The majority of industry experts agree that strong returns in developed markets have been driven by equities re-rating rather than a pick-up in company earnings growth, which has led to the expansion of P/E ratios.
Performance of indices over 2yrs
Source: FE Analytics
Earnings growth is desperately needed in order for the recent rally in equities to continue, according to many fund managers, but Podger (pictured) says expectations may already be too high.
The manager says that the fate of this year’s earnings growth largely depends on areas of the market that are more economically sensitive. While the current forecasts suggest they will be able to deliver high earnings growth, the manager says those expectations are still over-optimistic at this point in time.
“I think a lot depends on a recovery in areas where company profits are still depressed, like energy materials and to some extent financials, where we can see rapid earnings growth is expected.”
“Clearly however, these are cyclical sectors and it could turn out that these expectations are a little ambitious,” Podger said.
The manager says that the other sectors are also at risk of disappointing.
“In addition, I think it is worth pointing out that some areas within consumer discretionary and the industrial sector are expected to grow earnings fast, but both are at very high profit margin levels already, so look potentially ambitious.”
“In summary, I think that earnings growth does need to come through and expectations look a little bit high at this stage. For this reason, bottom-up stock selection is even more important.”
Markets have started 2014 poorly with the leading indices such as the FTSE All Share and the S&P 500 both posting a negative return.
While FE Alpha Manager Podger is by no means bearish on equities and expects them to outperform other asset classes, he says investors should expect lower returns in 2014 than in other years if earnings growth doesn’t come through to support valuations.
“After the run-up to what we have seen in equity markets, investors have become quite concerned about valuations,” Podger said.
“I think equities remain relatively attractive compared with bonds and equity risk premium has come down over the last year due to higher equity markets and higher bond yields, but – by historic standards – it still remains pretty high.”
“I think that shows that a follow-through in corporate earnings really does appear to be necessary for equity markets to make significant further headway and this could be particularly true if central banks begin to withdraw stimulus this year.”
“Global corporate earnings have flatlined over the past two years while equity markets have risen to levels last seen in 2007.”
“At this stage we find many of the best opportunities in certain parts of consumer discretionary, but certainly also healthcare, IT and some telecom names,” he added.
Like Podger, Nigel Cuming – chief investment officer at Canaccord Genuity – is bullish on equities over the long-run. However, he too says that the need for earnings growth could be the biggest threat to the market this year.
“One of the reasons that equities are not expected to do as well as last year is that they can no longer be described as cheap. While equity valuation is a somewhat subjective affair, most measures point to them being fair value,” Cuming said.
“2013’s rally was largely due to multiples expansion and therefore we will need to see some improvement in earnings this year or otherwise there is a real danger that the rally will stall,” he added.
Bruce Stout (pictured), manager of the ever-popular Murray International Investment Trust, is renowned for maintaining a more bearish portfolio than the rest of his peers.
In his most recent note to investors, the manager said that the currently high expectations for earnings growth in 2014 are another example of naïve speculation in the market. “A world without robust profit growth set against a backdrop of excessive indebtedness, stubbornly high unemployment, negative real income growth, diminishing purchasing power and rising bond yields seems to be of no concern to current conventional judgment,” Stout said.
“Investing in concepts, in hope, and in expectation has, and will no doubt always, inflate equity prices, but only solid earnings growth and sustainable dividends can fundamentally support long-term valuations.”
“The portfolio remains acutely aware of prevailing distorted valuations and hence is very much focused on the latter,” he added.
Podger took over the £1.5bn Fidelity Global Special Situations fund from Sudipto Banerji in March 2012.
The fund has been a top-quartile performer in the IMA Global sector over that time with returns of 26.21 per cent, compared with 18.03 per cent from the MSCI AC World index.
Performance of fund vs sector and index since Mar 2012
Source: FE Analytics
It also boasts top-quartile returns over 12 months.
The fund is currently overweight the information technology, healthcare and consumer discretionary sectors. Fidelity Global Special Situations has an ongoing charges figure (OCF) of 1.71 per cent and requires a minimum investment of £1,000.
With returns of 260.49 per cent, our data shows that Murray International is the best performing portfolio in the IT Global Equity Income sector since Stout took over the trust in June 2004.
Performance of trust vs sector since June 2004
Source: FE Analytics
However, as the graph shows, that performance has dropped off in the period after the financial crisis; due to Stout’s positioning and a widening discount, investors in Murray International have lost more than 10 per cent over one year.
It still trades on a premium of 1.95 per cent, but that premium had reached 12 per cent over the last 12 months.
For his equity exposure, Stout favours more defensive stocks with reliable earnings such as British American Tobacco, Roche and Unilever Indonesia.
The trust yields 4.5 per cent and has gearing of 16 per cent. Ongoing charges, including performance fee, are 1 per cent.
