Don your CAPE to outperform

CAPE serves as a more effective valuation metric in forecasting long term equity market returns relative to its 12-month trailing PE. The wide gulf in valuations of global equity indices provides investors an opportunity to outperform global benchmarks by increasing exposure to cheap countries while reducing exposure to expensive countries. A simple active strategy used in the CAPE model has successfully outperformed global benchmarks over the past 11 years by an average of 1.8% annually.

Hunting for value in CAPE

Investors are frequently known to misjudge when to gain exposure or exit the stock markets as fear and greed prevail over rational thought. In fact most economic forecasts and analyst reports at the start of the year have misguided investors due to their inability to predict the unknown unknowns that occur over time. In the current scenario of high volatility and mediocre corporate profit growth, we believe it would be prudent for investors to turn to valuations as a superior predictor of long term global equity market returns.

The cyclically adjusted price-earnings ratio (CAPE), measures the ratio of the current market price to the average inflation- adjusted profits of the ten preceding years. It was popularised by economist Robert Shiller and is considered the most reliable yardstick for valuations as it adjusts for temporary, highly misleading swings in profits thereby addressing the weakness of the classic price to earnings (P/E) ratio. CAPE helps to gauge whether the valuation of an equity market is high or low compared with its profit level. We believe CAPE to be the single best gauge for measuring future stock market returns as it has outperformed not only P/E ratios but other well-known metrics such as government debt to GDP, dividend yield and the Fed model (Earnings yield/Bond yield). However, it is worth pointing out that CAPE is not as efficient in timing market bubbles and chasing short term profits as it is in forecasting long term future returns from global stock markets. Conversely, it can shield investors from making brash decisions in times of crisis.

Divergence of global CAPE valuations beckons an opportunity

The past 8 years of excessive monetary easing, political uncertainty, diminishing corporate profits and a rise in share buybacks and changing dividend pay-outs have created a wide gulf in valuations globally favouring some countries over others. On observing the cape valuations of 52 global equity markets, the United States small caps emerged as the most expensive market globally at 43x. In addition US large caps feature in the top 10 most expensive countries with a cape of 21x. The S&P 500 Index is trading at a 30% premium to its long term average of 16x, these levels were last exceeded before the 1929 great depression, the 1990 dot com bubble and the 2008 financial crisis. Irish stocks appear the next most expensive and therefore hold a less favourable outlook.

Greece remains the world’s cheapest market with a CAPE valuation as low as 1.7x. Among the emerging markets – Russia, Brazil and Turkey appear attractively valued and CAPE valuations have been suggesting this for a while. While the slump in oil prices at the start of 2016 and Western sanctions have deterred investors from investing in Russia, the country’s equity markets remains attractive and is the second cheapest market globally. In Europe – Spain, Portugal and Poland are poised to deliver higher inflation adjusted annual returns over the next decade. While Spain is struggling with high unemployment levels and structural issues, its economic growth currently and over the last three years has outpaced the European Union. Not to mention its equity market remains home to highly successful multinational companies such as BBVA, Santander, Inditex and Telefonica.

The CAPE model works

We believe the wide differences in the CAPE valuations among 52 global equity markets provide investors with an opportunity to exploit. This can be executed by taking a positive exposure to the cheapest ranked 10 global equity markets and a negative exposure to the most expensive ranked 10 global equity markets according to CAPE. The strategy is rebalanced on a quarterly basis to reflect the changes from quarterly earnings season. Each quarter, the long and short positions in the portfolio are rebalanced based on the changing CAPE valuations versus the long term average. On back testing this strategy since 2005, the model successfully outperformed its benchmarks- the MSCI All Countries World Index and the FTSE All World Index by a significant margin of 31% and 25% respectively.

The CAPE model yielded an annualised return of 5% exceeding the global benchmarks at a lower volatility of 16.3%. The model was able to deliver a Sharpe and Information ratio of 0.21 and 0.11 respectively at a remarkably lower beta of 0.48 over the past 11 years. Furthermore, it trades at a relatively low frequency of once a quarter with an average annualised gross portfolio turnover of 40%.

Diversify your risk & reap modest returns

The wide gulf among global equity market valuations offers investors the opportunity to favour the cheap global equity markets versus the expensive. The CAPE model enables this, by using a tactical strategy to gain exposure to the cheaper markets and reduce exposure to the more expensive, thereby spreading an investors risk over the long term. In doing so, investors are able to contend with current heightened levels of volatility whilst achieving modest annualised returns over the long term. While CAPE by no means is a perfect indicator, it is superior to the majority of valuation metrics in forecasting long term equity returns. While there is always the risk that cheap gets cheaper and expensive could outperform, we believe prices will eventually mean revert to reflect underlying fundamentals.

"Combining two complementary viewpoints, which provide a more complete picture of investment risks and opportunities"

Laurent Nguyen explains in the latest issue of the ifund fundmanager interview, how he combines financial analysis with multi-dimensional ESG analysis in the Pictet European Sustainable Equities fund. Thereby, he aims at outperforming over the full market cycle but especially in times of high volatility and an uncertain environment.

What is your fund all about and what differentiates it from your competitors?
Our philosophy is to select companies by applying a unified view of sustainability in both the financial AND extra-financial dimensions. We believe in blending the respective skills of judgmental, quantitative and ESG analysts to build defensive, diversified, albeit active, portfolios. Since our dual quantitative-ESG expertise dates back to the late 90s, we are convinced that the experience gained over those years coupled with our highly-skilled team members are our most precious assets.

Literally, the word “sustainable” denotes what is able to last or continue for a long time. In-line with this definition, we take a very candid approach to sustainability by investing in companies which, in our view, are more likely to still be there in the future. We are convinced that such companies should have two key features:

  • Financial robustness, in order to generate attractive risk-adjusted returns and face economic downturns.
  • Corporate responsibility, in order to make better long-term decisions 

Our investment objective is to deliver superior risk-adjusted returns by investing in companies that excel in both dimensions. By contrast, we seek to avoid companies that partially meet our investment criteria, for example by generating profits at the expense of society or the natural environment.

We achieve this by combining two complementary viewpoints (financial and extra-financial) which, taken together, provide a more complete picture of investment risks and opportunities.

How do you add value for your investors?
On the financial side, we apply a proprietary framework for assessing companies’ financial robustness. This is our Quality framework developed after the 2008 financial crisis and based on the observation that extra-financial analysis by itself was a necessary but not sufficient condition for generating attractive risk-adjusted returns over a full market cycle.

Our proprietary framework is based on what we call the 4 P’s of “quality”: Profitability, Prudence, Protection and Price.

  • Profitable companies are less-likely to take short-term, potentially counter-productive, measures due to market pressures. The comfort of a wide economic moat should translate in better strategic, value-enhancing, decisions in the long-run.
  • High financial leverage and aggressive M&A policies are double-edged swords. Prudent companies should be less vulnerable than their reckless peers during and after the unavoidable “hangover” phase.
  • Companies having demonstrated their ability to better navigate the economic cycle tend to provide down-market protection which is in-line with our conviction that in the long-run, to gain more, you have to start by losing less.
  • For a given stream of future cash-flows, the higher the price, the higher the riskiness (i.e. duration) of the asset. Moreover, stocks with high expectations embedded in the price are more likely to disappoint than others. Thus, attractively-priced companies are expected to outperform over the long-run.

Quality companies can hence be described as high and stable return businesses that are resilient to economic cycles and attractively priced. We analyze companies along those four axes by using financial indicators which capture the essence of each “P”. 

Similar to our financial analysis, we apply a multi-dimensional approach on the ESG side. We articulate our ESG research framework around four key pillars (Governance, Operations, Products, Controversies). This framework provides us with a strong basis for gaining further insight in corporate responsibility, detecting green washing, and integrating innovative data sources as they become available to the marketplace.

  • Governance is an important factor due to key role of board members in shaping a company’s long-term strategy and managing potential conflicts of interests between principals (shareholders) and agents (senior management). Our assessment includes conventional aspects of corporate governance (e.g. board composition, executive remuneration, auditing and shareholder’s rights) as well as unconventional aspects such as accounting integrity (which aims at detecting potential overstatements of revenues/assets and understatements of expenses/liabilities) and tax citizenship which measures the extent to which companies pay abnormally low corporate tax.
  • Operations focus on measurable environmental and social impacts of a company’s activities, including but not limited to: greenhouse gas (GHG) emissions, energy efficiency, water intensive operations, process and occupational safety. These factors are deployed in sectors where they are most material.
  • Products seek to identify companies that generate positive or negative externalities on society and/or the environment through their product mix. Products and services that we seek to gain exposure to include: zero and low carbon energy sources, energy efficiency solutions, pollution control, water & waste management, life & health insurance, healthy & organic food, healthcare equipment and services, and finance to SMEs. By contrast, products & services that we seek to avoid include: oil and coal, carbonated soft drinks, fast food, pesticides and insecticides, investment banking and high frequency trading. Hard exclusions apply to companies with at least 5% turnover in weapons, nuclear, tobacco, alcohol, gambling, pornography and GMOs.
  • Controversies enable to identify serious and recurrent cases of bribery and corruption, market abuse, supply chain and labor issues, pollution incidents or product scandals. This factor provides a good proxy of company reputation and adherence to universal principles such as the UN Global Compact.

In order to maximize the potential to deliver superior risk-adjusted returns based on financial and extra-financial analysis, we implement a systematic, scalable portfolio construction process, which builds upon our fundamental and quantitative skills.

How do you generate investment ideas?
As managers blending quantitative and fundamental analysis, our process is bottom-up by design. Our positioning reflects our ESG and quality assessment. We do not visit companies. 

How is your team structured and who is responsible for the investment decisions?
Our team is structured around three poles of research: quantitative, financial, ESG. Moreover, as systematic investors we rely on a robust IT infrastructure. The team comprises 7 people with a double-digit year average seniority.

In which market environment does your investment style work best?
Our multi-dimensional quality approach favors companies that tend to outperform the market over a full market cycle while being less risky than their peers. While tending to outperform over a full market cycle, our fund works best in highly volatile, uncertain environments. It is fact based evidence that in a global economy stuck in a climate of low growth and low inflation, the companies that tend to do well are those with stronger balance sheets and greater pricing power. Such stocks are less volatile over the long run, and tend to deliver stronger returns in distressed periods. An equity portfolio composed of financially robust companies can spread risk far more effectively over the course of the economic cycle. 

Beyond the cycle itself, the fund is also set to benefit from the gradual shift to a more sustainable economy driven by changing consumer preferences, technological advances, more stringent regulation and other measures that seek to protect public health and the environment.

Where do you currently see the best potential and largest risks in the market?

Especially after the Brexit vote, Europe is at a crossroad. Uncertainty will be high and markets will be even more dependent on policy responses. In that environment, we are confident that our natural defensive stance should deliver attractive risk-adjusted in the years to come. We consider that the biggest risk lies in the banking system.

Which aspects of responsible investing do you consider in your investment process?
Responsible investment is completely embedded in our stock selection criteria and ownership practices.  We only invest in companies that are within the top 50% of our ESG assessment.  We exercise our voting rights systematically and do not lend our shares, which enables us to vote on 100% of shares held in the portfolio. Portfolio companies are closely monitored to provide an early warning in case an accident happens. If the issue is serious and is not properly addressed by management, we will sell off. We also publish the ESG characteristics and composition of the portfolio on a quarterly basis. For example at the end of March, we were invested in companies that are 33% less carbon intensive than the MSCI Europe.

The sustainable nature of the fund is recognized by the German Forum Nachhaltige Geldanlagen (FNG) which awarded two stars in 2015. See http://nachhaltigkeitsprofil.forum-ng.org/pictet-european_sustainable_equities-fng_nachhaltigkeitsprofil.pdf.

About Pictet
Founded in Geneva in 1805, the Pictet Group is today one of Europe's leading independent wealth and asset managers, with CHF 424 billion in assets under management or custody at 31 March 2016. The Pictet Group is owned and managed by seven partners ,with principles of ownership and succession that have remained unchanged since foundation.
The Group applies a prudent risk management policy. This policy is expressed in a high liquidity coverage ratio that reflects our conservative balance sheet policies. Furthermore, the Group's equity level is well in excess of the Swiss legal requirements, among the most stringent in the world.
The Pictet Group, headquartered in Geneva, employs more than 3,900 people. It is also present in Amsterdam, Barcelona, Basel, Brussels, Dubai, Florence, Frankfurt, Hong Kong, Lausanne, London, Luxembourg, Madrid, Milan, Montreal, Nassau, Osaka, Paris, Rome, Singapore, Taipei, Tel Aviv, Turin, Tokyo and Zurich.

About ifund
ifund provides fund research, manager selection and asset management based on liquid investment funds. Clients include banks, asset managers, family offices, pension funds and insurance companies in Europe. ifund has signed the UN Principles for Responsible Investment and integrates sustainability criteria in fund analysis. www.ifundservices.com, info@ifundservices.com, +41 44 286 8000

About altii
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