Home / Peter Elston’s Investment Letter – Issue 3 July 2015

Peter Elston’s Investment Letter – Issue 3 July 2015

For the Love of Charts…

I like charts.

This month I take a look at MSCI’s major global sectors and see if there is anything that can be learned from what has been going on the last 20 years with respect to accounts items and ratios relating to profitability, leverage and valuation.

I get all this from Bloomberg, which aggregates the data for MSCI’s sector indices: Energy, Materials, Health Care, Information Technology, Financials, Consumer Discretionary, Utilities, Consumer Staples, Industrials and Telecom Services.

I’ve also made comparisons between the sector index data and the data for the overall MSCI World Index. It should be noted that these indices are for developed markets only and thus exclude companies in emerging markets.

I’ve tried to focus in on data where a particular ratio is at or near its extreme, or where there is a strong trend that may or may not be turning.

Here goes!

Revenue per Share

The sector that has exhibited both the strongest and the most stable growth in revenues is Health Care. Since 1994, revenues per share have grown nearly six times, compared with just short of a doubling for the World index. Furthermore, growth has not only been strong but also stable. While revenues for the World index fell materially both following the tech burst and the GFC, Health Care companies’ revenues continued to rise. This is perhaps the best example of a secular trend which has been extremely clear and also shows no sign of ending. Indeed, given the ageing of the world’s population and the continued scientific breakthroughs, one would expect this trend to continue.

Revenue per Share

Chart 1


Operating Income per Share

With respect to operating income, it is interesting to note just how extraordinary the energy boom was in the years leading up to the GFC. Indexed to 1 in January 1995, operating income per share for the Energy sector rose by over ten times before collapsing in 2009. The driver of operating income of course has been the oil price but one should note that despite the decline over the last 12 months, the Energy sector’s operating income has still risen more than any other sector over the entire 20 year period.

As for Health Care, operating income has flattened out the last three or so years, despite revenues that have continued to rise. It is not clear why this is the case but it is certainly something to keep an eye on.

The IT sector’s operating income has been more volatile than that of the Health Care sector but it is now slightly ahead over the 20 years.

As for Utilities, cash flows are supposed to be very stable but the reality is that in recent years this has not been the case – 2011-2012 saw significant declines in profit.

Finally, a word on Financials which was the worst hit sector in 2009. Operating income for the sector has recovered and continues to recover but is still half what it was pre-GFC.

Operating Income per Share

Chart 2


Capital Expenditure

There are a couple of interesting things to note about the capital expenditure data.

The first relates to the Energy sector and how despite the sharp falls in operating income to 2005 levels, capital expenditures have hardly fallen. If the oil price does not rise from current levels, I think there is a strong possibility that capital expenditures could fall a lot further.

As for capital expenditures for the World index as a whole, it is noticeable that they have been flat for three years now. This must be of concern for central banks who via negative real interest rates are hoping to encourage companies to increase capex.

The Bank of Japan’s governor, Haruhiko Kuroda has been getting particularly exasperated with his country’s hoarding of cash by corporates, telling them last November that such behaviour would be costly for them.

Perhaps increasing capital stock does not make sense in a country where demographic headwinds are so strong. Indeed, the falling global population growth may explain the weak capex in other developed countries.

Capital Expenditure

Chart 3


Dividends per Share

I have picked out five of the eight sectors in relation to dividends per share.

Although it may be related to one company or a small number of companies in the sector, the dividends that the IT sector has been distributing have been growing at a remarkable pace. Along with Health Care, the IT sector is one where there is a strong secular trend in place, albeit one which includes the odd collapse in profits. The dividend performance of Consumer Staples and Health are are closely related, which is understandable: Health Care is after all in many ways a consumer staple. Dividends in the Energy sector have not yet fallen but if operating profits in the sector are anything to go by, cuts may be just around the corner.

Dividends per Share

Chart 4


Total Assets per Share

It is interesting to contrast the fortunes of the Financial sector which continues to de-leverage (as measured by total assets) with those of Health Care which goes from strength to strength.

Total assets of the Financial sector fell sharply in 2008 and 2009 but have since continued to fall, driven by tighter capital requirements and weak loan demand.

Total Assets per Share

Chart 5


Gross Profit Margin

Gross profit margins can vary from industry to industry (the highest are to be found in the Telecom service and Utilities sector where asset turnover is very low).

However, changes over time can be instructive and in this regard it is interesting to note that while gross margins for Health Care have been declining, those for IT have been on the up.

Indeed, in 2013, the IT sector’s gross profit margin surpassed that of the Health Care sector.

Gross Profit Margin

Chart 6


Return on Equity

It is remarkable just how stable return on equity has been for Health Care companies. While this measure of profitability has been very volatile for other sectors, with return on equity for the World index anywhere between 2% and 17% over the last 20 years, the Health Care sector has posted numbers consistently in the 15-20% range.

The chart below also illustrates well the extent to which profitability in the Energy sector has been cratering, with it now sitting close to 20 year lows.

Return on Equity

Chart 7


Net Debt per Share and Net Debt to EBITDA

One sector stood out with respect to net debt, namely Information Technology.

This is a sector which over the last 20 years has seen a progressive strengthening of balance sheets. While much of this strength can be attributed to Apple inc, the sector is well placed to move quickly in the event of scientific progress being made in areas such as quantum computing or artificial intelligence.

Net Debt per Share

Chart 8

Net Debt to EBITDA

Chart 9


Price to Book Ratio

Four sectors to pick up on with respect to price-to-book ratios as well as the World Index as a whole.

First, although Health Care and IT valuations have been on the rise, they are still far below the levels they reached in the late 90s. Price to book ratios of consumer staples on the other hand have risen in line with the aforementioned two sectors but are now quite close to 20 year highs attained back in 1998. One might expect a bit divergence from here, similar to what happened in the late 90s.

As for the Energy sector, valuations at 1.6 times book are now close to historic lows, suggesting that much of the challenge being faced currently by the sector may be discounted in share prices.

As for aggregate World Index valuations, they have risen from 1.3 times book at the depths of the GFC to around 2.2 times currently. This is well below the 4 times book reached in the late 90s so arguably still represents good value.

Price to Book Ratio

Chart 10


Dividend Yield

Finally, the most important number of all: dividend yield. Viewing nine lines in one chart would have been difficult so I have split them between the following two charts, with the first of them including the yield for the World Index.

Starting with latter, the dividend yield for the World index is currently 2.2%. This is bang in line with the 20 year average so not overstretched by any means. Indeed, in the context of real long term interest rates that are much lower than 20 year averages, the current 2.4% is arguably attractive. Furthermore, the lowest levels that yields reached in the 20 year period under review was 1.2%, in the late 90s, so there is still scope for yields to fall further.

As for sectors, it is interesting to note that IT has converged with Health Care. Which of these deserves to be the higher rated is up for debate but on the basis of past volatility it should be the latter. Energy’s yield of 3.6% may well reflect fear of dividend cuts, but even factoring material declines is still attractive. Elsewhere, given past performance, the fact that the yield of Consumer Discretionary is a lot lower than Consumer Staples appears anomalous.

Dividend Yield

Chart 11

Dividend Yield

Chart 12


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Past performance is not a guide to future returns. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content.

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