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Features - Jan 2012



The Bahamas Investor

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Is the time right for cyclicals?

Is the time right for cyclicals?

After a harsh sell-off period, cyclicals, such as materials and industrials, could present an attractive buying opportunity

The Bahamas Investor Magazine
January 19, 2012
January 19, 2012
Paul O’Neill (left), David W Stewart (right)

Amongst the sectors worst hit during the recent stock market turbulence were economically sensitive cyclicals, such as materials and industrials. Following the declines, many of these stocks now appear to be trading on attractive valuations. Many investors are rightly questioning if this represents a buying opportunity.

Although economic growth in the US and elsewhere has not been as strong as previously thought, corporate profitability is at all time record levels and it is difficult to reconcile this with weak underlying economic fundamentals. Following the recent results season, which was actually quite good, analysts’ expectations for earnings growth for the companies in the S&P 500 Index is nearly 18 per cent in 2011 and 12 per cent in 2012. For 2011, this is the same as was forecasted earlier in the year, when the economic outlook was far more optimistic. In combination, they imply new record profit margins being reported both last year and this year.

Companies are better positioned to deal with the downturn than they were in early 2008: headcount is lower; there is less of a headwind from the US housing and construction markets; lean inventories will help protect margins and company balance sheets look strong. Yet to believe in the current expected level of earnings growth means buying into a V-shaped economic recovery, which is hard to see. That is the crucial difference between now and early 2009, and is particularly relevant for those cheap, but economically sensitive, cyclicals.

One of the most significant opportunities to capture long-term growth as conditions improve is in the best of the biggest–the MegaCap Blue Chips. During the recent sell-off, such stocks held up better than most. But the long-term thesis is that, in the decades to come, the biggest multinational companies will prove more secure than many of the sovereign government bonds previously considered safe. With their strong balance sheets and stable, well diversified business models, they will have both financial stability and strategic flexibility. In place of a static interest payment from a government that will have a vested interest in “stealth” default outcomes, such as devaluation or inflation, investors will be paid a good and growing stream of dividend payments. And, instead of being tied to a single, challenged economy, these multinationals will follow growth around the world.

Normally, you would expect to pay a premium price for quality, whatever the market. But MegaCaps now stand on a PE of just 10.8x and yield 3.8 per cent, compared to world equities on a PE of 12.1x and yield of only 2.9 per cent. A deliberate conservatism combined with quiet optimism for the future will generate better returns, whilst providing a level of serenity distinctly lacking from most market-timing peers.

Bio: Paul O’Neill

  • O’Neill is a senior investment research manager at Butterfield Group. A former barrister, he studied for his MBA at Columbia Business School and joined Butterfield in April 2011.
  • Bio: David W Stewart

  • Stewart is group chief investment officer at Butterfield Group. He has an MA (Hons) in Philosophy from University of Edinburgh, and an MBA from Cass Business School in London.
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