). However, this does raise the question of whether the spike and subsequent collapse of two decades ago will be repeated this time around.

The above trends certainly seem to enable the manic behaviour of start-ups, many of whom appear to be adopting a slightly different mantra, “move quickly and burn money,” sprinting to an IPO before the VC cash runs out. An additional and final cause for concern is the rising number of tech IPOs that are issuing dual class shares, which are typically viewed as a way to raise money but without ceding control. To illustrate, an average of 35% have issued such shares since 2015, up dramatically from the historical mean of 6% (Figure 6).

For most of the modern history of American equity markets the NYSE did not list companies with dual-class voting. However, standards have slipped during recent decades. Popularised by the Google IPO in 2004, weighted voting rights have been featured in the high-profile IPOs of LinkedIn, Groupon, Zynga, Facebook, Fitbit, Blue Apron and Dropbox. Snap took this awkward development to a new level in 2017 when it became the first company since at least 1940 to launch an IPO with shares having zero voting rights. This allowed CEO Evan Spiegel and CTO Robert Murphy to hold a combined 88.5% of the company’s total voting power. More recently, Lyft and Pinterest are among the 2019 listings that have issued dual class shares.

To illustrate why this is a problem, earlier this month 32% of Facebook’s external shareholders voted against the re-election of Mark Zuckerberg to the board, with 67% backing a proposal for the introduction of an independent board chair. However, neither of these moves stood a chance as Zuckerberg holds 58% of the voting power, even though he only owns 13% of the total company shares. Unchallengeable control by one person over such a large and complex firm is troubling, especially considering the multiple controversies the company is currently grappling with. Facebook has become the poster child for governance challenges, with an increasing number of regulators and institutional investors calling for sunset provisions or even outright bans on dual-class structures.

The complexity of voting rights can also make the valuation of VC-backed companies extremely confusing^[1]. After multiple funding rounds, many unicorns end up with convoluted financial structures, which can be confusing and misleading, even for sophisticated insiders. Such complexity is a common feature of asset bubbles (this was particularly the case during the housing market excesses a decade ago), which raises the question of whether the surge in unicorns and IPOs is just the tip of a much larger iceberg.

Is the IPO frenzy just one aspect of a broader e-commerce bubble?

There have been (at least) seven clearly identifiable bubbles over the last 40 years or so (Figure 7). The first bubble is gold, which peaked in 1980 at about 5x its initial price. The most recent candidate is e-commerce, which is up over 8x since mid-2010. Although we are not convinced it’s a bubble, we must admit it shares a lot of the characteristics of one. Such excesses always involve a dislocative event that promises to upend the existing order. The current hype about two-sided digital platforms and blitzscaling, featuring a growth over profits mentality, certainly raises the possibility that e-commerce might be yet another bubble just waiting to be popped.

In addition to a dislocative event, bubbles also require that conventional valuation measures become stretched and untethered from fundamentals. Epoch has always preferred companies with business models that are capable of generating sustainable FCF, if not immediately then in the near future.

On that basis, though, the e-commerce Index appears only slightly extended. The index currently trades on an FCF yield of 4.1%, which is only moderately below the 4.5% yield of the S&P 500. This suggests the index could be marginally overpriced, but not even close to bubble territory. Taking this point further, the remainder of this paper will present evidence that the surge in unicorns and IPOs may indicate a moderate degree of froth, but nothing like what transpired during the dot-com boom and certainly not representing a systemic risk to the equity market.

Investment conclusions

It is crucial to analyse each company individually, based on its own ability to produce FCF on a sustainable basis. Although a number of the key metrics employed for valuing digital platforms are somewhat novel, the FCF principles we have been applying for years are fully relevant to start-ups that have not yet listed on public markets.

This paper has focused on unicorns and IPOs, but Epoch has always believed that, regardless of geography or sector, investors should focus on companies that:

(a) have an ability to produce FCF on a sustainable basis; and (b) possess superior management with a proven track record of allocating capital wisely, including investing today for future value creation.

We are confident that these companies are the most probable winners and the ones most likely to provide investors with the best returns. Crucially, we believe these principles are as relevant to unicorns and IPOs as they are to firms that have traded on public markets for decades.

[1] See “Squaring Venture Capital Valuations with Reality,” UBC and Stanford University, W. Gornall and I. Strebulaev, 2018.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2019 Epoch Investment Partners, Inc.

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A record deficit 10 years into an expansion would leave Keynes flabbergasted, but it is likely just a taste of what is to come.

While the US is ‘back from the brink’ and markets have returned to positive territory in 2019, this cycle is well into its late innings. As discussed in this article from GSFM’s investment partner, Epoch Investment Partners, written by CEO and co-CIO Bill Priest, there are three reasons to maintain a cautious investment stance.

The biggest event for markets in the first quarter of 2019 was the “Powell Pivot.” Toward the end of last year, the Fed chair communicated to markets that quantitative tightening (QT) was on autopilot and that the Fed planned multiple rate hikes in 2019. Fears of tighter financial conditions spooked investors, resulting in significant market volatility, with US and global equity markets falling almost 15% in the fourth quarter of 2018.

Fearing a bear market with its negative spillovers for the real economy, Powell executed a swift 180 degree turn, adopting a neutral bias and promising to end QT this September. The pivot brought the market back from the brink, with first quarter gains wiping out most of the losses suffered in the previous quarter.

A second positive development was the moderation of trade tensions with China, with the White House reporting we are now quite close to a signed deal. Trade negotiations have proved much more complex than most investors anticipated a year or two ago. Quite rightly the key outstanding issue is enforcement, something that previous administrations paid far too little attention to. Luckily, US Trade Representative Robert Lighthizer is exactly the right person for this task, although his relentless and mind-numbing attention to detail is likely testing the patience of political bosses on both sides of the Pacific.

Additionally, toward the end of 2018 China began implementing its own policy pivot, hitting both the monetary and fiscal thrusters. This has resulted in an almost immediate improvement in economic momentum, as shown by the dramatic recovery in its composite PMI.

These three developments resulted in early-2019 looking like the mirror image of late-2018. The good news is that markets have moved back from the brink, and we anticipate a relatively benign mid-to high-single-digit return to stocks for the remainder of the year. That said, this cycle is well into its late innings and we now outline three reasons to maintain a cautious investment stance.

Soon to be the longest expansion in US history

The last US recession officially ended in June 2009 and the current expansion has just celebrated its 10th birthday (Figure 1). However, all good things must come to an end as suggested by a host of indicators, including the (almost) inverted yield curve and weak consumer expectations. Precisely when, though, is anyone’s guess, as the record of failure to predict recessions is virtually unblemished.

The approaching Minsky moment: stability breeds instability

The second reason concerns the risks arising from the high and rising level of debt throughout the US economy. While corporate leverage might not be the direct cause of the next recession, it is certain to act as an amplifier making the repercussions considerably more damaging for both the real economy and the equity market. Policymakers agree, with this point emphasized in February by Fed Chair Powell and in early April by the IMF.

One major risk factor follows from the investment grade index now being dominated by BBBs, which means the next downturn may witness a tsunami of “fallen angels,” which could overwhelm high yield liquidity and result in severe market dislocations.

Additionally, about US$1 trillion of this debt is accounted for by firms with debts greater than four times EBITDA and interest bills that consume over half of their EBIT. Such debts, which may be first to default during the next downturn, are now roughly the same size as subprime mortgage debt was in 2007.

Moreover, the stock of “leveraged loans” has grown sharply in recent years, with many policymakers issuing warnings about its risks. Their worries are based on three characteristics leveraged loans share with the subprime-mortgage boom: securitisation, deteriorating quality and insufficient regulatory oversight.

Collateralized loan obligations (CLO) in particular soak up more than half of the issuance of leveraged loans in America and 85% of new issuance consists of “covenant-light” loans.

We have similar concerns about the booming private equity markets, where assets under management have reached over US$3.4 trillion and valuations are just shy of the excesses reached in 2007. We firmly believe that the corporate debt market will be at the epicentre of the next financial crisis. Just as distinguished economist Hyman Minsky would have predicted, a decade characterised by record low interest rates and a flood of central bank liquidity has produced an accident just waiting to happen.

Manufacturing margins have peaked

Four factors explain why manufacturers’ margins have more than doubled over the last two decades: (i) the reduction in effective tax rates; (ii) the decline in interest rates; (iii) wage savings from offshoring; and (iv) the reduced wage bill resulting from more efficient domestic plants. The first two of these factors are likely fully played out, with the third starting to reverse over the last two years, and the last continuing to plod along, but not moving the needle very much. With opportunities for labour cost arbitrage largely behind us, and global supply chains under threat from trade tensions (especially pertaining to tech hardware), the likelihood of further margin expansion is quite low in our view (Figure 2).

Consensus expects S&P500 EPS growth of only 3% this year, down markedly from 20% in 2018 (due in large part to the EPS sugar high that resulted from the end-2017 tax reform). However, consensus expects EPS growth to bounce back to 12% in 2020, an outcome that assumes significant margin expansion. As mentioned, we are thoroughly sceptical regarding the possibility of double-digit earnings growth at this stage of the cycle.

MMT: why now?

Modern monetary theory (MMT) has received a great deal of media attention lately. Its proponents have been encouraged by the benign inflation backdrop and the lack of any discernible relationship between sovereign debt/deficit levels and interest rates. A growing minority of politicians believe this disconnect provides them with a green light to promise aggressive fiscal policies.

In fact, even if uncredited, MMT is probably a good framework for understanding fiscal policy since the early 2000s, and maybe as far back as Reagan. Moreover, MMT will likely be used to justify further fiscal expansion regardless of the outcome in November 2020.

MMT proposes that a country with its own currency, such as the US, doesn’t have to worry about accumulating too much debt because it cannot go broke — it can always print more money to pay interest. So, the only true constraint on spending is inflation, which should accelerate if the output gap is positive (that is, GDP is above potential). However, if the output gap is negative, MMT implies the government can spend whatever it deems appropriate to maintain full employment (and achieve other goals, such as halting climate change). After all, in the modern era of “fiat” currency, governments no longer need to worry about having enough gold to back their paper money.

Crucially, MMT aspires to swap the roles of monetary and fiscal policy. The former relies on tweaking short-term interest rates and occasionally implementing unconventional policies like QE. However, while most acknowledge QE’s crucial role in repairing temporary illiquidity from 2008 to 2010, a majority of commentators question the efficacy of subsequent QE experiments.

The roughly $10 trillion in negative yielding bonds globally attests to monetary policy’s inability to vanquish secular stagnation. This is a major reason for the sudden interest in unconventional policies and approaches. MMT proponents believe fiscal policy should drive monetary policy (with the nation’s central bank mandated to carry out the bidding of its treasury).

MMT challenges a core principle of conventional economics, which is that an increase in public debt and budget deficits will tend to raise interest rates, all else equal. While we are not fans of MMT, we must admit that they do have a point here (Figure 3). Thus, we believe fiscal policy will likely become an even more active policy tool, with an even more expansionary bias, over coming years.

In spite of the concerns described above, our outlook is for relatively benign markets during the remainder of 2019 but followed by a rockier path in 2020 and 2021. Epoch has always favoured companies that consistently and sustainably generate free cash flow, and possess superior managements with a proven track record of allocating that cash flow wisely between return of capital options and reinvestment/acquisition opportunities. We believe such companies are the most probable winners and the ones most likely to provide investors with the best returns. In today’s challenging, late-cycle investment environment we believe these principles are ever more important.

A record deficit 10 years into an expansion would leave Keynes flabbergasted, but it is likely just a taste of what is to come. The current US deficit is the largest it has ever been outside of wartime and recession. Moreover, it is occurring toward the end of what seems destined to be the longest recovery in the history of the US. Note that at the same point in the 1991 to 2001 recovery, we enjoyed a budget surplus of over 2%. In our view, the current budget deficit is indefensible and suggests we may already be living in an MMT world.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2019 Epoch Investment Partners, Inc.

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Historically, Americans have been very pro-trade, however, a majority of citizens agree with the US President’s views about moving toward deglobalisation.

China 2025 is perceived as an existential threat to US commercial and technological leadership. This raises the risk that the Trump administration could conclude that its best response is to decouple much of the US supply chain from China.

As discussed in this paper from Epoch Investment Partners, penned by CEO and co-CIO Bill Priest and Managing Director of Global Portfolio Management Kevin Hebner, such a move toward deglobalisation would prove acutely negative for corporate margins and earnings.

US President Trump has been an unabashed trade hawk for decades. He has called for protectionist measures since at least 1989 when he declared “I’m not afraid of a trade war,” presaging his more recent exhortation that “trade wars are good, and easy to win.”

Historically, Americans have been very pro-trade. Today, however, a majority of citizens agree with the US President’s views, especially when it comes to dealing with its new rival, China. It is no longer just about jobs. The US is worried about China’s growing commercial and technological clout, with both sides vying for dominance over new technologies that will determine the economic balance of power in the 21st century.

China has changed the terms of engagement since President Xi’s ascension in 2012. While his predecessors emphasised the slogan “peaceful rise,” President Xi has been far more assertive than anything seen since the days of Mao Zedong.

This “new era,” as Chinese officials have taken to calling it, has celebrated and entrenched the state’s leading role in the modern economy. The key reason why tensions have ramped up recently is “Made in China 2025”, Beijing’s aggressive blueprint for dominating the tech industries of the future, including robotics, biomedicine, renewable energy, aerospace, communications equipment, new materials and artificial intelligence (AI).

Made in China 2025

US policy makers have been startled by the plan’s focus on “indigenous innovation” and the Maoist calls for “self-reliance”, aspiring to achieve self-sufficiency through domestic “secure and controllable” technology and import substitution. Publicly proclaiming the aim of dominating critical high-tech industries has confirmed suspicions in DC that China is not looking for a win-win in trade relations.

It is difficult to understand why Beijing didn’t foresee how hostilely such a massive and pivotal state-led program would be received in America. Made in China 2025 is an ambitious scheme that directs huge state subsidies at key new tech sectors that China wishes to dominate.

From America’s perspective, two aspects of the blueprint are particularly worrisome: first, its reaffirmation of the government’s central role in economic planning; and second, its focus on import substitution.

Made in China 2025 expressly calls for China to achieve 70-80% self-sufficiency in a wide range of critical, tech-heavy industries. Achieving such brazen market share targets clearly requires enormous government support, much of which occurs through a web of opaque subsidies. Firms associated with Made in China 2025 are provided with extensive financial assistance through a multitude of state-directed investment funds.

Although it is challenging to find a comprehensive listing of all sources, it is possible that total support could exceed an eye-popping $1 trillion. The US Chamber of Commerce estimated that the Chinese government plans to spend $161billion by 2025 to develop the semiconductor sector. That is a huge sum of money, and it only refers to one industry.

All ten of the sectors targeted by China 2025 are viewed as key to future economic growth by both China and the US. However, the truly breathtaking innovations are occurring in fields directly affected by AI.

To illustrate, earlier this year both PwC and McKinsey estimated that, by 2030, world GDP could increase by around $15 trillion (or 14%) purely because of AI, with China being the primary beneficiary (receiving about 45% of the total gain). This makes AI the biggest commercial opportunity in today’s dynamic economy and means the stakes are unprecedentedly high.

Mercantilism: a core feature

Mercantilism is a core feature of the Chinese economic system. Imports of manufactured goods from the US represent less than 1% of GDP.

There are also severe restrictions on foreign direct investment. According to the Organization for Economic Cooperation and Development, China maintains one of the most restrictive investment regimes with only a few countries, such as Saudi Arabia, ranking worse. Many sectors have rigid foreign equity restrictions or joint venture requirements. These restrictions either block opportunities, or, in some cases, create a de facto technology transfer requirement to the Chinese partner as a pre-condition for market access.

Data compiled by Global Trade Alert (an independent think-tank based in the UK) demonstrates that China has implemented a distressingly large number of mercantilist measures over the last decade (figure one). While the US and other countries have also exhibited a proclivity toward protectionism, China is in a league of its own among large economies.

Finally, the US has unquestionably been the world leader in the commercialisation of the internet.

However, no US website ranks in the top 25 most visited in China. This is a direct result of China having banned, blocked or placed high restrictions on sites such as Google, YouTube, Facebook, Instagram, WhatsApp, Snapchat, Twitter, Pinterest, Flickr, Tumblr, Dropbox, the New York Times, Bloomberg and the Wall Street Journal.

China’s mercantilist behaviour has undermined political support in the US for free trade and openness. There has been a ramping up of anti-trade rhetoric, the WTO appears increasingly irrelevant, and the US has withdrawn from the Trans-Pacific Partnership process.

If the trend continues, we could end up with a segmented world trading system instead of a global one, an outcome that would be lose-lose.

The US response

During the last couple of decades, America’s approach to China has been founded on a belief in political and economic integration and convergence. However, by celebrating and entrenching the state’s leading role in the industries of the future, President Xi and his “new era” have demonstrated that convergence was never their goal.

The Trump administration has adopted an aggressive stance, demanding three key changes. First, that China jettisons the mercantilist web of rules that have systemically protected and lavishly subsidised companies in numerous sectors throughout the economy.

Next, that China ceases its chronic practice of purloining US companies’ trade secrets (via forced technology transfer, state-sponsored cyber theft, and corporate acquisitions).

Finally, that Beijing fully embrace the principles of reciprocity and full market access for US businesses operating in or exporting to China.

In October, Vice President Pence delivered a remarkable, 40-minute broadside against China that justifiably received an enormous amount of attention. The Financial Times argued this speech was the most important event of 2018. In surprisingly blunt and strident terms, Pence accused China of bullying American companies and stealing their technology and Intellectual Property (IP).

He concluded that it is up to China to avoid a Cold War, demanding concessions on several issues, including its rampant IP theft, forced technology transfer, and restricted access to Chinese markets.

While Pence’s speech has received significant attention, the craftsman behind US trade policy, and chief China critic, is Robert Lighthizer, Trump’s US Trade Representative.

Lighthizer makes a compelling case that China’s economic and political system is fundamentally incompatible with our conception of free trade rules and has been particularly critical of the systemic non-compliance practiced by China for decades.

With forced technology transfer, unfair licensing requirements, corporate acquisitions and government-backed cyber theft as primary sticking points in the ongoing negotiations between Presidents Xi and Trump, one does not have to be a trade lawyer to realise how difficult it will be to obtain a verifiable agreement that both can bring home and declare victory. Effective 24 September 2018, the US imposed tariffs on $200 billion of Chinese imports.

Ongoing negotiations, with a soft deadline of 1 March 2019, will determine if the tariff rate is raised from 10% to 25%, and if tariffs will be applied to additional imports from China.

The global supply chain unravels

It has been just over a decade since Thomas Friedman’s “The World Is Flat” painted globalisation as a seemingly unstoppable trend. It may have marked globalisation’s peak. During the past few years global supply chains have begun to buckle, with the world’s two giant economies clearly de-coupling.

If the global supply-chain does bifurcate, with one part centred around the US and the other around China, which sectors would be most affected?

Ground zero is likely to be all ten sectors that are targeted by China 2025, especially where sensitive technologies are involved. Among the hardest hit industries would be tech hardware, especially semiconductors, with tech software and services being less directly affected. Other exposed industries include capital goods, and possibly autos, as well as certain consumer durables and chemical/commodity sectors.

Still, a full chasm between the two countries seems improbable, with the possibility that energy and agricultural commodities could even become beneficiaries of the new trade architecture.

As trade tensions mount, what countries are most likely to benefit by stepping into the void left by China?

While relatively little would return to the US, it is feasible that some high-end manufacturers could move to Korea, Taiwan, Japan and Singapore, while the low-end manufacturing could shift to ASEAN countries, and possibly Mexico.

Even if a relatively small percentage of existing production were relocated, or if capacity expansions began to favour these destinations, the local impact could be highly significant.

Foreign direct investment (FDI) has been flowing solidly into the ASEAN region over the last decade, even as FDI into China has started to moderate. This suggests that the marginal relocation process is well underway, with Vietnam, Malaysia and Thailand appearing best positioned to attract significant FDI inflows.

Manufacturing margins under pressure in 2019

If global supply chains do in fact bifurcate, what is the likely impact on corporate margins and earnings?

One channel that hasn’t received sufficient attention concerns the impact of overcapacity in China 2025 sectors. Whenever countries undertake overly ambitious central planning exercises, excess capacity inevitability results.

This occurred earlier in China’s development when it built-out its heavy industry capabilities (steel, cement, petrochemicals) and this time around is likely to prove even more wasteful.

Such excess capacity will probably drive down margins and profitability in most China 2025 industries, and not just in China, but globally.

An even more worrisome channel concerns unwinding the decades of progress that has been made with globalisation. International trade accelerated from 1990, following the fall of the Berlin Wall, and was then turbo-charged at the turn of the century when China entered the World Trade Organisation (WTO). A key part of this acceleration was, over a period of many years, putting in place the complex global supply chains that exist today, a process that helped drive a dramatic increase in manufacturing margins (figure two).

This suggests the recent turn toward protectionism is likely to be particularly negative for sectors such as tech hardware, semiconductors, industrial capital goods and some consumer cyclicals

Moreover, the labour cost savings from locating production abroad (largely in China) are estimated to have accounted for about one-fifth of the increase in manufacturing margins since 2000.

However, this factor is likely fully played out and will probably be at least partially reversed during the next couple years. A bifurcation that results in a much less efficient global supply chain would cause additional damage to margins. This is why we believe the peak in manufacturing margins is now well behind us.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2019 Epoch Investment Partners, Inc.

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Disruptive innovation will affect all economic sectors, not just information technology.

In a recent series of presentations to advisers in Australia, industry veteran Epoch’s CEO and co-CIO Bill Priest, discussed the new world order, in which bits replace atoms, tech is the new macro and companies need to evolve to stay relevant.

Global businesses have arguably entered a period of unprecedented innovation and disruption, one where platform technologies, network economics and winner-takes-all markets favour global champions. The accelerated pace of technology means disruptive innovation is affecting every sector of the economy; there will be more laggards than winners, and investors need to be wary of value traps, as many seemingly cheap companies struggle in the face of change.

The digital age

The second machine age – or digital age – commenced with the shift from mechanical and analogue electronic technology to digital electronics in the late 1950s.

In 1965, Gordon Moore, who later founded Intel, theorised an exponential relationship between integrated circuit complexity and time, in which circuits would double in performance roughly every 18 months. Although the impact of the digital age was difficult to see for the first few decades, as even exponential growth from a small base is not visible for a long time, Epoch believes technological innovation reached an inflection point around 2007 with the emergence of a raft of technology companies and innovations, illustrated in figure one.

Today’s tech companies benefit from broad developments such as faster processing power, cheaper and better data storage and improving network bandwidth and transmission capacity. They also benefit from lighter and longer-lasting batteries for devices and advances in artificial intelligence and machine learning.

Since progress in the digital age is exponential rather than linear, the business world has never seen disruption at this speed and scale before: witness the dramatic transformation in industries such as newspaper, film, music, telecommunications, retail, transportation, and accommodation.

In 2006, the US’s 2,400 newspapers generated almost $50 billion of advertising revenues. However, within a decade these revenues had declined by 70% and are expected to continue declining by 15% per year over the next five years. On the other hand, internet ad revenues have been growing by 20% per year, with Google and Facebook being the biggest beneficiaries of that growth (their digital ad revenues are up tenfold since 2001).

Case study one: The retail sector feels the pointy end of disruptive innovation

Developments in the retail sector provide a good case study regarding the implications of technology for employment and wages. E-commerce has been around for a while, but its impact has been most profound since August 1998 when Amazon announced plans to move beyond books, with the intent to ‘sell everything to everybody’.

In recent years, online retail sales have been growing by a solid 15% per year, which is roughly four times the growth rate for traditional brick-and-mortar retailers. Despite faster sales growth, the share of retail employees who work for internet retailers has barely budged. This is reflected in a much lower employment-to-sales ratio, a trend which shows no signs of reversing.

To the contrary, by dramatically reducing transaction costs, e-commerce has captured 65% of all retail sales growth over the past two years (with Amazon alone capturing 60-70% of that). This process will likely continue to put downward pressure on both wages and employment in the retail sector.

Bits versus atoms

The exponential growth of processing power, as aptly expressed by Moore’s Law, has helped drive the digitisation of information. This data is composed of ‘bits’ rather than ‘atoms.’

Bits represent the digital age whereas atoms represented the first machine age. The key differentiating point is that data in the form of bits can be copied freely, perfectly and instantaneously. As such, they are usable over and over again, unlike goods constructed from atoms.

The old saying, “you cannot have your cake and eat it, too,” speaks to the world of atoms. Economists use the term ‘rivalrous’ consumption to describe such goods. On the other hand, a ‘bit’ of information is ‘non-rivalrous’; it can be consumed or reused over and over again.

This and other related properties of the digital age have important implications for the structure of the economy and traditional business models. This includes higher margins and profits for the relatively small number of dominant firms.

If a company determines that it does not need the same level of assets to run its business as it did in the past because technology has replaced the need for atoms (people and fixed assets), it can remove equity from the business through cash dividends, share buybacks, or debt pay downs.

This follows from the observed trend toward asset light business models. The ‘atoms’ of human beings and fixed tangible assets are being replaced by ‘bits’ of technology and intangible assets. This effect is appearing in almost every company Epoch examines as each endeavours to become more efficient in its use of labour and assets. Any firm not pursuing an ‘asset light’ model faces obsolescence, as rivals will compete its business away.

Case study two: the music industry moves from physical to digital

The global music industry has been forced to dramatically change its economic model over the last decade or so. Worldwide sales of recorded music declined by roughly 50% from US$24 billion in 1999 to just over US$12 billion in 2014, with a massive transition from physical to digital (see figure two).

In 2014, the global music industry generated roughly equal amounts of revenue from digital channels as from physical formats such as CDs. However, Epoch estimates digital sales will be five times that of physical sales by 2021 – ‘bits’ crush ‘atoms’ yet again.

Free, perfect and instantaneous are the hallmarks of digital disruptive strategies. Once digitised, information goods can be freely copied, with the digital copies being perfect duplicates of the original. The internet makes their distribution almost instantaneous.

With cloud computing, AI and machine learning, more data translates to a smarter, more effective platform. Traditional goods and services are at a huge disadvantage since they do not possess these qualities.

A digital platform can be characterised by near zero marginal cost of access, duplication, and distribution. Common digital platforms include Amazon, Netflix, Google’s search engine, Facebook, the iPhone’s app store, Spotify, Uber, and Airbnb. They all feature business models with high fixed costs and low marginal costs, which are the key attributes of natural monopolies.

Importantly, lower does not mean zero. No company, even in the digital age, is able to scale its business meaningfully without incurring some additional expenses. For example, Amazon needs to build more warehouses and Netflix needs to produce more content.

Network effects are an essential element in the digital age, and Facebook is the most frequently cited example of network effects today. The value of a network rises exponentially relative to its number of active members. For example, the more people that use Facebook, the greater its value to both its users and advertisers.

Indirect network effects can also be powerful. For example, an increase in the number of iPhone users encourages more app developers to invest in the platform.

In addition, digital platforms are able to continuously mine and analyse customer data to create much smarter platforms (for example, Amazon content recommendations). It has become increasingly popular for tech companies to offer complementary goods on their platforms (for example, AirBnB selling local experiences), a tactic called bundling.

Is e-commerce a bubble?

Although Epoch believes the e-commerce index as a whole does appear stretched, there are two key points to consider.

Firstly, cheap changes everything. Digital technologies are much more powerful than their predecessors, because the inherent scalability massively lowers firms’ marginal costs. The result is a seminal business model that is capable of producing an impressive win-win, with both companies and consumers becoming vastly better off.

Secondly, cynics risk tarring all e-commerce companies with the same brush, while Epoch believes many companies in the sector possess sound and promising business models. To accurately distinguish between the likely winners and losers, it is crucial to analyse each company based on its ability to produce free cash flow on a sustainable basis and on management’s skills in capital allocation, including investing today for future value creation.

These principles are as relevant to e-commerce companies as they are to firms in more traditional sectors such as consumer staples or industrials.

There have been (at least) seven clearly identifiable bubbles over the last forty years or so, as illustrated in figure three. The first bubble was gold, which peaked in 1980 at about 5x its initial price. The most recent candidate is e-commerce, which is up over 8x since mid-2010. Although not convinced it’s a bubble, Epoch admits it shares a lot of the characteristics of one.

Bubbles always involve a dislocative event that promises to upend the existing order. This produces outsized gains for a number of years, and typically generates clever explanations for why traditional valuation metrics are inaccurate, inappropriate and irrelevant. This was certainly true of the Nikkei bubble in the late-1980s (Japan Inc. was going to take over the world, so a PER of 80x was totally reasonable) and tech’s massive gains a decade later.

The current hype about two-sided platforms, big data and ‘blitzscaling’, featuring a growth over-profits mentality, certainly raises the possibility that e-commerce might be yet another bubble waiting to be popped.

The digital age has undoubtedly turbo-charged the process of creative destruction, which is now occurring more swiftly and tumultuously than ever before. However, it has always been the case in tech that titans rise and then, often quite suddenly, titans fall.

Some of the notable examples of this process include: Atari in the late-70s to early-80s (marked the beginning of the PC, created a new American art form and, at its peak, was the fastest growing company in US history, and then ‘poof’ it pretty much disappeared), America Online (king of the dial-up internet era), Netscape in the late-90s (was dominant from 1995–1998, but lost to Microsoft in the “browser wars”), and Myspace a decade ago (it was the world’s #1 social networking site from 2005–2008, but was then overtaken by Facebook).

Technology has a long history of producing disruptive companies that appear dominant and unstoppable one year, only to find themselves abruptly and acutely on the ropes as they in turn are disrupted.

For a more quantitative perspective, Epoch estimates companies that are in the top 10 at one moment in time had a 60% chance of remaining in the top group five years later, a 45% chance after a decade, and only 35% after 15 years had passed.

The companies currently at the top of the list (see figure four) look entrenched and difficult to dislodge, but they always do, and the historical record suggests we should expect the rankings to change quite substantially between now and 2023 or 2028.

Looking at the next tier of companies, those ranked 11th to 25th, only 55% of them remained in the top 25 five years later, a figure that dropped to 30% after a decade. On the other hand, for these second-tier companies there is only a 15% chance of moving into the top ten after a decade has passed. This suggests they are in a very competitive and dynamic space, with a much higher probability of moving out then of moving up.

At first, it might seem quite remarkable how many companies come from out of nowhere to make it into the top ten. Such companies in the 2000s included eBay, Cisco and Google, while more recent entrants have included Facebook, Amazon, Alibaba and Tencent. However, statistically, the numbers are not so encouraging. On average only 15% of companies in the top 10 weren’t even in the top 25 list five years earlier, a number that rises to 30% if the lookback is increased to ten years.

Disruptive innovation will affect all economic sectors, not just information technology. As a result, Epoch believes it’s increasingly important to favour companies with a demonstrated ability to produce free cash flow and allocate that cash flow wisely between return of capital options and reinvestment or acquisition opportunities.

Companies that possess superior managements with competent capital allocation policies possess the attributes most likely to be even more important going forward, as management is tasked with creating value by marshalling talent and technologies during a period of unprecedented innovation and disruption.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. References to any security do not constitute a recommendation to buy, sell or hold such security. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2018 Grant Samuel Funds Management

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On November 8, 2016, the U.S. elected Donald Trump to become the country’s 45th President. The balance of power in Congress remained unchanged with the Republicans retaining a majority in both the House and Senate.

The election of Donald Trump was a surprising outcome that can be viewed as a rebellion against the policy consensus of the past 30 years. The election of an anti-establishment candidate introduces greater uncertainty and risk into the markets.

There are a number of areas of concern for us, based on the rhetoric espoused on the campaign trail, particularly the anti-trade sentiment and potential for trade spats. In addition, markets generally prefer some diversity in the balance of power in Washington, not one party controlling both the executive and legislative branches. Finally, the election of a populist candidate in the US may bolster the support for similar candidates in the European Union, introducing additional uncertainty into those markets. On the flip side, there are a number of potential policies and initiatives that may be beneficial for investors. For example, increased infrastructure spending could act as a stimulus to growth; corporate tax reform may increase cash flow and lead companies to repatriate huge sums of capital currently sitting abroad; and deregulation may benefit sectors such as financials, health care and energy.

Ultimately, the election has not changed our core outlook for sluggish global growth. We are in a period of secular stagnation. Much of that is driven by demographics, and demography is, in the end, destiny. Gross Domestic Product (GDP) is made up of growth in the workforce plus productivity growth. Measured productivity growth in the US is currently running around zero. Growth in the workforce is somewhere between 1% and 1.5%. Combined, this shows why we have been saying for some time that 2% (real GDP growth) is the new 4% for developed economies. The good news is that nominal wages are growing at a rate of 2.5% to 3.0%. While not a huge growth rate, it is growth nonetheless.

Some areas we believe may be impacted by the election of Donald Trump are:

Bond yields

President-elect Trump’s policies are likely to mean higher bond yields, principally because we are going to see a substitution of fiscal policy for monetary policy.

First, real bond yields have been trending down for 30 years. Currently, real yields are touching zero and we believe the chances of that continuing are small.

We will likely remain in a low-for-longer rate environment, but it is unlikely that we will the see the yield curve shift down again. What is more likely is that there will be modest increases in the short end and depending on how much debt is needed to finance some of Trump’s stated plans, we could see a rise in the long-term rate as well.

Technology

Both Presidential candidates largely ignored this macro driver, but there are profound implications for labour markets and corporate profits that may necessitate policy initiatives to step up education, skill training and mobility.

When you look at technology you see a substitution whereby less physical capital — property, plant & equipment — and labour is required for companies to generate a dollar of revenue. All of this works well for corporations and profitability and means that payout ratios can continue to increase, which we believe is likely. The drawback is that the substitution of technology for labour can hurt employment, though we don’t know by how much. Robots don’t buy anything and neither does artificial intelligence, so there would be a negative impact on consumption. Not much time was spent on this dynamic during the election, but we believe that President-elect Trump will need to address it in order to stay true to his goal of “Making America Work Again.”

Monetary policy, interest rates and currencies

The market is still pricing in an 80% probability that the Federal Reserve will hike rates in December and this did not change much in the closing days of the election or following the outcome. We are likely to see some fiscal policy expansion, which would result in 10-year yields rising. In this type of environment, the US dollar could appreciate. We believe that most other central banks will remain on hold for some time, so a Fed that is in a modest rate-hiking cycle could benefit the dollar.

One factor that will be important for determining monetary policy is the composition of the Federal Reserve Board of Governors and there will be some important changes to it over the next year or so. The first change would be to the Chair of the Board. Current Chair Janet Yellen’s term expires on February 3, 2018. President-elect Trump had been highly critical of her during the campaign process.

It is unprecedented for a sitting chair to resign following a change in government, so we do not think that will happen, but it is also unlikely that she would be reappointed for another term. Additionally, two of the seven positions on the board are currently open. Given the Republican sweep, it is likely that the President’s appointments would be easily confirmed and those nominees should tend toward the hawkish side. Overall it appears that we will be in an environment where both the long and short ends of the yield curve will likely be rising, coupled with some US dollar appreciation.

Fiscal policy, infrastructure and tax policy

President-elect Trump talked often about fiscal expansion but did not provide many details on what that might look like. One benchmark might be Secretary Clinton’s proposed plans, although Trump’s could be significantly larger. She spoke about US$275 billion of spending, which alone is a huge number, but in the context of US GDP (US$18 trillion) is not all that big. In addition, that money would be spent over five years, which amounts to about 0.3% of GDP per year. At the same time, state and local governments are reducing their own investments due to budgetary pressures. Given these factors, we believe that net total government spending will grow over the next couple of years, but not by an eye popping number. Nonetheless, this could provide a boost to GDP, albeit a moderate one.

What’s more important, as it relates to policy, is corporate tax reform. President-elect Trump spoke passionately about the need for corporate tax reform, which is long overdue. The last time the US had comprehensive reform was 1986.

President-elect Trump indicated his intention to reduce the headline corporate tax rate from 35% to something closer to 15%. Most people, however, believe that something closer to 20% is possible. This change would have a number of implications, including a solid boost to cash flow. Some analysts believe this could boost 2017 EPS by 8%; that is, from around US$116 to US$125. Further, we could see hundreds of billions of dollars being repatriated, similar to what happened following the 2006 Homeland Investment Act. This influx would leave many companies awash with cash and, given that they need less of it to generate a dollar of revenue today, it would likely boost the levels of dividends, buybacks and debt reduction, as well as M&A activity.

Reduced globalisation and trade

Anti-trade sentiment was a recurring theme of presidential campaign rhetoric and President-elect Trump’s voice was often the loudest. He maintained that trade agreements typically result in fewer jobs and lower wages for US workers.

Historical evidence suggests otherwise, as Epoch detailed in its paper The Case for Trade Remains Overwhelming (May 2016). Global trade, despite some of its failures, has delivered remarkable returns to investors over the past 30 years, particularly equity investors. So, it’s hard to see how blowback against this investor-friendly policy can be good for investors. We acknowledge however, that with globalisation there is often a proportion of the labour force that is profoundly hurt. Further, the US and other developed markets have not done a good job of working to help these people through skill training and income support.

Even before Trump’s election, protectionists had already succeeded in beginning to turn back the globalisation clock. Since 2009, protectionist policies have expanded globally and in our view this proliferation has helped to bring about the longest period of trade stagnation since World War II. The election of Mr Trump will likely extend this period, and the degree of further trade stagnation depends on what his intentions are in terms of renegotiating or cancelling existing trade pacts such as the North American Free Trade Agreement and in increasing tariffs against countries such as China and Mexico. Such outcomes could trigger renewed global trade spats, with a detrimental impact on the global economy and financial markets. Further, the chances of ratifying trade agreements that are now being negotiated, such as those with Asia or Europe are extremely unlikely.

Financials

The post-GFC environment of low growth and low inflation, as well as increasing regulation, has been very challenging for the financial sector. However, we are now likely to see short rates and possibly long rates go up as mentioned. This would create a tailwind for the financial sector. More importantly, the Trump administration will be less inclined to introduce the types of regulation on the sector that Secretary Hillary Clinton intended to enact. This is particularly true in relation to systematically important financial institutions. In addition, the sector appears cheap especially some of the smaller regional institutions. Ultimately however, for robust strength in the sector we need to see strong loan growth, particularly commercial and industrial loan growth. We have been seeing some signs of that but the outlook does appear to be uncertain.

Health care

Health care will remain a deeply divisive issue. President-elect Trump has been a harsh and caustic critic of the Affordable Care Act, but has not been clear on what he would like to replace it with. He has spoken quite a bit on the other issue facing the sector, pharmaceutical pricing. Based on his comments, it is likely that there will be interventions from a Trump administration, but they will be less harsh than what we would have seen from a Clinton administration. This could be considered a positive for the sector, but negative public sentiment and growing competition within the industry will make it difficult for companies in that space to raise prices. In our minds though, the re-rating that the sector has experienced appears to be overdone. The sector looks cheap and it does possess solid cash flow growth potential going forward.

Energy

President-elect Trump feels strongly about the energy sector and thinks that a friendlier regulatory environment can help the sector grow and create jobs.

For example, this should prove positive for pipelines and other types of energy infrastructure. These developments will likely increase the supply of US oil, as well as natural gas. However, this increased supply will be negative for the price of WTI. Finally, a Trump administration will likely offer fewer subsidies to renewable and alternative energy sources such as wind and solar.

Conclusion

Despite the increased risk and uncertainty created by this election, as well as the potential growth stimulating policy initiatives, our core outlook remains largely unchanged. For example, US growth is likely to remain closer to 2% than to 4% for the foreseeable future. Further, as quantitative easing winds down and rates rise, the support for PE expansion will diminish. With PE multiples no longer expanding, the other two components of equity return, dividends and earnings, will become more important for investors. We remain positive on the outlook for dividends, as well as buybacks, and corporate tax reform could give a sizeable boost to earnings. The companies that will do well are the ones that generate cash flows and are prudent in their capital allocation policies, as reflected in shareholder yield and capital investment opportunities. As we have said many times, the value of a company is driven by its cash flow.

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These comments represent a summary of Epoch’s webinar, held on 9 November 2016. A replay of the webinar can be viewed on GSFM’s website at: http://www.gsfm.com.au/2016/11/10/investment-implications-of-the-us-election-epoch/ The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2016 Epoch.

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Economic data is put under the microscope. On the other hand, Epoch Investment Partners (Epoch), manager of the Grant Samuel Epoch Global Equity Shareholder Yield Funds, takes a ‘free cash flow lens approach’ across all of its strategies. In this article, Epoch’s CEO and co-CIO Bill Priest, and Managing Director of Global Portfolio Management Kevin Hebner, put Japan under the microscope to determine whether Japan is investable when examined through a free cash flow lens.

In short, the answer is yes. Beneath the surface, and with relatively little fanfare, corporate japan is changing.

Japan has historically scored poorly on corporate governance criteria. However, Prime Minister Abe has made improving corporate governance a priority and the initial indications are encouraging. The June 2015 reforms emphasised shareholders’ rights, increased disclosure and transparency, required the appointment of at least two independent directors, and highlighted the importance of specific return (for example, return on equity, or ROE) targets.

Additionally, 2016 is set to be a record year for buybacks, which will likely continue to increase, given growing cash positions, subdued capex and negative interest rates. Further, the dividend yield for the Tokyo Stock Price Index (TOPIX) is now marginally higher than for the S&P 500 (2.2% vs 2.1%), and dividend per share growth for the TOPIX has averaged 13% per year over the last three years. Other encouraging developments include the boom in outbound M&A and the decline in cross-shareholding ratios.

Japan is the only major market where net cash levels have risen dramatically during recent years, a development that is of particular interest to cash-flow focused investors. One consequence is that over 50% of TOPIX companies are net cash, the highest percentage of any major equity market. This is one reason Epoch expects Japanese companies to continue increasing dividends, buybacks and M&A activity. Further, Japanese equities appear cheap on a price to cash flow (P/CF) basis.

An examination of 20 Tokyo Stock Exchange sectors finds that six appear particularly promising for cash-flow-focused investors: rubber, transportation, air transport, other financials, construction and pharmaceuticals. Surprisingly, telecoms, food and utilities appear uncompelling in Japan, even though they are typically among the most promising sectors for yield-focused investors in other major markets.

However, Epoch does not want to overstate the case for Japan. Policy remains muddled in the face of a formidably challenging macro environment. Corporate governance reforms are just starting to take hold and a majority of sectors appear essentially uninvestable through a cash-flow prism. Investment strategies that require tangible, multi-year evidence that progress is in fact occurring will justifiably demand patience. Still, recent developments suggest toning down one’s cynicism a notch, at least for the minority of sectors identified as promising.

2016 set to be a record year for Japanese buybacks

Buybacks are up 40% year on year among TOPIX stocks according to CLSA, which is doubly impressive given that 2015 was already a record year. Over 280 Tokyo Stock Exchange (TSE) companies have announced share buybacks so far in 2016, with a total announced value of ¥4.8 trillion. Over the last three years, buybacks have represented just under 1% of market capitalisation (Figure 1). More pertinently, the median buyback announcement was for 1.9% of shares, comfortably above the 10-year average of 1.5%.

Buybacks have been well received by investors, with a company’s shares typically outperforming the TOPIX by 3% (within a 2%-to-6% range) in the 20 trading days after an announcement. Also, over the past 12 years, actual buybacks have equalled or exceeded announced buybacks in every year except 2012 (and that miss was quite small). So announcements are a good guide to what is likely to occur. Epoch believe buybacks will probably continue to increase, reflecting growing cash positions at many companies, subdued levels of capex and greater influence from the 2015 corporate governance reforms.

Dividends have increased three-fold since 2000 in Japan

In addition to a rising shareholder yield from buybacks, the dividend yield for the TOPIX is now marginally higher than for the S&P 500 (2.2% vs 2.1%), and dividend-per-share growth for the TOPIX has averaged 13% per year over the last three years. Further, dividends have tripled since 2000 (Figure 2), representing a moderately higher growth rate than that of the S&P 500, and a much stronger growth rate than that experienced in the UK and EU.

Further, the TOPIX payout ratio is a moderate 36%, with significant upside potential. Japanese dividends remain a manageable fraction of all earnings and cash flow measures, suggesting dividend-per-share growth is likely even if earnings shuffle sideways from here. The key risks to this view include:

• a top-line recession
• an acceleration in labour compensation
• a dramatic increase in capex (which appears highly unlikely).

Outbound M&A is booming

Another encouraging development is the ongoing surge in outbound M&A (Figure 4). During the last five years, 65% of Japan’s M&A was outbound (the other two categories are inbound and domestic). This figure is up from 15% during the 2001–2007 period and is about twice the global norm.

Cross-shareholding ratios are declining

As recently as the early 1990s, a majority of Japanese shares were held in cross-holding relationships. This reflected the historically dominant keiretsu model that was centred around the banks, trading companies and heavy industry arms of groups such as Mitsui, Mitsubishi and Sumitomo.

Since then, both broad and narrow definitions of cross-shareholding ratios have declined to new record lows. This is an important development, as it allows for more arms-length transactions, better capital allocation and improved corporate governance. For example, the June 2015 reforms that emphasised shareholders’ rights, increased disclosure and transparency, independent directors and ROE targets, would have been unimaginable in the corporate structure that dominated just two decades ago.

Over 50% of TOPIX companies are net cash

Japan is the only major market where cash ratios have risen dramatically (Figure 6, grey line). This has occurred partly because capex in Japan has declined during six of the last nine quarters and remains well below its 20 year mean. Further, tepid growth in labour compensation has allowed firms to build up cash even in years when earnings growth was sub-par. Epoch expects this cash accumulation to continue to drive strong dividend-per-share growth, more buybacks and further M&A activity.

Six sectors appear particularly promising for cash flow focused investors

Overall, the Tokyo Stock Exchange possesses several positive attributes for cash flow focused investors: a dividend yield of 2.2%, strong dividend-per share growth, record buyback activity, sharply declining net debt and a price to cash flow (P/CF) ratio of only 5.2. Epoch examined 20 TSE sectors and found that six appear particularly promising, exhibiting a high dividend yield, strong dividend growth and supportive cash flow fundamentals. They are: rubber, transportation, air transport, other financials, construction and pharmaceuticals (Table 1).

Six other TSE sectors possess high dividend yields, but appear to be less promising due to their challenging fundamentals: oil, securities firms, banks, wholesale traders, insurance and marine transport. Further, telecoms, food and utilities appear uncompelling from a cash-flow perspective even though they are among the most promising sectors for yield-focused investors in other major markets.

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2016 Epoch Investment Partners, Inc.

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“While active managers may be under pressure from passive and low cost approaches, they must stay true to their long term strategies.

“Every investor is trying solve the same problems: to balance the competing needs of capital preservation and capital growth as well as finding recurring sources of after tax income,” he said.

Mr Priest is a co-founder of Epoch and is recognized as a stalwart of funds management, an industry he has worked in since 1965 – the year when the Dow Jones industrial average first crossed through to 1000. He has witnessed first-hand the many milestones and periods of extreme volatility in markets.

GSFM formed an alliance in October 2007 with Epoch to distribute Epoch’s investment products to Australian clients. Australian retail and self managed super fund investors have invested over $2 billion in the hedged and unhedged funds since the strategy was launched in Australia.

Mr Priest said: “Today’s investment environment perhaps presents the greatest of challenges in over 40 years as we work our way through the outcomes of the very unusual and extraordinary monetary policies that affect financial markets today.

“Quantitative easing (QE) has significantly altered the discount rate applied to all financial assets thereby causing a surge in values but with relatively little impact on the real economies in the world – the ultimate source of earnings gains.

“Active management can deliver positive risk adjusted return in the long run but it is never easy.”

He says there are three important ingredients that active managers need to succeed.

“Firstly, investment managers need to have a culture that is investment led and puts the client first. If the client does not win, the investment manager does not deserve to win.

“Secondly, they also need to harness technology in a way that aids human judgment. If you have an investment process that allows quantitative tools collect the dots – and an investment team that connects the dots – that system will be superior to either one on their own.

“The third essential is that research analysts and portfolio managers must adhere to a defined investment philosophy that is transparent and also meets the definition of a sound financial architecture.

“The key to understanding a company requires an understanding of the cash generating drivers of the business. Not a focus on accounting terms like earnings or book value.

“The important questions are how does a business generate its free cash flow, and how does its management allocate that cash for the betterment of shareholders.

“It is the ability to generate free cash flow that makes a business worth anything to begin with, and it is the ability of management to allocate that cash flow properly that determines whether the value of the business rises or falls.

“Accrual based accounting measures such as earnings and valuations metrics based on earnings simply do not provide the relevant information as to whether a company is successfully generating free cash flow and whether management is allocating that cash flow properly.

“If a company can invest – either internally or through an acquisition – and it can generate a marginal return on investor capital that is greater than its marginal cost of capital, then that investment will increase the value of the business.

“But if the return is less than the cost of capital – making the investment actually reduces the value of the business – and management should return that capital to the shareholders via a cash dividend or share buy back or reduction in debt – rather than engage is supporting a bad investment.

“In today’s complex environment the business of protecting and growing capital and providing for recurring sources of income is very challenging.

“At the same time active management is under pressure today as never before, but with the correct culture and investment philosophy and by leveraging technology, active management remains central to helping investors obtain their goals,” Mr Priest said.

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Bill Priest

Bill Priest, CEO and co-CIO at New York-based Epoch Investment Partners, manager of the Grant Samuel Epoch Global Equity Shareholder Yield Funds, provides an update with two subjects — Epoch’s capital markets outlook and their view of the implications of Brexit; the latter is inextricably tied to the former.

We analyse the potential impact of Brexit by examining three forms of contagion — financial, economic, and political (Figure 1). There should be little financial contagion from Brexit, as the central banks of the world are ready and willing to act. Thus, Brexit does not present a liquidity concern. Also, although we expect there will be some economic contagion, this should be visible early and capital markets should quickly present value it. We expect, however, that Brexit will contribute to political contagion, the impact of which will have a wide reach, most notably in Europe.

(Former) Prime Minister David Cameron led his country into an unnecessary debacle. Ever greater unity has been a cornerstone of the EU since its formation over 60 years ago. Even though the EU was a monetary rather than a fiscal union, its goal and soul were directed toward the unification of Europe. We are witnessing a hiatus of this objective at best and its genuine unwinding at worst. The combination of the travails of the euro, the tide of immigration, and high unemployment have led to a “loss of patience, prudence, and memory,” as one writer recently said. The English economy has been doing well, but this is likely to change. Uncertainty will rise sharply (there is no “Leave” plan), and capital spending projects will be placed on hold or even cancelled as corporate capital allocators adopt a wait-and-see approach. Scotland voted 62% to 38% to Remain and will likely try to leave Great Britain in order to seek EU membership. Similarly, Northern Ireland voted 56% Remain to 44% Leave, and it, too, likely will seek greater independence.

There are undoubtedly many reasons for the 52% Leave vote, including the perception by Leave voters that globalisation is a dark, controlling “bogeyman” characterised by unfair capitalism with tax havens for the rich and no growth in working class wages. Other factors include high immigration, a large hangover from the Global Financial Crisis of 2008, and an expensive and deadly war in Iraq that had no visible purpose or positive outcome.

But the uncertainty surrounding Brexit will negatively impact investment spending plans and commitments. Furthermore, if Britain actually reverses trade agreements and sends workers home, there will be fewer people in the British workforce and, inevitably, lower consumption. A disavowal of trade agreements would reduce the economic benefits of trade, espoused so elegantly in 1820 by David Ricardo, an Englishman, in his treatise on the Law of Comparative Advantage. The “win-win” of trade will become a “lose-lose” if trade agreements are rolled back.

I have always believed the adage that “in the short run politics determine economics, but in the long run economics determine politics.” At the moment, however, social concerns regarding income disparity, job displacement attributable to improved technology, and a perceived disinclination of immigrants to assimilate into their adopted cultures are affecting politics, not just in the UK but elsewhere.

How does Brexit impact our views of global investment? We believe both interest rates and real GDP growth will be “lower for longer.” We have been in the “secular stagnation” camp for some time, believing that the sum of growth in the work force and growth in productivity, the sole determinants of GDP, was unlikely to exceed 2% in the developed world. While emerging markets may have grown faster, their underdeveloped capital markets, the reduction in the wage arbitrage between the developing and developed worlds, and the benefits that manufacturers now expect to gain from being closer to buyers suggest that economic growth will slow for emerging market countries as well. Brexit will not help any of these negative trends.

Furthermore, we are entering a “capital light” world, which is evidenced by the reduction of investment spending by corporations. Manufacturing’s contribution to economies throughout the world is declining. Meanwhile, technology and services have become increasingly important to global GDP. Capital goods have become cheaper. As a result, targeted levels of investment can be achieved with less spending and borrowing, resulting in a correlative reduction in capital investment.

Whereas QE was absolutely essential in 2008, it no longer drives the essential components of growth — workforce expansion and productivity gains. Financial assets have soared in value (see Figure 2) over the past few years but growth in the real economy (Figure 3) has not come close to forecasts by the IMF. Slow growth and fear of deflation have caused monetary policymakers to attempt to prop up inflated asset prices in the hope that real economic growth will follow. History suggests, however, that long periods of negative real rates coincide with periods of anaemic growth. Importantly, low rates encourage capital misallocation, as recent increased M&A activity may suggest.

Excessive money printing has also increased correlations among and within asset classes. One variable, capitalisation rates (think P/E ratios), explains more than 50% of stock market returns over the past four years as illustrated in Figure 2. In other words, beta has been the single dominant driver of returns over this period. QE effectively lowered the range of returns within an asset class, thereby reducing potential rewards from active management. The recent surge of interest in passive investing is partly explained by this effect of QE.

Nevertheless, companies whose managements have a history of wise capital allocation will provide superior returns in the end. Cash flow drives a company’s value and the astute allocation of cash maximises that value. Identifying companies that have these characteristics demands research, analysis and human judgment, and that requires an active management effort.
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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Epoch Investment Partners, Inc (Epoch) and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Epoch, Grant Samuel Funds Management, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. ©2016 Epoch Investment Partners, Inc.

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