Causeway Capital Commentary: Apocalypse Now? Buy High-Quality Cyclicals

'The coronavirus selloff of 2020 has been particularly unforgiving for companies directly impacted by the virus and the coincident fall in consumer spending'

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Sydnee Gatewood
Mar 25, 2020
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Key insights

  • Market valuations of global cyclicals appear far too dire. Currently they imply that earnings will shrink by 4% annually—forever.
  • We believe when the recovery inevitably comes, the market will be led by cyclicals, as it has following past drawdowns.
  • In our view, a focus on quality is imperative, and we are using the environment to significantly upgrade our clients’ portfolios into shares of several "best-in-class" companies.

The coronavirus selloff of 2020 has been particularly unforgiving for companies directly impacted by the virus and the coincident fall in consumer spending. Cyclical stocks have generally performed the worst during this year-to-date period. Judging by the recent performance of cyclical stocks, one could easily assume that the global economy will never fully recover. But as governments unleash unprecedented levels of monetary and fiscal stimulus, economies should benefit. Many of these economically sensitive companies should return to normal operations when COVID-19 no longer dominates the headlines.

Well before an economic recovery, equity markets will witness peak new coronavirus cases and we anticipate investors will want those stocks most ravaged by sellers, particularly those that have adeptly managed their businesses through this difficult period. In the meantime, Causeway has the rare opportunity—not seen since the Global Financial Crisis (GFC)—to buy shares in several “best-in-class” companies for our clients at sizable discounts to our estimates of fair value.

From a top-down valuation perspective, how extreme is the current buying opportunity? In Exhibit 1, we rank all stocks in the MSCI ACWI Index universe by their cyclicality, sort them into quintiles, and record the median forward price-to-earnings (P/E) multiple of the most extreme quintiles over time. The gold dotted line plots the significant valuation premium between the most defensive quintile (Q5) and the most cyclical quintile (Q1). As of March 20, 2020, defensive stocks traded at over twice the forward P/E multiple of cyclical stocks, and that premium is approaching the record peak from the GFC.

What is the market implying about future earnings for cyclical stocks? To answer this, the Gordon Growth model provides a useful framework, equating a stock’s price to the expected stream of future earnings per share (assuming all earnings are paid as dividends) discounted by its cost of equity. Rearranging variables, the market-implied perpetuity growth rate equals a stock’s cost of equity minus its forward earnings yield. Exhibit 2 plots this growth rate for the most cyclical quintile of the MSCI ACWI and MSCI EAFE Indices. Current multiples imply that earnings will perpetually shrink by 4% annually for cyclicals in the MSCI ACWI Index. Cyclicals in the MSCI EAFE Index reflect even greater pessimism and assume a 6% annual earnings decline – forever.

At the stock level, we believe the most compelling opportunities for our clients are at the epicenter of the economic pain from coronavirus lockdowns. These include industrials (transportation, capital goods, and especially aerospace), consumer discretionary (travel & tourism, automotive, and retail), financials (banks and insurance), and other travel-related businesses such as global distribution system software. Will aircraft continue to need maintenance? Will aerospace companies still need engine technology and materials? Will travelers no longer buy meals and sundries in airports and train stations? Will consumers not need catering at places of employment, hospitals, schools, and sporting events? Will travel agents stop using software to book flights and hotels? We are finding high-quality cyclical companies, often operating with few competitors in oligopolies, offering strong balance sheets and talented, proven management teams. Unlike the GFC, banks are not the problem this time. The world’s best banking institutions, in our view, have at least double the level of capital they had in 2008, yet some trade at lower valuations than in the GFC. Fear, forced selling, and very short investment horizons may explain this temporary disconnect between these well-run cyclical companies and their current, extremely low equity valuations.

Why buy these cyclical stocks now, rather than wait for better economic news? Exhibit 2 implies a level of pessimism currently even more negative than during the GFC and simply irreconcilable with nearly any historical period. And when the recovery inevitably comes, which we believe will happen, the market should be led by cyclicals, at least if past drawdowns are any indication. In Exhibit 3, we examined sector behavior during the largest three previous drawdowns and recoveries over the past 25 years in developed markets (MSCI EAFE Index countries and the US): The Tech Bubble, the Global Financial Crisis, and the Euro Crisis. One consistent trend is that the more cyclical sectors (industrials, consumer discretionary, financials) tended to outperform more defensive sectors (consumer staples, health care, utilities) during recoveries.

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