Leyland, who manages the £113m JOHCM Global Opportunities fund and is deputy manager on FE Alpha Manager John Wood's £1.4bn JOHCM UK Opportunities fund, is increasingly bearish and concerned that the market has not remembered the importance of strong balance sheets in the face of an inflexion in the market cycle.
He says low interest rates as a consequence of low inflation and weak economic growth have moved attention away from the importance of a strong balance sheet.
“[Balance sheet strength] was very important in the dark days of 2009 but credit markets have moved full circle and compression of credit spreads has meant that financial directors have not been rewarded for maintaining strong balance sheets,” Leyland said.
“Not only do you have strong balance sheets as a result of debt being taken on at cheap rates, you also have a lack of real investment for growth at the expense of financial engineering.”
“The equity market isn't differentiating between companies which are investing in themselves to grow and companies that are buying back shares like there is no tomorrow. The epidemic is starting to get a lot of attention and I don't think it is a positive development for the economic environment.”
According to FE Analytics, developed markets have led the way, particularly in the US, in recovery from the depths of the financial crisis with the S&P 500 up 127.06 per cent and the FTSE All Share up 106.02 per cent.
Performance of indices since Apr 2009
Source: FE Analytics
By comparison the MSCI AC World and the MSCI Emerging Markets are up 97 per cent and 77 per cent respectively, leading several to claim that this return has been driven by an illusion of earnings per share growth bolstered by share buybacks.
Over the past month, concern over global growth, a weaker eurozone and a strengthening US dollar have seen equity markets stumble, although the US has stood up better than other developed markets.
Performance of indices since 12 Sep
Source: FE Analytics
Leyland, who has almost 20 per cent of his fund in cash, says the strongly rising markets over the past three years have meant investors are ignoring downside risk because it hasn't materialised for so long.
“When markets rise without a drawdown for more than three years, no one is really interested in margin of safety and downside risk because it simply hasn't materialised for so long,” he said.
“I have no idea when it will become important again but what I do know is that at some point the investment cycle will change and then you won’t be able to move for people sending you tables of companies with strong balance sheets and pricing power [who have] spent the last three years investing for growth but it is not on agendas now.”
“However, it is important to prioritise things now while others are not interested.”
A buyback happens when a firm buys its own shares and then either holds them for future re-issue or cancels the repurchased shares altogether, reducing the number in circulation and therefore increasing the earnings per share.
According to David Motsonelidze, investment strategist at Barclays, companies are increasingly using share buybacks to squeeze their earnings per share higher and make their stock more attractive.
“For the three months ended March 2014, they [buybacks in the S&P 500] stood at $159.3bn, the largest amount since September 2007. Have equity market returns been inflated by this bit of financial legerdemain?” he said.
“During the recovery period since 2009, we have seen news of financial engineering, in which many successful American enterprises have used stock buybacks to manage their earnings per share.”
However, Motsonelidze says earnings per share are roughly in line with actual earnings growth which suggests that there is no illusion of growth.
“The value of a buyback depends on whether it has been an efficient use of capital. In short, not all buybacks have the same purpose, and sometimes buybacks can be an effective and smart way of returning capital to shareholders.”
“Repurchases do not seem to be an explanatory variable for rising equity prices. Rather, equity price rises seem to have been driven by earnings growth, which has been aided by expansion in company margins.”
Leyland has managed JOHCM Global Opportunities since it launched in June 2012 since when it has been second quartile in the IMA Global fund, returning 32.3 per cent compared to a sector average of 28.46 per cent and the MSCI AC World index gaining 31.46 per cent.
Performance of fund, sector and index since June 2012
Source: FE Analytics
Over the past month it has moved to the top quartile as markets have sold off but has lost 5.3 per cent while the MSCI AC World has lost 4.89 per cent.
