The global investment environment is challenging as we enter the New Year. Global growth is constrained -- moderate in the United States, Europe, and Japan, and uneven in the developing world. Many developing-market manufacturing exporters are in decent shape, but commodity exporters are still navigating the commodity cycle downturn, and some are deeply troubled. A strong U.S. Dollar continues to weigh on U.S. multinational exporters' profits.
The OPEC cartel has capitulated, and oil's failure to find a convincing bottom is leading market psychology into unfounded fears that a global recession is around the corner.
The strength of China's service sector and consumer-facing industries is not enough to allay market participants' fears of a poorly managed hard landing in Chinese industrials, and the damage it would wreak in global demand. Geopolitical worries remain simmering in the Middle East and Eastern Europe.
The U.S. Fed is embarking on interest rate normalization after years of extraordinarily accommodative monetary policy, and we agree with other analysts that nascent inflation may create the need for more interest-rate hikes in 2016 than the consensus expects.
To top it off, developed economies' stock markets as a whole aren't cheap, with the U.S. S&P 500 slightly overvalued and the strength of profit growth in question due to all the factors mentioned above. What's an investor to do?
We believe the environment that is shaping up for 2016 is one that will favor discrimination and thorough analysis. During the years of QE and other interventions that followed the financial crisis, we saw strengthening correlation as individual stocks' differentiations faded and investors just "bought the market," relying on indices that were buoyed indiscriminately by easy monetary policies. It was an environment in which a rising tide lifted many boats that did not deserve to rise.
We believe that we are on the edge of a period in which correlations will begin to weaken. With the indices fairly valued or slightly overvalued, we think the market environment in 2016 will favor the careful selection of individual stocks over buying the index, as the factors that differentiate the "best of breed" companies become more significant in an environment where growth is scarce and often much too expensive. In short, after six years of recovery from the Great Recession, wise investors will increasingly return to the principles of "growth at a reasonable price."
Our implementation of this strategy comes from studying from the top down and analyzing from the bottom up.
Although we believe that best-of-breed companies will differentiate themselves from their indices more strongly in the environment that's emerging, they still exist in a global context. The first task is to identify the regions and countries with favorable macroeconomic and geopolitical fundamentals, and the industries within those countries with tailwinds. In our view, for example, the global environment will continue to be inhospitable for commodity exporters in 2016, so we will not be screening and studying companies within those markets.
At the moment, we favor developed markets. Later in 2016, depending on the strength or weakness of the U.S. Dollar, we may see opportunities in various emerging-market currencies. We do not anticipate that emerging-market equities will be attractive, with the possible exception of some Chinese consumer and internet stocks -- although even after the summer's market carnage, most of these stocks remain overvalued.
Having identified the "best of breed" markets -- those that are strongest given the present global macro environment -- within them, we look for industries with tailwinds. And having identified our industries of interest, we look for "best of breed" companies in which to invest. In 2016, "best of breed" looks like this to us:
- Strong balance sheets. We will be very cautious about companies that have highly leveraged and who have over-extended themselves; we prefer companies whose managements have been sober stewards. A rising interest-rate environment provides many potential stumbling blocks for over-extended companies, as well as a market psychology disinclined to overlook such risks.
- Low P/E ratios. We'll be looking for companies that are relatively undervalued, with below-market multiples -- not the infinite or near-infinite valuations sported by some of the expensive growth names which have come to dominate what is now a very narrow market. We do not believe that we are in an environment that will continue to reward the owners of such stocks.
- Consistent growth. We'll be looking for companies with a track record of consistent growth, as well as exposure to the tailwinds we've identified. We'll avoid companies with over-enthusiastic guidance and analyst estimates, which we believe may well be about to encounter a year where "diminished expectations" are merciless in taking down the excessive valuations such projections can generate.
- And last but not least, strong, capable, and proven management.
We believe these characteristics will differentiate the companies that outperform in 2016. The year we're entering will be one where careful fundamental homework rewards the perceptive investor, and where investors who rely on duplicating the indices will encounter another year of nerve-wracking volatility and meager returns to show for their trouble.
Investment implications: In the era of plentiful liquidity that accompanied QE and six-plus years of near-zero interest rates, the rising tide lifted many boats that really didn't deserve to get lifted. U.S. markets are now slightly over-valued, and have a number of psychological and macroeconomic headwinds. We think this is an environment where correlations will get weaker, "best of breed" companies will outperform the indices, and careful analysis and selection of individual stocks will be rewarded. After selecting markets and industries with positive macro fundamentals, we'll spend 2016 carefully analyzing stocks -- looking preferentially for those with strong and proven managements, strong balance sheets, low valuations, realistic earnings guidance, and track records of modest and consistent growth.
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