Groundhog day: 2011 will be a repeat of 2010’s themes…
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In many cases, we expect themes for 2011 to be a repeat of 2010, when getting countries right became just as important as sector picking: the dispersion of returns was the same for both. This was driven not only by sovereign risks (which were plentiful) but by economic divergence. In the last year there has been a tight correlation (+87%) between GDP across countries and their respective stock markets.
Within Eurozone, the periphery will likely continue to suffer
We continue to recommend taking advantage of growth differentials across Europe via two recommended trades: i) long exposure to Core Eurozone (GSSTCEMU) vs. short stocks with peripheral Eurozone exposure (GSSTPEMU); and ii) long German consumer stocks (GSSTGCON) vs. STOXX Europe (SXXP).
BRICs-exposed stocks to do well (again)
We forecast that the BRICs economies will continue to outpace Europe for some time as they rapidly industrialize. While there will likely be hiccups along the way, for example further tightening in China may stall the markets temporarily, we would not regard these as a long-term concern especially for those with a six month plus horizon. We continue to recommend being long our basket of EM exposed stocks (GSSTBRIC). We remove our short in US exposed stocks (GSSTAMER) given a stronger US outlook.
Initiating a long on stocks with high operating leverage
We forecast 2011 to be another year of strong global economic growth and companies with high operational leverage should continue to outperform. We recommend a long in our operational leverage basket (GSSTOPLV) vs. the market, and note that the companies in this basket are not at a premium despite much greater potential for upgrades, in our view.
Dividends and pensions on the radar in 2011
We also have two more micro themes. Dividend yields are high vs. bond yields but it has been difficult to generate returns by going long high yield stocks. We think a better strategy is to go long those with high yields and potential for dividend growth (GSSTHIDY) vs. short those with high yields but vulnerable to cuts (GSSTDCUT). We also recommend a short in stocks vulnerable to higher pension expenses/solvency issues (GSSTPENS).
We highlight five themes for 2011 and discuss below recommended implementations:
1. Divergence within Europe;
2. BRICs growth;
3. Operating leverage;
4. High yield companies that can grow dividends vs. those in danger of cutting;
5. Shorting a basket of companies with high pension risks.
The first three themes are macro in focus and the last two are more concerned with micro risks. Running through most of these themes is the concept that investors are not paying fully for divergence in growth. We discuss this in more detail in Portfolio Strategy: Going for growth, December 1, 2010. Risk aversion remains high at the moment and this reduces investor willingness to pay a premium for companies that offer a promise of future growth.
But as tail risks fade through 2011, we expect the risk premium to fall and for stocks with access to strong growth (through BRICs or through Germany or simply through having a balance sheet with the capacity to grow dividends) to perform well.
Macro themes: Europe divergence, BRICs and operating leverage
1) Divergence in Europe (page 5): Country performance has been a key driver of returns in 2010 and we expect this to continue. This has not just been driven by sovereign spreads; there has been a very tight correlation (+87%) between GDP growth across countries and their respective stock market performances. We see this continuing in 2011, in particular we foresee further painful adjustments for the peripheral Eurozone economies in order for them to gain competitiveness. We have two implementations to express our view. i. Long stocks with exposure to core Eurozone countries (GSSTCEMU) vs. a short on those with exposure to peripheral Eurozone (GSSTPEMU). We have extended the stocks in GSSTPEMU to include those that now face higher funding costs. ii.
Long German consumer stocks (GSSTGCON) vs. short STOXX Europe (SXXP). We are removing our recommendation to be Long DAX vs. short IBEX given very strong performance and look for a better entry point.
2) BRICs growth to continue to overshadow European growth (page 16). We forecast that the BRICs economies will continue to outpace Europe for some time as they rapidly industrialize. While there are likely to be hiccups along the way, for example the chance of some further tightening of financial conditions in China may stall the markets temporarily, we would not regard these as a long-term concern especially for those with a six month plus horizon.
Our basket of BRICs-exposed European companies (GSSTBRIC) has been a strong performer but has not – and we think this is crucial – experienced a rerating vs. the rest of the market. The median multiple for the basket is the same as for the market. We believe continued strong performance by these companies will be driven by earnings upgrades: the 3Q earnings season saw comparatively more upgrades for BRICs-exposed stocks. We have several implementations of this theme.
i. Long GSSTBRIC vs. short domestic Eurozone exposure (GSSTDOME).
ii. Long our basket of developed market companies with EM exposure vs. short the MSCI world (GSSTDM50 vs. MXWO).
iii. Long our basket of top performing EM companies vs. short the MSCI EM index (GSSTEM50 vs. MXEF).
We are removing our recommendation to be Long GSSTBRIC vs. short GSSTAMER (European companies with US exposure) as this trade has worked well but recent strong growth in the US and upgrades by our US economists make it less attractive in our view.
3) Operating leverage to drive earnings in 2011 (page 19). We expect earnings growth to be strong this year driven by a continuation of the cyclical recovery and our profit growth forecasts are materially above consensus. We believe company earnings in cyclical sectors, with particularly high operational leverage are likely to surprise the market to the upside. We did a backtest looking at the performance of the most highly operating levered companies and we found that historically the share prices of these companies tended do well throughout the recovery in earnings. Furthermore, like so many of the themes that we recommend, outperformance so far has reflected relative earnings growth, not valuation. We initiate a recommendation to go long our basket of highly leveraged companies GSSTOPLV vs. short the market SXXP.
Micro themes: Dividends and pensions
High dividend yield stocks with growth (page 21). Currently, an unusually large proportion of companies in the STOXX Europe 600 are yielding more than corporate credit. But so far despite this, pure ‘yield’ strategies have not worked in Europe. Investors are concerned that a lot of high yield stocks become classic ‘value’ traps; the stock appears ‘cheap’ only to get progressively ‘cheaper’ as investors downgrade their expectations of dividends and growth. We find refining a high dividend yield strategy to only include stocks with sustainable and growing dividends can enhance the market-relative performance materially.
We recommend our basket of high dividend yield companies (GSSTHIDY) vs. a short in those with high yields but vulnerable to a cut (GSSTDCUT). We close our recommendation to be long GSSTHIDY vs. the STOXX Europe index; this trade has not worked well, a reflection of the difficulty of trading a pure yield theme in Europe.
Companies with pension risk to come under more pressure (page 26). When adjusting for ytd asset returns and changes in bond yields, we estimate that the aggregate pension deficit for the STOXX Europe 600 has increased by €86-101 bn and that the deficit as a proportion of market cap has reached a new high. In November this year we recommended selling companies that we expect to have increased pension risks in the first half of 2011. We believe lower returns on assets in 2010 (and thus higher pension expenses) combined with an increase in pension deficits owing to lower bond yields is likely to increase the focus on pension problems in the coming months.
We recommend a Long in the STOXX Europe index (SXXP) vs. our basket of companies vulnerable to higher pension expense (GSSTPENS). We think this trade will work well over a 3-6 month horizon as the market focuses on the results and accounts for 2010.
1) Profiting from the divergence in Europe
We believe divergence in country performance across Europe, a significant theme in 2010, will continue to be a similarly important factor in returns in 2011. We have two recommended trades to profit from country divergence.
1. Go long our basket of stocks with exposure to core Eurozone countries (GSSTCEMU) vs. a short on those with exposure to peripheral Eurozone (GSSTPEMU). We have been recommending this trade since April 2010 but we see more potential upside given the structural problems in the periphery. We have extended the stocks in GSSTPEMU to include those that now face higher funding costs.
2. Long German consumer stocks (GSSTGCON) vs. short STOXX Europe (SXXP). Higher employment and a stronger euro should help restore the confidence of German consumers and we would expect consumer related companies with exposure to Germany to benefit from rising demand. The first of these trades could suffer at least initially if/when sovereign spreads in Europe were to narrow. But we would see this not only as a way of trading sovereign risks but, more importantly, as a way of trading divergent trends in economic growth across Europe. However, we are removing our recommended trade to be long DAX vs. short IBEX given the concentrated nature of the IBEX and the strong recent performance of this trade.
1. Long core Eurozone (GSSTCEMU) vs. short peripheral Eurozone (GSSTPEMU)
Country performance has been a key driver of returns in 2010 and we expect this to continue. Exhibit 6 shows a fairly tight relationship (correlation of +87%) between GDP estimates across countries and equity market performance. One can almost see the counties split into three blocks: the peripheral Europeans (Greece, Ireland, Portugal, Spain and to a lesser extent Italy), which have had the weakest recoveries, the most debt problems and hence the biggest hit to fiscal spending, the core of Europe, which has been better off than the periphery but still struggled to some extent under debt deleveraging and weak banks, and the Nordic countries where strong global growth has been the main driver.
The divergence between the peripheral counties and the rest has been the most marked (Exhibit 8) and has been one of our key themes throughout 2010.
The relative performance of equities mirrors the divergence in earnings revisions and sentiment throughout 2010 (Exhibits 9 &10). The cumulative change of earnings estimates for the core since the trough is 37% compared to 30% for the periphery countries. Similarly, earnings sentiment for companies in core countries is positive while for periphery countries it remains negative. We have also witnessed a similar divergence throughout the earnings seasons – while in aggregate earnings have surprised to the upside throughout the year, we have found that the relative strength of surprises was higher in the core countries (see Strategy Matters: 3Q earnings season: Surprises, performance and revisions, November 18, 2010).
Headwinds are likely to stay for periphery countries
Even if sovereign risks were to reduce and be managed for the periphery countries, those countries would still face some persistent headwinds. The fiscal austerity programs are likely to depress domestic demand while there is a large divergence in industrial production between core and periphery countries, both owing to lack of competitiveness, a weaker banks sector and export performance. Based on manufacturing PMI surveys this divergence is likely to continue (Exhibit 11) – in recent months industrial production for the periphery countries has already fallen while the core Eurozone countries, even excluding Germany, have been steaming ahead.
Our economists estimate that the European periphery would need to see a 20%-30% depreciation in the real effective exchange rate to tackle the current account imbalance. As the bulk of the periphery’s trade is with the remainder of the Eurozone, most of this adjustment is likely to come from serious wage restraint as labour costs have become uncompetitive in the last 10 years (Exhibit 12).
Rising funding costs are likely to make a bad situation worse
Another important headwind for companies in the periphery are rising funding costs owing to a spillover of sovereign risk to the private sector (see European Weekly Analyst: Rising funding costs in the periphery, November 4, 2010). Indeed, the median CDS for core Eurozone companies in the STOXX Europe 600 is now 85bp below the median CDS for companies domiciled in the periphery (Exhibit 13).
Sovereign risk matters in particular for financials – the median CDS of financials in the periphery is 93bp higher than for those in the core and are highly correlated to the sovereign CDS. The difference for non-financials is only 60bp. Banks and insurance companies usually hold significant amounts of mostly domestic sovereign debt on their balance sheet. Currently, the link between banks’ actual funding cost and CDS is less clear as the ECB provides a liquidity facility at 100bp, which banks, particularly in the periphery, still use heavily (see Europe: Banks: October reliance on ECB: Spain down €40 bn, Ireland up €11 bn, November 12, 2010). However, our economists expect that the ECB will phase out those liquidity measures in 2011, which could put more pressure on periphery banks.
Sell our revised GSSTPEMU basket (periphery) against the GSSTCEMU (core)
To profit from further divergence we continue to recommend selling companies that rely on domestic sales in the Eurozone based in the periphery (Bloomberg ticker: GSSTPEMU) and buy those based on the core countries (Bloomberg ticker: GSSTCEMU). Both baskets include companies listed in the Eurozone, which our analysts cover and have 90% or more of their sales to Europe ex UK. We have adjusted the cut-off to 80% for Portuguese companies to ensure some representation in the baskets.
We have also set a minimum market capitalization of €1 bn for all companies (€3 bn for banks to avoid concentration). Finally we have checked for borrowing cost and removed companies where this is prohibitive, or where shorting is not possible, as is the case in Greece at the moment. To improve diversification for the GSSTPEMU we add eight new companies with relatively high leverage (>15% interest/ EBITDA) that might suffer from higher funding costs, while also having over 60% sales exposure to the Eurozone. This gives us a total of 31 stocks in the basket. Based on the median consensus FY2 P/E the GSSTPEMU already trades at a 22% discount to the GSSTCEMU. But this is not that different from the historical range, since 1995 the average discount of the GSSTPEMU to the GSSTCEMU has been 16%. We think the discount could extend further and we would expect relatively weaker earnings revisions for the periphery exposed stocks.
2. Long German consumer (GSSTGCON) vs. short STOXX Europe (SXXP)
While the peripheral countries suffer under the weight of de-leveraging, the aftermath of housing booms and uncompetitive export sectors, Germany and especially the German consumer is starting to see solid signs of improvement.
Higher employment and a stronger euro should help restore the confidence of German consumers and we would expect consumer related companies with exposure to Germany to benefit from rising demand, see Strategy Matters: The German consumer: Stirring sleeping beauty, October 14, 2010. There are already signs of this improvement in sentiment. The consumer ‘willingness to buy’ component of the Gfk survey and the retail component of the Ifo survey both suggest that German consumer confidence has risen strongly, indeed the retail component is more positive than in the last peak in late 2006 and has risen significantly in the last few months. Moreover, the unemployment rate in Germany is now below that in the US – and crucially this gap is likely to widen in the next year as, on our forecasts, the US will suffer from a lacklustre recovery in jobs. Improvements in labour market flexibility have been especially successful in creating more jobs in Germany in the last few years.
It is difficult to come up with stocks exposed to the German consumer. Nevertheless in our October piece we put together a basket of 23 companies that, as a group, we believe trades the theme (Bloomberg ticker: GSSTGCON). Inclusion in the list requires at least 25% sales exposure to Germany and for that exposure to be in a consumer area or very closely allied to it.
We have been generous in our definition of consumer areas, including, for example, both Allianz and Deutsche Telekom, which are both large German names but not necessarily instantly thought of as consumer related. Allianz has a significant life and non-life businesses in Germany and in addition the asset management business should be sensitive to consumer trends. Deutsche Telekom, while having a significant business related component, also has significant consumer exposure. Also, it is notable that telecoms expenditure has been one of the few ‘growth’ components of German consumer spending in the last few years.
The basket has already performed very well vs. our basket of peripheral Eurozone exposed companies (GSSTPEMU) especially in the last month or so as the market has priced increased sovereign risks for the peripheral countries. The strength of performance has taken it to 4-year highs; we therefore see more value in long GSSTGCON vs. the broader market, STOXX Europe (SXXP) (Exhibit 21).
The very strong recent performance increases near term risks for this trade. But the valuation is not stretched in our view. We think that a small premium for German consumer stocks is justified
In the short term removing our trade to be Long DAX vs. short IBEX
We expect a strong German economy in 2011 driven by a pick-up in both domestic demand and export strength. As mentioned above, the German consumer is benefiting from strong employment and income growth. GDP growth in Germany is forecast by our economists to be 2.7% in 2011 vs. just 1.0% in Spain.
However, the DAX has already outperformed the IBEX by more than 30% this year and in recent weeks the underperformance of the IBEX has been especially sharp driven by the growing concerns about sovereign risks and contagion in Europe. We do not expect the Spanish government to require an IMF or European bail-out (although given more recent events such a possibility can not be excluded). But even if/when the sovereign crisis fades there are still severe structural impediments to Spanish growth. This is certainly a trade that we may look to put back on some time in 2011 when we think there is a better entry point.
It is possible that there may be a permanent discount for Spanish companies. The current bond spread between Spain and Germany is very close to the one we had in 1996 (not anywhere near as high as earlier in the 1990s when spreads were over 500bp). Back in 1996, Germany traded on a 40% premium to the Spanish market (Exhibit 23). Today the German market is on a 26% premium to Spain (based on the latest 12-month forward IBES data). Of course back in 1996, the two markets were different in terms of sector and stock exposure: the Spanish banks, Telefonica and Inditex are also very exposed internationally – not just to Spain – and these are the biggest stocks in the index. However, prior to EMU there was a discount for Spain (and a similar one for other peripheral countries) and this was related to the sovereign risks. This could easily reemerge.
2) BRICs: Plenty of growth still to come
We continue to recommend a Long in GSSTBRIC and short GSSTDOME our basket of companies exposed to domestic Eurozone.
In our 2010 outlook report, we highlighted BRICs exposure as one of our key themes for 2010. At the time, we argued that stronger growth in emerging economies would allow companies with exposure to these regions to outperform their peers exposed to weaker domestic demand in Europe and the US. Over the course of the year, this theme has played out well with both our European BRICs basket and our DM Nifty 50 outperforming their respective benchmark indices.
We remain convinced that BRICs exposed companies will benefit from the structural realignment of the global economy. As these companies enjoy a higher growth rate in their end market than their domestically exposed peers, we think they will outperform them on a long horizon.
When looking at the Japanese experience over the last twenty years, we found that in a situation where external demand growth significantly outpaced domestic demand growth, companies able to capture the former tended to outperform their market for a significant period without becoming more expensive. This has been true for the BRICs-exposed European companies today: they have performed well but do not on average trade on a premium.
On top of the earnings growth differential, we believe that this time around the BRICs basket valuation relative to the market has the potential to expand. In the Japanese experience, the starting multiples were significantly higher than in Europe and the overall market de-rated for almost a decade. Valuations are currently inexpensive in Europe, and as we have highlighted in our previous report (see Europe Portfolio Strategy: The Value of Growth, September 7, 2010) high growth companies are tending to trade at much lower premiums than in the past.
However, in the near term, there are some risks for BRICs-exposed stocks. Emerging market economies have rebounded more sharply than developed ones from the crisis (and this is what has partly driven the outperformance of our basket). As a result EM are more ahead in the economic cycle and inflation is now increasing in emerging markets, while we continue to forecast low inflation in both the US and Europe. The first half 2011 may therefore be a time during which EM central banks continue to tighten while we do not forecast that the ECB will raise rates over that horizon, and we expect the Fed to stay on hold through to the end of 2012.
This year we have already partly witnessed this phenomenon as China started to tighten preemptively at the beginning of the year. This has not, however, hindered the outperformance of our BRICs basket (Exhibit 27). However, this year’s tightening happened while the European sovereign crisis unfolded and the US was suffering from the negative drag of the end of the inventory cycle and the withdrawal of fiscal stimulus. Arguably higher inflation was then the better problem to have and our BRICs basket outperformed. The next few months are likely to present a very different picture if our economists are right; we expect growth in the US to improve gradually through 2011 reaching 3.0% year on year in 4Q and for sovereign risk to fade in the Eurozone. Given this there are some near-terms risks to the trade, but for those with a more medium term horizon (6 months or more) we see the risks presented by moderately tighter policy in EM as small compared with the ongoing economic outperformance. Our economists expect the BRICs economies to grow by 8.7% in 2011 and 8.3% in 2012 after posting 8.7% growth in 2010; hardly a rapid slowdown caused by tightening policy. This compares with forecast Eurozone growth of 2.0% and 1.8% in 2011 and 2012.
However, in light of stronger US data and given our economists’ upgrades to US growth forecasts, we remove our recommendation to be long GSSTBRIC vs. short GSSTAMER, our basket of US-exposed European names. This trade has performed well and is up 10.4% since we recommended it in the summer.
3) Operating leverage initiate on a new theme
We initiate a new recommendation to be long European companies with high operating leverage (GSSTOPLV) vs. the market (SXXP).
We expect earnings growth to be strong in 2011 driven by a continuation of the cyclical recovery and our profit growth forecasts are materially above consensus. We expect margins to increase across the market by 104bp in 2011E and expect positive operating leverage for the market as a whole. We also think cyclical sectors will be driving the growth of earnings and expect operating leverage for these sectors to be particularly strong. Companies in cyclical sectors, with particularly high operational leverage are, in our view, likely to surprise market expectations to the upside on earnings; we recommend being long highly operationally levered companies.
We performed a backtest looking at the performance of the most highly operationally levered companies and we find that historically these companies tended do well throughout the recovery in earnings.
As shown in Exhibit 29, in the previous cycles, operating leverage outperformed the market from 1992 to 1997 and from 2002 to early 2007. In this cycle, the strategy has started to outperform from the trough of the market and has already recovered a part of its underperformance. Investors might be put off by the already impressive degree of outperformance. However, our backtest shows that this strategy performed well beyond the initial stage of the recovery in the past and actually quite late in the market cycle. Furthermore, like so many of the themes that we recommend, outperformance so far has been driven by relative earnings growth, not valuation. As Exhibit 30 shows, the relative median forward consensus P/E of this strategy is very similar to that of the market as a whole. Even if highly operationally levered companies initially become more expensive than the market in the first stage of the recovery they de-rate quicker than the market when earnings rebound.
4) Buy high dividend yield stocks (with growth)
We recommend a long in our basket of stocks with high yields plus potential to growth dividends (GSSTHIDY) vs. short in our basket of high yield stocks but where dividends are not as sustainable (GSSTDCUT).
In our 2010 outlook report we also highlighted the attractiveness of high dividend yield stocks. While we expected companies exposed to stronger growth outperform, we also saw value at the ‘deep value’ end of the market. Historically, high dividend yield strategies have done well in the ‘growth’ phase and in periods when equities were yielding more than bonds owing to the traditional search for yield. Currently, an unusually large proportion of companies in the STOXX Europe 600 are yielding more than corporate credit (Exhibit 32). Dividend yields tend to be below bond yields as equity investors benefit from future growth—the opposite occurs mainly if the market expects a sustained low growth and deflationary environment.
However, over the past year it has been difficult to outperform the market buying high dividend yield stocks as they tend to be in defensive, low beta, ex-growth sectors that are often battling structural declines in ROE and lower top line growth (Exhibit 34) (see the Growth of Yield, October 8, 2010).
Investors are concerned that a lot of high yield stocks become classic ‘value’ traps; the stock appears ‘cheap’ only to get progressively ‘cheaper’ as investors downgrade their expectations of dividends and growth. Refining a high dividend yield strategy to only include stocks with sustainable and growing dividends can enhance the market relative performance materially (Exhibit 35).
In 2010 our high dividend yield + growth basket (Bloomberg ticker: GSSTHIDY), which aims to achieve just that, has underperformed the market by 6.4% (Exhibit 36). High dividend yield strategies are still out of favour following high profile dividend cuts during the credit crunch, in particular from financials, and as AuM from equity income funds fled to corporate credit. We expect dividends and dividend yields to grow in line with strong corporate earnings growth both this year and next driven by the strength of global GDP. With returns from corporate credit falling and rising bond yields, we believe that equity income funds should see more inflows. However, we think with continued strong earnings growth, high yield stocks, owing to their more defensive nature, will again struggle to outperform the market despite significant valuation discounts.
To capture the theme of attractive high dividend yield stocks independent of the market’s preference for value or growth stocks, we recommend shorting a basket of companies with high dividend yields that are at risk of cutting dividends (Bloomberg ticker: GSSTDCUT) against the GSSTHIDY. Reasons for potential cuts include taxation, forecast ROE declines, limited reinvestment for growth, high payout ratios and low FCF cover, high leverage, and contingent liabilities such as pension deficits and other provisions. Our GSSTHIDY basket has outperformed the GSSTDCUT by 8.9% in 2010.
We are closing our recommendation to be long GSSTHIDY vs. the STOXX Europe index; this trade has not performed well, in our view a reflection of the difficulty in trading a pure yield theme.
Based on consensus estimates our GSSTHIDY basket is currently trading at a 14% discount to the market based on the 2011E P/E and has 6.1% lower earnings growth than the market and a higher FCF yield. It also trades at a 28% discount to the GSSTDCUT, which has lower growth and lower FCF yield, which suggests a FCF cover of less than 1. The higher growth and more sustainable dividends of the GSSTHIDY should lead to continued outperformance relative to the GSSTDCUT.
GSSTHIDY: High dividend yield + growth basket
Criteria: Stocks with a 2010E dividend yield (payable in 2011) above 4% based on our analysts’ DPS forecasts. We exclude companies with: a market cap below €1 bn; 2010E/11E payout ratios above 70%; 2010E free cash flow cover less than 0.5x (0.75x in 2011E); 2010E net debt/EBITDA above 3.5x; forecast dividend growth below 0%; option implied dividend growth below -20%; CDS above 300bp. We exclude Sell rated stocks from our analysts and we have relaxed the 2010E criteria for Oil & Gas stocks as we think they should be a key component of a high yield portfolio. Finally we cap the maximum weight for each sector at 12% (which only reduces the sector weight for insurance). The basket is screened for liquidity and borrow availability.
GSSTDCUT: High dividend yield + risk basket
Criteria: Stocks with a 2010E dividend yield (payable in 2011) above 4% based on our analysts’ DPS forecasts. We exclude companies with: a market cap below €1 bn; 2010E payout ratio below 50%; 2010E free cash flow cover more than 1x; 2010E net debt/EBITDA less than 3.5x. We only include companies with a long-term growth (ROE × payout ratio) of less than 10% (based on five-year average ROE and payout ratio). The basket is screened for liquidity and borrow availability.
5) Sell companies with high pension risks
We recommend a short in our basket of companies exposed to higher pension expenses or potential solvency issues (GSSTPENS) vs. the market. We see this trade as working well on a three to six month horizon when investors will be focused on the release of 2010 accounts data.
Companies with pension risk could come under more pressure
In November this year we recommended to selling companies with increased pension risks on concerns of strong headwinds for those companies in the first half of 2011. We think lower returns on assets in 2010 (and thus higher pension expenses) combined with an increase in pension deficits owing to lower bond yields is likely to increase the focus on pension problems in the coming months.
When adjusting for ytd asset returns and changes in bond yields, we estimate that the aggregate pension deficit for the STOXX Europe 600 has increased by €86-101 bn (Exhibit 40) and that the deficit as a proportion of market cap has reached a new high (Exhibit 41). Scenario 1 decreases the discount rate in line with fall in iBoxx AA corporate bonds yields ytd while Scenario 2 sets the discount rate equal to it – we assume a duration of 20 years for pension liabilities (for details see Strategy Matters: Low bonds yields and flat equities increase corporate pension risks, October 29, 2010).
Pension risk and changes in pension solvency matter for equities for different reasons. First, changes in pension expenses can impact a company’s P&L, pension deficits can cause significant off balance sheet liabilities (and thus ncrease a company’s leverage) and regulatory pressure can result in forced cash contributions, which might put dividends or capex plans at risk. Second, changes in longer-term inflation or mortality assumptions can have a major impact. As a result, markets tend to discount pension risk – companies with large pension obligations have a higher beta and trade at a discount to their sector and the market.
We recommend selling a basket of companies with large pension obligations and deficits as corporate pension problems worsen (Bloomberg ticker: GSSTPENS). We would implement this trade on a sector-neutral basis. After underperforming since 2007, the basket is nearly flat in 2010 relative to the market and sectors despite the worsening of pension problems (Exhibit 42).
The valuations of companies in the GSSTPENS basket are already at a significant discount to the market and their sectors (Exhibit 45) but the discount has narrowed recently and is close to averages excluding spikes during equity market corrections in 2001 and 2008. We believe future underperformance can be driven by a combination of negative earnings revisions following higher than expected pension expenses as well as a widening of the discount back to and beyond highs considering record high pension deficits.
Most European companies provide details on their pensions with their annual results during the first quarter of 2011. In addition, potential IAS changes to be finalised in mid- 2011 could have a negative impact – besides a call for increased transparency the new IAS 19 standard might not allow ‘corridor accounting’ any more and force companies to assume a long-term expected return on assets in line with the discount rate. Both changes can increase pension deficits. On the other hand, we expect positive equity returns in 2011 and think that bond yields are past cyclical lows, both of which would ease problems. We expect this trade to perform in the next 5-6 months.
The criteria for companies to be included in our basket are:
Last reported pension liabilities as a % of market cap >30%, and
Pension deficit >5% either under mark-to-market Scenario 1 or Scenario 2.
We think these are the companies that could see higher pension expenses that are material enough to depress share prices and that could come under pressure from regulators to make cash contributions to improve pension fund solvency.
We exclude companies that are in countries with weak pension regulation and where pension liabilities cannot be enforced easily – these countries are Germany, France and Switzerland. As a result most of the companies in our basket are from the UK and the Netherlands. The basket is screened for liquidity and borrow availability. We also provide additional potential screening criteria based on the potential impact from IAS 19 changes and updated solvency estimates based on our mark-to-market scenarios.
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Source: ETFWorld – Goldman Sachs Global Economics, Commodities and Strategy Research
