Is Brazil The Next BRIC To Ride EM Equity Wave?

On an equal-weighted, USD basis, Russia is up 46% year-to-date, by far the best performing country in the MSCI All-Country World Index. Coming in second, is China which is up 29%. India is the 14th best performing country (8.2%). The lone man out is Brazil which is the fifth WORST performing country year-to-date, one of only 10 countries posting a negative return year-to-date (-7%). However, there are some signs in the market internal data for Brazil that momentum is picking up.

Even though Brazil has underperformed year-to-date, so far in April Brazil has had a pretty stellar month (+11%). We are starting to see this improved momentum flow through some market internal data. 77% of Brazilian stocks are trading above its 50-day moving average and approaching a short-term overbought level. On March 27th, this level stood at only 13%. 50% of Brazilian stocks are trading above its 100-day moving average. This is the most number of stocks trading above its 100-day moving average since last September. Lastly the 200-day moving average provides some reassurance for investors that have missed this month's equity surge. Currently, only a paltry 13% of Brazilian stocks are trading above its 200-day moving average. This means that on a longer term basis Brazilian stocks are still very oversold. The upside potential then is positive if one believes the EM equity advance has legs to it. 

MSCI Country Performance (as of 4/16/2015)

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On Playing the Odds to Improve Your Batting Average

As baseball season commences we thought it only appropriate to draw an analogy between America's favorite pass-time and investing. As every good baseball fan knows, batters in baseball acquire a batting average that is aggregation of a players cumulative hits divided by the total at-bats throughout a season. Throughout the season a batter might go on runs or slumps in which their batting average is materially higher or lower than their season long batting average. But, at at the end of the day, all those cyclical ups and downs eventually revert to a somewhat predictable mean.

The same concept goes for investing: sometimes stocks in a particular market are hot (outperforming), and sometimes they are not (underperforming), but they always return to the mean in due time.

So with that, here is a review of the cyclical batting average of a few widely followed markets around the world. Each chart below shows the percent of stocks in that market that are outperforming the global stock market over the previous 65 trading days. The point here is to recognize where stocks in a particular market are in their cyclical outperformance/underperformance trend. Since all of these series predictably display strong return the mean characteristics, when too many stocks in a market are hot one should consider reducing exposure, and when too many stocks in a market are not, one should consider adding exposure.

Right now Europe and Asia are smoldering hot, and North America is cold to lukewarm. EMs are are heating up, but not yet boiling. Thus, if one wants to play the odds, one would think seriously about tactically reducing exposure to developed Europe and Asia in favor of North America.

Are Commodities And EM Stocks Becoming Less Sensitive To The Dollar?

Are commodities becoming less sensitive to changes in the USD? The surge in the dollar has negatively affected commodities somewhat but not nearly as much as one might have expected given that the real trade-weighted dollar is 19% higher than it was in July. Commodities are about 19% lower during this time. However, when the dollar surged by 14% in 2008, commodities fell by 39%.

For EM stocks, there is no doubt they have been on a tear in April. EM stocks are down about 8% since July. However, this is relatively a minor drop considering in 2008 EM stocks were down by nearly 50% when the dollar was surging. EM stocks also dropped by about 32% from 2000 to early 2002 when the real trade-weighted dollar index rose by about 18%. Will EM stocks be able to continue to relatively shrug off a stronger dollar? Or will the USD make an about-face and weaken? It seems that something has to give and the gap that has opened up in the chart below will need to be reconciled one way or another.

Can The Marriage of Two Knowledge Followers Produce a Knowledge Leader?

Most of our readers are familiar with our process that seeks to identify what we refer to as Knowledge Leaders or, quite simply, companies that consistently invest in knowledge-intensive activities such as research & development, advertising, and employee training.  Common attributes of knowledge leaders include, but are not limited to, less volatile earnings and sales growth, lower adjusted ROE, and a larger stock of intangible capital on their balance sheets.  While Knowledge Followers may also invest in important intangibles like R&D, research suggests that they do so in less productive ways and with less profound results.

Which brings us to the news that Communications Equipment manufacturer Nokia sealed a deal to purchase rival Alcatel-Lucent-- which sent shares of the latter up ~15% yesterday (followed by a decline of about the same magnitude today).  While neither of these MSCI Europe members passes our screening process to become a Knowledge Leader, their peers in the Information Technology sector have a higher than average pass rate relative to the other developed regions.  So where do these two companies miss the mark?  Alcatel-Lucent hasn't been able to maintain a positive seven-year average with respect to its free cash flow margin and neither company has managed to generate a positive average ROIC over the same time period.  In addition, while Nokia manages to score in the 50th percentile with respect to our quality metric (mostly due to a strong balance sheet), Alcatel-Lucent only ranks in the 30th percentile.

Taking a closer look at the fundamentals for the sector, we see that (true to Knowledge Follower form) both companies invest a fair amount of capital in knowledge-related activities such as R&D and advertising:



Which produces the expected increase in intellectual property assets on their balance sheets:



In fact, their collective asset bases are more than $23 Billion larger when intangible investments are properly accounted for:

Reported


Intangible-Adjusted


While this investment would seem to suggest that investors should view these two companies in a positive light, further examination shows us where such conclusions break down (at least with respect to the search for Knowledge Leaders).
Worse than average gross margins and negative net margins weigh on the companies' abilities to generate solid profitability in a competitive environment:





And cash flow metrics reveal just how much they lag industry peers:



But, you may ask, in the absence of solid fundamentals, can the case be made for a value investment?  Though each of the stocks trade at a discount relative to the MSCI World Index on a P/CF basis...



Both of them still trade a a premium to their respective 10-year averages:



And, finally, looking at them through the lens of our point and figure methodology, we see that (in both cases) significant rallies going back to 2012 appear to be faltering at levels of long-term resistance.  While those may yet be overcome, much of the picture painted by the fundamentals would seem to suggest a tough road ahead for this duo.

The information listed above is for example purposes only and should not be construed as the Investment Advisor’s opinion or investment outlook. 

The "Moonshot" Portfolio

When going through out point and figure charts, we sometimes come across a chart formation that we colloquially refer to as a "moonshot".  A "moonshot" is when a chart has been in a basing formation or in a trading range for some time and then strongly bursts out of it to the upside.  It's the ultimate example of a momentum play. What is unique about a moonshot, is it rarely underperforms the market by at least 7.5% (in order to make a 3-box reversal) to allow late investors a chance to get into the action. Instead, it stays in a long column of "Xs" for weeks, months or even years. However, this isn't a risk-free play into finding a stock that is set to outperform for years to come. Instead, there is always the risk that the thrust on the upside will give way to an equal, if not greater, thrust to the downside as momentum fades since there isn't even the scent of support nearby. With all the being said, we thought we would share 10 Knowledge Leaders that are currently in a "moonshot" formation for the momentum investors out there (or mean-reversion short sellers).

Manufacturing Survey Showdown - Who Got It Right?

US industrial production in March declined the most month-over-month since 2009. Weather again played a role as colder weather in February led to a spike in utilities output last month and this month we saw the effects of the unwinding of that spike. On a 3-month annualized basis, industrial production has fallen by -3.7%, again the lowest level since 2009.



The manufacturing component finished the first quarter on a -2.7% annualized pace. The fastest quarterly decline since 2012. What is confusing is the divergence that has developed between the available PMI surveys.  The widely followed Markit manufacturing PMI increased in January, February and March even as momentum in the hard data was slowing. However, the ISM manufacturing PMI series steadily declined throughout the first quarter. So even though the Markit surveys have become the "go to" PMI series for many economic observers, the old standby ISM series seems to have been a better indicator at least for the first quarter of this year.

Inflation Expectations & Relative Performance

For about six weeks, between the middle of January and the first week of March, inflation expectations embedded in the US Treasury market bounced after declining for the second half of 2014.



With the double whammy of lower than expected US retail sales growth (now down under 1% year over year) and weak NFIB Small Business Optimism survey (down 5 points in the last month), bond yields are retreating today.  In the last four trading sessions, breakeven inflation expectations embedded in the 10 Year US Treasury bond are already down around 5bps and failed to eclipse the highs of early March.  It would appear market expectations of higher inflation have now reversed with the latest weak economy data points.

This is important for asset allocation considerations because counter-cyclical stocks tend to outperform when inflation expectations are falling and underperform when inflation expectations are rising.  In the charts below, we show the relative performance of MSCI World counter-cyclicals vs. cyclicals compared to US Treasury breakeven inflation expectations.





The relative performance of counter-cyclicals vs. cyclicals has an 85% correlation with 10 Year US Treasury breakeven inflation and an 82% with year breakeven inflation.  After a 6% relative outperformance of cyclicals from January 20 through February 20, they are now following the trend of breakeven inflation.  If bonds yields and inflation expectations continue to decline it would suggest the major trend of counter-cyclical outperformance will reassert itself.

A Discussion On Return On Equity

One the primary reasons we adjust financial statements to include intangible assets is have a more realistic lens to view every company with. Investment in intangible assets such as R&D, employee training and brand equity create sustainable, competitive advantages that result in higher market share and pricing power. This is accomplished by the fact that intangible investments create a unique capital stock which generates future profits. When intangible investments are treated as an expense rather than as an investment, it distorts certain operating metrics that analysts rely upon by understating current profits, understating long-term assets, and understating retained earnings. Current period profits are understated because all investments in intangible assets are expensed on the income statement. This lowers current period (taxable) net profits and also reduces retained earnings under shareholder equity. Long-term assets are understated because intangible investments are never capitalized onto the balance sheet and never carried at depreciated, historic cost. Consequently, important "flow to level" operating ratios such as return on assets (ROA) or return on equity (ROE) are unrealistically inflated.

Let's take a look at this effect on a company level using Gap (ticker: GPS) and then the effect on aggregate sector data for the MSCI World Index.

Gap is global apparel retail company founded in 1969 in California. Gap has gross margins of around 38% and generates a free cash flow margin of 8.6%. Gap has been a pretty steady company over the past 20 years managing to grow sales per share, EPS, book value per share and cash flow per share by about 9-10% per year on least squares growth basis. Gap also currently has a 2.2% dividend yield. As these numbers indicate, Gap is undoubtedly a mature company that would never be classified as a "growth" stock. Given all of this, does it make any sense then that Gap currently has an ROE of 42.3%?

Let's go back to our CFA textbooks and remind ourselves what makes up ROE under a DuPont Analysis framework. ROE is made up of net profit margin (net income/sales), asset turnover (sales/total assets) and financial leverage (total assets/total equity).  In the table below is Gap's DuPont Analysis using Gap's "as-reported" data.

As-Reported ROE Calculation


Now let's view Gap through an "intangible-adjusted" lens. In the table below, we again show Gap's DuPont Analysis but this time including intangible investments. First off, you notice that ROE drops by nearly half to a much more realistic, but still impressive, 23.6%. We see that net profit margin increases by 20 bps from 7.7% to 7.9%. Net profit margin increases because we are no longer expensing current period intangible investments. However, net profit margin is also brought down by the greater amount of depreciation expense from prior periods intangible investments. Asset turnover decreases by over 28% has Gap's long-term assets as a percent of total assets increases from 36% to 52% with the capitalization of intangibles investments. Lastly, financial leverage decreases from 2.6x to 1.9x. This is caused because shareholder equity is revised upwards from just under $3 billion to over $5.5 billion. Total assets also increase from $7.7 billion to $10.2 billion. Overall, a ROE of 23.6% passes the smell test much easier than 42.3% given everything we know about Gap.

Intangible-Adjusted ROE Calculation


If we broaden this discussion out and look at sector level data, we see ROE ratios that are much more in line with a slow, but growing, global economy. All sector data is looked at on a USD, equal-weighted basis. Overall, ROE levels drop from about 18% for the MSCI World Index to about 12% on average. ROE in consumer dominated sectors drop back the most. As these companies spend quite a bit on brand building and non-scientific R&D, it makes sense that they would have a very large asset base that currently goes underappreciated when looked through the lens of "as-reported" data.

As-Reported ROE Calculation By Sector


Intangible-Adjusted ROE Calculation By Sector


The proper treatment of intangible investments in financial statements is becoming more imperative as businesses shift away from classic fixed capital investment to knowledge based, intangible capital investment. Every year more intangible capital is created by innovative companies, and every year since 1974, due to SFAS No. 2, this capital base is completely missed by the greater financial community. This information mismatch creates an alpha opportunity for investors who know where to look.

Emerging Market Equities Are On Fire In The 2Q

The average stock in USD terms in the MSCI Emerging Market Index is up an impressive 6.2% in just 8 trading days so far in the second quarter. This compares to 2.5% for MSCI Developed Market Index.

On a country basis, China is nearly 18% higher QTD. Russia continues to its impressive streak as the best performing country in 2015 as it is over 13% higher this month. Of the 23 Emerging Market country indices, only two (Egypt and Greece) are negative this month. Even Latin American countries are getting into the action as Brazil is up over 8.5% and Colombia is over 7% higher. However, three of the five Latin American countries are still negative year-to-date.

MSCI Emerging Markets Performance By Country


On a sector basis, breadth is pretty strong. All 10 sectors are positive for the month and six of the 10 sectors are over 6% higher for the month. Energy is the best performing sector (as it is in the developed markets) and information technology is the worst. Year-to-date, four EM sectors are up over 10%.

MSCI Emerging Markets Performance By Sector


Lastly, the highest of the high fliers are all out of China. The top 10 best performing stocks QTD are all from China and are up an astounding 50% on average. 6.3% of all MSCI Emerging Market stocks are up at least 20% this quarter. And 20% of all EM stocks are up at least 10%. Only about 4% of developed market stocks are up at least 10%.

Top 10 Best Performing Stocks QTD