Friday, 4 November 2016

Which sector to begin

My layered model is in theory anyway going to cover all the relevant sectors and then some.  But Where should I start?  Let me initially make some comments about the pros and cons of starting with each of the sectors.
These comments coalesce my initial views on the sectors together with my assessment of the likely economic future.  Regardless of my final sector choice, I will be picking an ETF which trades on a US exchange and which has liquidity and, likely, a preponderance of US then European corporate entities in it.  So my focus will not just be on global economics but also US and European in particular.  My horizon of choice is 2 years starting from now.

The macro economy, the US economy and the European economy are all three inhabiting a unique economic climate.  We have slowly emerged from a significant synchronised world recession, and these economies all bear a large and growing fraction of debt.  The hotly debated termination of so-called financial repression  is a hot topic (2016) and certainly interest rates will in the US soon be on the rise.  How far and how steep the rise will be is uncertain - perhaps to 2%, historically low, before we can expect to hit another recession.  At which point CBs will perhaps need to implement further quantitative easings or decompose the structural impediments to running an economy with significant negative real interest rates.

It has also  been arguable just why the various quantitative easings have not resulted in greater levels of inflation.  On the other hand, productivity growth is sub-par and returns to labour are notoriously low versus returns to capital.  This, together with a natural uptick in returns to the well educated as a result of globalisation has created a growing anti-globalisation political backdrop.

Sustained low rates encourage the growth of borrowings and make the burden of current borrowings easier to bear.  These becomes less so as interest rates rise.  Savers benefit (the wealthy save a larger fraction of their income than the poor) and borrowers loose out as the cost of new borrowings grows.  But existing borrowings are based on an at-onset nominal borrow level and terms are often fixed on a life-of-deal basis or 2-5 years for longer borrowings - notably domestic property.  For holders of of debt like this, some inflation erodes the burden of their debt.

Energy is a large, multi-faceted and I think, complex sector.  It is subject to world geo-political risk and to the economic and commodity cycles.  It also is subject to innovation risk - note how the new generation of US natural gas suppliers are going head to head with Saudi Arabia and the resulting oil price volatility.  This sector, while offering huge opportunity for big wins and losses, I think is too complex to be my first sector.

I like these categories a lot.  It represents the main economy and hence will be influenced a lot by it.  It is close enough to manufacturing to allow dramatic growth and contraction based on workable economies of scale.  Downsides are it too is sensitive to the hard-to-predict commodity cycle and to the effects of political instability generally.

Consumer discretionary 
Consumer staples 
I'm lumping these to together.  I'd like to know when they broke out as 2 peer sectors, as a matter of historical fact.  But generally this is very consumer based and hence sensitive to the business cycle (and commodity cycle too).  There's a huge range of companies in here.    The essential business model here is the manufacture and sale of millions of consumable objects to millions of consumers.  It is a scale sector.  If those objects cost little and get sold often to the average consumer, it is more likely to be in the staple category, rarely bought expensive objects being more in the discretionary.

This is such a heterogeneous (and large) sector that I wonder how stable the in-sector fundamentals would be.

This is also a growth sector which I like.  The biggest problem is the likelihood of political interference.  However there will be a continuing need for this service and governments, directly or indirectly, will be funding it.  A recent survey of the UK's National Health Service found that, of the lifetime cost associated with an average person's use of the service, the lion's share of that cost happens in the last 6 months of their life, when expensive operations, death-fighting treatments, intensive support, palliative care, pain relief, therapy, etc all happen most frequently.

A fair fraction of the healthcare offering, I would imagine, is service based, which is potentially harder to scale.

Another sector I am going to eliminate quickly as a first sector candidate is financials.  The reason is that financials present unique valuation problems for analysts and they are tied in special ways to the credit cycle and to the economic cycle generally.  Whilst their in-sector interpretation might be consistent, the meaning of all those fundamental factor levels will be, due to the mix on their balance sheets, too different to the other sectors.  Also politics plays too large a role in these names, and this varies too much in recent times. I think there's a decent chance that this pattern will continue given the overall anti-globalisation mood.

Information technology 
Telecommunication services 
I lump these two together.  In a way telecommunication services is the most apparent outgrowth of information technology.  Both are reasonable candidates.  Telecoms is more regulation sensitive and by now has a small number of well known names who though former public ownership histories or though m&a tend to have grown quite dominant in a regional context.  However I expect increasing levels of regulation in telecoms.

Information technology I like.  This is a decent candidate.
It is effectively a post WWII industry and endlessly innovative.  I see great growth potential here.  It also has a large number of new entrants too, with concomitant risk to incumbents.  It touches other sectors too.  Given the rate of innovation and the ease with which information services can travel across national boundaries, I feel that this can also escape a degree of regulation at its innovative edges.  Eventually big hitters will succumb to the regional jurisdictional demand, but that still leaves many potentially globalised companies a lot of growing space before that happens.

Utility companies can be thought of as dividend products with regulatory variance and with additional sensitivity to innovative insurgent companies trying to break into their market.  They also tend to be regional, often national.  Governments like there to be a local domestic champion or set of incumbents.  The barriers to entry are high.  Fees, and hence profits are closely  regulated.

Services get to be considered utilities insofar as the service they provide has come to seem, in that country, essential to an average household's happiness.

There will be many utility-like companies in various other sectors.  Utilities thee days include: domestic energy companies; electricity delivery companies; water companies, fixed line telephone companies.  Other utility services are performed directly by local government in partnership with outsourced private companies - for example around waste disposal.  After a period of rapid innovation, often in technology sectors, a service stabilises in its offering and gains a large fraction of the population as its customer.  This is when additional government control is initiated around the service.

Companies like this tend to be low beta, with a decent dividend.  Some utilities one could imagine would be around forever - water companies, electricity companies, waste disposal companies.  And some perhaps seem more time-specific - i'm thinking here of data suppliers (telecoms and technology).  Maybe in time these will settle down and become as tightly regulated as other utilities.  Some forms of insurance often seem to be to approach becoming utilities, and in a sense high street banking is also highly regulated and shares some characteristics with utilities, except for their stock volatility.

There are subtleties within the energy utilities since there will be unique factors associated with the cost of delivering gas for heating to a house as opposed to other forms of heating.  Households can and do switch between utilities, though often there's quite some inertia around switching,

+ these companies often are following similar business models and report their earnings in a long established set of conventions.  A consequence ought to be semantically homogeneous factors.  Also given the more or less fungible nature of the service, fundamental factors, in a healthy competitive environment, ought to be able to distinguish successful from less successfully managed companies. 

- However these companies themselves are likely to be sensitive to commodity prices worldwide and to political-regional disruption.  This is likely harder to predict.  On the plus side of this point, some oil or gas hedging can smooth out short term disruptions.

- in America a utility company is also subject to state-wide political regulation, which can be quite distorting in theory  As an almost example, consider medicare providers.  Whilst not utilities, they are a quasi-utility under Obamacare, and company coverage state-wide has become a political pawn in the recent DOJ battles with merging healthcare providers.  I would guess that the variance on price action between similar utilities is small, meaning there's less juice in equity factor modelling. Consequently if the model worked, it is likely to beat the market by a smaller amount.  All in all this is a reasonable first choice, but I'd only put it as high as 'reasonable'

Real estate 
What are you doing when you buy the property market in general?  You're buying a collection of companies who all have a remarkably consistent business model.  They borrow some fraction (1-d)% of the principal for the property estate, valued at P.  They pay back some interest on the Px(1-d) borrowed at a rate of m% and receive some rent on the full value r% (m<r) and they retain a cash buffer such that draw-downs in the value of the property capital value, to say P', will not result in bankruptcy ( P' +PV(borrowings) <E, the net equity in the company.  And you do this in as tax efficient a way for your tax jurisdiction.  Key moments in this involve when it is necessary to reoll the debt, which occurs periodically and the timing is sensitive to the volatility of equity valuations generally and to the cost of funding the estate.  It is assumed that the rental yield is less important or volatile but this is less so for commercial property, where economic downturns make rental demand fall also.  These three factors are all inter-related.

Two general observations to note about this model: there's a good degree of homogeneity about it, and second it ought to be incredibly sensitive to interest rates and property prices and the economy.

So I would expect economic factors to drive the allocation decision on this and the more traditional equity factors to drive the fundamentals of comparing one company to another.  

On this basis real estate is a reasonable initial candidate for being the first sector to look at.  It might be that there are moments when the asset allocator would flash net short, in which case the factors would look to highlight critical or unhealthy indicators of particular names.  It would be necessary to see how property companies in the US structure themselves (REIT v property company).  Finally, you'd expect fundamental factors which track this company's debt sustainability and degradation might be useful, as would factors which track this company's specific sensitivity to interest rate rises.

+ property is a real asset and hence has a degree of inflation protection burned in
- property funding becomes more costly in a rising rate environment, damping demand for property, all other things being equal
+ there is a recent painful US/UK memory of negative equity and this together from governmental involvement in regulating the level of this market would likely mean no bubble gets as out of hand as it did in the early 2000's
- the primary factors which drive this market are new houshold formation, government regulation, and interest rates (by which I mean the business cycle, the credit cycle).  Constant and predictable levels of government regulation lead to stable factors but there is always the risk of additional regulation.  The US and UK (and Europe too) are quite heavily involved in these markets.
+ in the US at least, property cycles tend to last 20 years or so.  The last crash was only about a decade ago so we can reasonably expect about another decade before the next big blowup

The two final candidates are real estate and information technology.   Real estate is, by market cap, the smallest and most stable of the sectors whereas IT is the largest.  The global dividend yield on real estate is 3.7% whereas the equivalent on IT is 1.7%.  This cuts both ways - if my strategy is to own the market (avg div yield 2.7%) and short the sector, then own my model's weightings of the sector's stocks, then there will be a higher sector bleed from being short the retail ETF.  The equivalent strategy with IT will see the market div yield more easily pay for the short sector div yield.  

I think there's more variability in interpretation on IT companies and also their business models are more heterogeneous.

EPS growth over the next 3 years is looking a lot healthier for IT and is pretty flat for real estate.  However, if I implemented my { long market, short sector long model names } portfolio then the EPS growth creates headwinds for me - any mistake in my names choice and I'll be loosing based on expected sector growth.  Whereas with retail, stable earnings outlooks mean there's probably no reason to believe a short ETF position will get whacked on EPS.

I think the 1 trillion USD real estate market will be my first sector to explore the ideas of equity factor modelling.