Mitigating earnings risk in a volatile market
The stimulus-pumped rally that began with Mario Draghi’s ‘whatever it takes’ speech has seen a bracing, if not unsurprising reversal. This has significant implications for investors who seek to navigate earnings risk.
It was the ECB talking down the cost of capital, that started with the now infamous Draghi speech, combined with a marginally improved corporate earnings environment, that led to the European equity re-rating which began mid-2012. However, corporate earnings are again feeling the pinch, as global trade slows and many exporters’ revenues are flat-lining. The dynamics that drive equity valuations – corporate earnings and the multiple paid for those earnings – are changing substantially.
While Draghi struck a dovish note at the last ECB meeting, he is far less well-armed to arrest a faltering economy beset by a worsening global trade outlook, a brutal oil sell-off, and a rise in global credit stress. Against this backdrop, earnings risk is rising and the path has narrowed in terms of ‘safe earnings’ for investors.
A diminished earnings horizon
So what are long-term investors supposed to do when earnings risk spreads? So far, the relative winners have been defensive names – consumer staples, health care, utilities and telcos – where perceived earnings stability has been rewarded with higher multiples.
Patience is a virtue in volatile markets
However for the more opportunistic investor, patience also pays off in volatile equity markets. And we are starting to see selective opportunities emerge to mitigate earnings risk. We continue to hold stocks exposed to structural growth themes, as well as domestic European cyclical names on inexpensive valuations that have the ability to pull cost levers in order to sustain profitability, and expect that we will soon be given opportunities to add to these positions.
French automaker Renault is a somewhat contrarian play given recent newsflow, however we think there is still value for investors willing to hold on for the longer term. Despite growing sales in emerging markets, Renault is still largely a European play, with three quarters of its profit made in the region. The recent emissions headlines on the company spooked investors, but turned out to be little more than a storm in a teacup. At 6.5x consensus earnings, the shares are pricing in a significant deterioration in Renault’s European auto sales in 2016, which we do not see happening. Instead, we expect lower costs to drive profitability, as more of their sales are produced on a common platform with Nissan cars.
As one of the four main suppliers to the biological pharmaceuticals manufacturing process, Sartorius AG is well placed to benefit from the ramp-up in biologics production. A market leader in single-use biologic drug fermentation technology, it will continue to grow as the mix shifts towards branded biological drugs, and when biosimilar (generics) start to make their way to market. This, combined with its high margins and increasing operational leverage as the business scales, will continue to drive profitability and returns on capital, justifying their premium rating of 29x earnings as the company continues to surprise markets on the upside.
For those looking to play the formation of an Italian ‘bad bank’, we like Milan-listed credit information and debt management company Cerved Information Solutions, which essentially offers investors two companies for the price of one.
Firstly, a credit management business which will benefit from the outsourcing of NPL (non-performing loan) portfolios, as banks outsource their loan portfolios to companies like Cerved. Secondly Cerved’s business information division, which profits from the sale of reports that analyse the creditworthiness of Italian companies, will benefit from the recovery of the consumer and business confidence. For a company that is growing top-line at high single digits and will see double digit earnings growth thanks to the operational leverage and further upgrades, we think the valuation of 14x earnings is just too cheap.
Tim Crockford, manager of the Hermes Sourcecap Europe ex-UK Fund