Global markets: risk love on the fat pitch

Alliance Bernstein

Winner of Money Management’s Fund Manager of the Year 2005 and international equities awards.

In our view, concerns about global inflation, interest rates, and economic growth have been exaggerated.

From a long-term perspective, upward price pressures remain muted and future monetary tightening is likely to be gradual and measured.

Although the rate of global economic growth has slowed from last year, corporate profitability and cash flow is strong based on cost cutting and productivity improvements.

We believe the gap between the best and worst performing stocks has narrowed.

Some investors argue that now is the time to take on extra risk by building more concentrated portfolios. We disagree and continue to build broadly diversified portfolios.

We have fewer aggressive sector over/underweights than usual. However, our research is enabling us to exploit pockets of opportunity in financials, commodity producers, and technology stocks.

Looking forward, we expect the bulk of our performance versus the benchmark to come from stock-specific value opportunities within industries.

Kevin Boreen is senior vice-president and senior portfolio manager for global value equities at Alliance Bernstein.

GMO Australia

Finalist in Money Management’s Fund Manager of the Year 2005 international equities category.

The years following the pricking of the tech bubble in March 2000 through to 2003-04 offered active global equities managers an ideal opportunity to land the big ‘elephants’ in terms of mispricing opportunities.

First and foremost, low price/book (value) stocks across the globe were modestly priced compared to the growth companies that had dominated.

Second, small cap stocks were trading very cheaply, as were ‘old economy’ stocks. Then it was emerging market equity’s turn to shine — this low-hanging fruit was snapped up by value managers during 2000 to 2002 and into early 2003.

Today, small caps stocks are no longer cheap, value no longer trades at a significant discount to growth, and even emerging market equities look close to fully priced.

So, where we once saw gaping chasms in valuation, we now see valuation compression. At the same time, the consensus seems to be that the world economy can continue moderate to strong growth rates.

Consensus forecasts for rolling 12-month world GDP for the past six years to March 2005 show that economists as a group never predict a major downturn — human beings tend to extrapolate the recent past. Is this as good as it gets?

Our response to this environment — that appears to be ‘priced for perfection’ — is as follows.

Seek quality where you can find it. Quality here refers to companies with high and stable profitability (ROE) and low debt.

Our research shows these companies have usually traded at a premium to the market of 8 to 10 per cent over the longer term. Investors have been willing to pay a little more for the defensive qualities that these companies typically offer. At present it is possible to pick up some of these quality names at no premium to the market.

Momentum as a diversifier: Trends in markets can persist much longer than mere fundamentals would suggest. Another great feature of momentum investing is that it is a natural complement to value investing.

Be patient and wait for the ‘fat pitch’. Don’t take on additional risks when the reward to risk may be poor. Over the past two years, markets have been dominated by ‘risk love’ — the riskier the asset class, the greater the return. To a large extent, this was a result of the US Federal Reserve keeping interest rates low and liquidity plentiful in the aftermath of September 11, 2001 — investors could see this as a ‘free pass’ to speculate in risky assets without fear of rapid rate rises.

The recent and continuing US interest rate rises seem to have slowed, and even brought an end to this phenomenon.

Risk rewards: GMO produces seven-year asset class return forecasts for all the major asset classes. As part of this process we also reviewed the ‘reward for risk taken’ over the calendar years 2003 and 2004.

During this time investors could have expected an average of 23 per cent per annum return for risk taken of 15 per cent per annum. Our research shows the ‘normal’ long-term reward to risk is around 6 per cent per annum for risk taken of 15 per cent per annum. Hence the warning not to reach a long way out on the risk spectrum with expectations of the sort of rewards that 2003-04 offered.

On a regional basis, EAFE (Europe, Asia, Far East) offers more scope for positive surprises as expectations are lower, notably in Germany and Japan (both economies have suffered at least two successive quarters of declining GDP, meeting the definition of recession). Also, valuations are not so demanding.

So, while the bull case for global equities is not strong, the relative opportunity looks good, but a relatively defensive orientation for the balance of 2005 seems prudent.

GMO’s key positions in the current environment are as follows:

n countries: overweight: Japan; Germany. Underweight US, UK;

n sectors: overweight: autos, utilities; oil and gas. Underweight: banks, media;

n size: overweight: medium-large caps.

Keri Pratt is head of marketing and client service at GMO.

MFS Investment Management

Finalist in Money Management’s Fund Manager of the Year 2005 international equities category.

The US market seems to appear fairly valued and, as such, we see stock market movement in 2005 being driven largely by earnings growth, but without significant expansion in the valuations. Companies will continue to generate increasing profits, due to their low and decreasing cost structures and relatively moderate labour-cost increases.

Large cap growth is ‘in’. In the US, small cap and value companies have reigned supreme for the past few years, however, we believe this run is coming to an end and expect large cap growth to outperform going forward.

Europe is where the action is. Labour reforms, cost-cutting and restructuring trends are still in their infancy in many of the European countries, particularly when compared to the US, and these factors can only increase profitability across the Eurozone. Stock valuations continue to trade at a discount to their US counterparts and have led some managers to overweight Europe.

Risk, both absolute and relative, is down. Whatever the reasons for this decrease may be — the rise and fall of ‘irrational exuberance’, late 1990s bubble-inflated risk over the short term, or perhaps a return to more ‘normal’ market conditions — it remains clear there is the opportunity for skilled stock-picking managers to outperform the herd.

Marian Poirier is a senior business development manager at BNP Paribas — sole distributor of MFS funds in Australia.