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Equity Letter - Debunking a few myths ….

 

THE ESSENTIAL

At least three long-lived myths have proved to be misleading; Japan faces persistently sluggish profit growth, political risk is a signal to sell, and protectionist rhetoric leads to a slowdown in world trade. The reality is very different.

 

Our focus this month -Agriculture: a sector with long-term growth potential- is on CPR’s Agriculture expertise.

Publication

 

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EDITORIAL

At least three long lived myths have proved to be misleading. Firstly, it was widely believed that because of a long period of deflation Japan, more than other country, was facing sluggish profit growth. The reality is that Japanese profits have recovered and even surpassed the historically high profit levels reached nine years ago. In contrast, in Europe the recovery potential is still intact and ahead of us.

Secondly, equity investors are also inclined to think that any kind of political risk should be perceived as a sell signal. The reality is different, as illustrated by three examples over the past three years– Russia, UK and Mexico- which show clearly that it is the forex market that regularly does the work of adjusting to political risk, very often brutally and through overshooting. This is not to deny the cost of a conflict (Ukraine – Russia), a divisive vote (Brexit) or an official warning (trade barriers and Trump’s plans for a wall along the Mexican border). However, the burden, instead of being evenly shared, is frequently more than fully borne by the forex and/or the bond market, even creating in some cases opportunities for equity investors.

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Thirdly, it is widely believed that growing calls for protectionism should feed through to a slump in global trade. Donald Trump made a lot of noise about new tariffs, making us believe that he could curb global trade growth. The reality however is that the bulk of the slowdown in global trade growth was already in place well before his election. Global trade collapsed in 2009 and has been stagnating since then, lagging global GDP growth. In fact, recent indicators suggest that trade in 2017 could paradoxically show signs of recovery.

Last but not least, while as of today we are not announcing any major upside for equity indices as published, especially in Europe, we reaffirm that Europe is perhaps the best place to be. Why? Because, over the coming months, in addition to earnings momentum, dividend yield alone would provide a return of over 3% (more than 12% on an annual basis), a factor to be set against any likely stagnation of published indices which are computed ex-dividend (except for the Dax).

This is one more reason which explains our preference for Europe. In addition to positive macro momentum and earnings potential, Europe is also the market offering the most attractive yields.

 

Romain Boscher, Global Head of Equities

 

 

CONVICTIONS

 

Convertible bonds: the beauty of convexity

Convertibles are a naturally convex product, i.e offering an symmetrical risk/return profile. The bond component offers relative downside protection in episodes of market stress, while the conversion option allows participation in equity market upside.

 

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After a disappointing 2016 for the asset class, 2017 looks more promising thanks to several technical factors which have become attractive once again

  1. Strong convexity: the equity sensitivity is extremely reactive to equity market movements. In a context of rising markets, the delta of European and global indices increased by more than 4 points in Q1. Convertibles are now back in the mixed zone with deltas around 40% where convexity is highest.
  2. On the credit side, the quality of the bond floor is being reinforced by investment grade issuers, thus increasing resilience.
  3. Primary market: the dynamic credit market along with improved credit quality is contributing to the overall convexity of the universe
  4. Valuation: the sharp fall in realised volatility has fed through to convertible valuations in a risk-on market environment, offering a real technical entry point 
  5. Interest rate sensitivity: convertibles by nature are less sensitive to interest rates than bonds and thus offer a good diversification opportunity in an environment of rising interest rates. In addition, if deltas continue to rise -driven by strong equity markets- interest rate sensitivity will decline mechanically

Thus, in the current environment, the asset class is ideally positioned to meet investor requirements: strong and controlled participation in equity market upside, with significant downside protection (parachute effect) and reduced sensitivity to rising interest rates.

Pierre-Luc Charron

Head of Convertible Bonds

 

Sabine Duchesne

Investment Specialist, Convertible Bonds and Volatility

 

Japan: significant strides in corporate governance

Supported by the establishment of the Stewardship Code and the Corporate Governance Code, awareness of importance of the corporate governance at Japanese companies is greatly improving. Major contributory factor is that the attitude of investors has changed regarding Japanese companies, which previously displayed low profitability and shareholder returns, and these investors are now demanding  higher achievements. The number of companies that are promoting reform by incorporating shareholders' opinions is increasing, and the amount of dividends and share buybacks, which declined due to the collapse of Lehman Brothers, has increased 2.7 times during a period of seven years to reach an all-time high.

Reform has spread to a broad-ranging review of capital policy aimed at enhancing shareholder value that encompasses not only large companies but also mid-tier companies. Ryosan, a semiconductor trading company that was held in our Japan Target fund, revised its capital policy, increased dividends by 3.5 times in four years, and actively carried out share buybacks. As a result, its valuation in the market also increased, and the share price more than doubled. The number of companies carrying out M&A and tender offers is also increasing, and JDL, a company developing accounting systems that we held, conducted an MBO at a price representing a 48% premium.

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At Amundi Japan, fund managers and ESG analysts are collaborating more than ever in engaging with Japanese companies as we are observing an increase in number of companies that are seeking to have dialogues in the purpose of strengthening their ESG initiatives and the disclosure of ESG information, with the aim of enhancing their sustainable corporate value. Amid the advance of the low birth rate and the aging society, awareness is increasing at companies regarding initiatives to raise productivity through changes to working styles, the creation of social value through measures such as the reinforcement of environmental contribution projects, and the realization of growth scenarios

 

Shizuko Omhi

Head of ESG Department, Amundi Japan

 

Hiromitsu Kamata

Head of Japan Target Expertise

 

The opportunities of Disruption

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Our Global Disruptive Opportunities strategy capitalises on a permanent and non-cyclical investment theme, able to generate long-term growth: disruption. It may be summarised as the arrival of a simpler, more intelligent, more practical and less expensive solution changing the establishing order, transforming an existing market or creating a new market.  Historically, disruption was an intangible trend, a long-term phenomenon where the changes occurred over a hundred years and were therefore not felt by the same generation. The latest major innovations, such as the Internet, connected objects, robotics, driverless cars and 3D printing, have in common that they have proliferated with unprecedented speed and profoundly changed the way we live, consume and work. While technological innovation may be the main driving force behind this exponential acceleration, it is also the result of a combination of other factors. The trend is driven as well by the globalisation of trade, demographic changes and environmental challenges.

As disruption is likely to happen in all sectors of the economy, our investment universe takes a broad multisector approach, covering the entire disruptive spectrum, to seize the whole theme’s growth potential. Our approach has made it possible to summarise the phenomenon into four dimensions encompassing the disruption cycle from its emergence in a market segment until its adoption by most consumers: Digital Economy, Industry 4.0, Healthcare & Lifesciences and the Planet.  In order to be exhaustive and bring greater diversification, our investment universe includes “pure players” as well as companies who react to adapt to changes in their markets. Our Global Disruptive Opportunities strategy stands out in its non-benchmarked active management style with no geographical, sector or market cap restrictions. The final portfolio has about 80 stocks, with a level of volatility comparable to the MSCI World. The target is to outperform the international equity markets over the long term (i.e., at least five years) by investing in shares of companies that have established disruptive business models, or that benefit from them, fully or partially.)

Estelle Menard

Deputy Head of Thematic Equities, CPR

 

Wesley Lebeau

Portfolio Manager, Thematic Equities, CPR

 

FOCUS

Agriculture:  sector with long-term growth potential

The long term investment case for agriculture equities is based on a structural imbalance between supply and demand. Demand will be supported by population growth and the impact of rising income on eating habits, especially in emerging markets. Indeed, meat (and more broadly animal protein) consumption has been growing in emerging markets. This trend has a multiplying effect on grain consumption (i.e. 7kg of grains are needed to produce 1 kg of beef for instance_ source Tyson Food).

While demand will rise, there are constraints on supply: arable land growth has been lower than population growth. Urbanization, soil degradation, water stress and climate change are constraining arable land growth.

Massive investments will be needed to help supply meet demand by adding new arable land and associated infrastructures and by optimizing land yield thanks to rationalization and mechanization of farms, progress on seed and crop protection technologies, development of precision farming. 

These massive investments should support growth for the agriculture sector and agriculture equities.

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A long term approach with solid convictions on the entire upstream agricultural value chain 

We break down the agriculture value chain into six segments: 

  • Agricultural Products (grain, sugar producers for instance),
  • Fertilizers
  • Agrichemicals (seeds and crop protection)
  • Farm Machinery,
  • Agricultural Services (infrastructure, trading, processing of agricultural products)
  • Livestock. 

These 6 segments have different sensitivities to soft commodity volumes and prices. Our approach is to allocate between segments depending on our analysis of agricultural products harvests and prices. But we also invest in stocks with a low sensitivity to soft commodity  volumes/prices as we do not want the portfolio performance to be mainly driven by weather patterns.

 

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Our short-term view

In the current environment of strong grain production and pressure on grain prices, Agricultural Services and Livestock should fare better than the other segments thanks to high capacity utilization for the former and low feed-costs for the latter. These two segments represent 50% of our strategy. In Agricultural Products we favor sugar producers as this market should remain in undersupply in 2017.

As regards to the other segments of the agriculture value chain, they have suffered significantly from the decline in farmers’ profitability over the last 3 years, following the decline in grain prices. However, the worst is probably behind us as some positive news have emerged recently. After three years of significant decline, the farm machinery market should stabilize in 2017. The fertilizer market has also been negatively impacted by a lackluster demand and significant capacity increase over the last few years. However, capacity additions should be limited from 2018 for urea and  2019 for potash. Finally, the concentration of the agrichemical market could support this segment. The Dow Chemical-Du Pont and Syngenta-Chemchina mergers have just been approved by US and UE authorities. The Bayer-Monsanto merger could be approved at the end of 2017

Over the past 5 years, our strategy has generated a total gross performance of 27.6%, i.e. 5.00% annualised.

 

Stéphane Soussan

Senior Thematic Equities Portfolio Manager

BOSCHER Romain , Co-Head of Equities
MELHUISH Nicholas , Chief Investment Officer, Equities – Amundi London
IWANAGA Yasunori , CFA, CIO Amundi Japan
HO Anthony , Chief Investment Officer - Asia ex Japan
DRABOWICZ Alexandre , Head of Development and Investment Specialists, Equity Strategies
ANDRE Sudeshna , Investment Specialist, Equity Strategies

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