Regional & Sector Strategy: Monthly Update

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1 Global Markets Strategy June 2, 2015 Regional & Sector Strategy: Monthly Update Crosscurrents Although there are no material changes to our regional or sector recommendations this month, there have been some noteworthy crosscurrents. Regional Crosscurrents Improved optimism about earnings in Europe ex. the U.K. is offset by valuations that are still relatively unattractive, so that the region remains Underweight. Jan S./Bigstock Sector Crosscurrents Similarly, the Underweight Energy sector has also seen some improvement in earnings optimism, but that has not been enough to offset the sector s relatively unattractive valuation. Food for Thought The shifting of GICS weights in the MSCI ACWI benchmark has implications for the materiality of specific ESG issues in sector strategy at any given point in time. Figure 1: Regional Rankings Figure 2: Sector Rankings Michael Geraghty Global Markets Strategist

2 Regional and Sector Strategy: Monthly Update Regional Strategy Update This month there are no changes to the recommendations in either our regional or sector strategy models. Our previous regional and sector recommendations were published in the May 2015 edition of the Cornerstone Capital Regional and Sector Strategy: Monthly Update. Despite the fact that there are no material changes to our regional or sector recommendations, there have been some noteworthy crosscurrents in the past month: Improved optimism about earnings in Europe ex. the U.K. is offset by valuations that are still relatively unattractive, so that the region remains Underweight. Similarly, the Underweight Energy sector has also seen some improvement in earnings optimism, but that has not been enough to offset the sector s relatively unattractive valuation. We have updated the inputs to the Cornerstone Capital Regional Strategy Model in which we rank eight regions/major economies that are included in the MSCI All Country World Index (ACWI). In terms of valuations, Figure 3 illustrates that the valuation of the Europe ex. the U.K. region remains relatively unattractive. Figure 3: Regional Valuations (50% of Aggregate Weight) Arrows Indicate Change vs. Last Month Up = More Expensive Down = Less Expensive 2

3 Figure 4 illustrates that earnings momentum in the Europe ex. the U.K. region improved again, and has been steadily trending upward in recent months. Figure 4: Earnings Momentum (33% of Earnings Weight) Arrows Indicate Change vs. Last Month Similarly, Figure 5 illustrates that the earnings revisions trends in the Europe ex. the U.K. region were modestly positive i.e., upgrades slightly exceeded downgrades. Figure 5: Earnings Revisions (33% of Earnings Weight) 3

4 Figure 6 illustrates free cash flow margins for the eight regions, both current and historical. Figure 6: Free Cash Flow Margins (15-20% of Earnings Weight) Source: Cornerstone Capital Inc. Figure 7 illustrates changes in shares outstanding by region over the past twelve months, with issuance being considered negative (i.e., dilutive), and buybacks being regarded as positive for shareholders. Figure 7: Net Share Issuance (15-20% of Earnings Weight) 4

5 Figure 8: Regional Recommendations Figure 8 summarizes the current regional recommendations and Figure 9 illustrates the dispersion of the regional scores. Figure 9: Ranking Regions by Weighting Valuation, Earnings, Environmental and Governance Scores 5

6 Sector Strategy Update We have updated the inputs to the Cornerstone Capital Sector Strategy Model in which we rank the ten GICs in the MSCI ACWI. Figure 10 illustrates that the relative valuation of the Energy sector became somewhat less attractive last month. Figure 10: Sector Valuations (20% of Aggregate Weight) Arrows Indicate Change vs. Last Month Up = More Expensive Down = Less Expensive Figure 11 illustrates a continued rebound in the Energy sector s expected earnings momentum (as well as further deterioration in the earnings momentum of the Industrials sector, which we downgraded to Underweight last month). However, relative to other sectors most notably Health Care, Information Technology, Financials the overall earnings momentum of the Energy sector is still very poor. Figure 11: Earnings Momentum (33% of Earnings Weight) Arrows Indicate Change vs. Last Month 6

7 Figure 12 shows that the Energy sector s earnings estimate revisions were sharply positive i.e., upward revisions by far outpaced downward revisions. Figure 12: Earnings Revisions (25% of Earnings Weight) Figure 13 illustrates free cash flow margins for the sectors, both current and historical. Figure 13: Free Cash Flow Margins (25% of Earnings Weight) 7

8 Figure 14 illustrates change in shares outstanding by sector over the past twelve months, with issuance being considered negative (i.e., dilutive), and buybacks being regarded as positive for shareholders. Utilities, an Underweight sector, has experienced a significant amount of share issuance over the last twelve months. A possible explanation for this is heavy capital spending on new equipment from power plants to pollution-control devices. Figure 14: Net Share Issuance = 15-20% of Earnings Weight Figure 15: Sector Recommendations Figure 15 summarizes the current sector recommendations. 8

9 Figure 16 illustrates the dispersion of the sector scores. Figure 16: Ranking Sectors by Weighting Valuation, Earnings and ESG Scores Combining the Regional and Sector Models Combining our regional and sector models, Figure 17 illustrates sector Over- and Underweights by region. We are Overweight Health Care in North America, the U.K. and Europe ex U.K. We are Overweight Information Technology in Emerging Asia, Japan and North America. We are Underweight or Neutral Energy, Materials and Industrials in the majority of regions. 9

10 Figure 17: Combining the Regional and Sector Models 10

11 Food for Thought: ESG in Sector Strategy What s Material? In previous reports, we looked at the investment significance of certain Environmental, Social and Governance (ESG) factors specifically as they related to sector strategy: The Economics of Environmental Issues in Sector Strategy, October 20, We studied the implications of a potential increase in key environmental costs for ten industry sectors. The Social Costs of Business: Implications for Sector Strategy, December 16, Utilizing a number of metrics (i) costs of community support; (ii) costs of cheap labor; (iii) costs of committed and safe employees; (iv) costs of attracting and retaining customers we estimated the social costs of business for the ten sectors in the MSCI All Country World Index (ACWI). We have continued to research these issues and plan to publish some updated analysis in the very near future. An important albeit likely self-evident observation is that the shifting of GICS weights in the MSCI ACWI benchmark has implications for the materiality of specific ESG issues in sector strategy at any given point in time. Figure 18 illustrates the shifting weights of the 10 GICS in the MSCI ACWI over the past 20 years. Figure 18: Sector Weights in MSCI All Country World Index (ACWI)* *2015 through April 30, 2015 Source: MSCI Inc. 11

12 More specifically, Figure 19 illustrates that the weighting of the Materials sector halved between 1995 (10%) and 2015 (5%), while the weighting of the Information Technology sector doubled in the same period (from 7% to 14%). In our October 2014 report The Economics of Environmental Issues in Sector Strategy we highlighted that, of the 10 GICS, the Materials sector is most exposed to environmental costs, while the Information Technology sector is least exposed. Figure 19: Sector Weights in MSCI All Country World Index (ACWI)* *2015 through April 30, 2015 Source: MSCI Inc. As our forthcoming analysis will discuss, the above would suggest (among other things) that the incorporation of ESG issues in sector strategy should be dynamic, and that a frequent reassessment should be undertaken of the current materiality of various non-traditional metrics. 12

13 Appendix 1: Summary Statistics Figure 20: Global Equity Markets Data, Bloomberg 13

14 Michael Geraghty is the Global Markets Strategist for Cornerstone Capital Group. He has over three decades of experience in the financial services industry including working as an investment strategist at UBS and Citi. Cornerstone Capital Inc. doing business as Cornerstone Capital Group ( Cornerstone ) is a Delaware corporation with headquarters in New York, NY. The Cornerstone Flagship Report ( Report ) is a service mark of Cornerstone Capital Inc. All other marks referenced are the property of their respective owners. The Report is licensed for use by named individual Authorized Users, and may not be reproduced, distributed, forwarded, posted, published, transmitted, uploaded or otherwise made available to others for commercial purposes, including to individuals within an Institutional Subscriber without written authorization from Cornerstone. The views expressed herein are the views of the individual authors and may not reflect the views of Cornerstone or any institution with which an author is affiliated. Such authors do not have any actual, implied or apparent authority to act on behalf of any issuer mentioned in this publication. This publication does not take into account the investment objectives, financial situation, restrictions, particular needs or financial, legal or tax situation of any particular person and should not be viewed as addressing the recipients particular investment needs. Recipients should consider the information contained in this publication as only a single factor in making an investment decision and should not rely solely on investment recommendations contained herein, if any, as a substitution for the exercise of independent judgment of the merits and risks of investments. This is not an offer or solicitation for the purchase or sale of any security, investment, or other product and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities. Investing in securities and other financial products entails certain risks, including the possible loss of the entire principal amount invested. You should obtain advice from your tax, financial, legal, and other advisors and only make investment decisions on the basis of your own objectives, experience, and resources. Information contained herein is current as of the date appearing herein and has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed and should not be relied upon as such. Cornerstone has no duty to update the information contained herein, and the opinions, estimates, projections, assessments and other views expressed in this publication (collectively Statements ) may change without notice due to many factors including but not limited to fluctuating market conditions and economic factors. The Statements contained herein are based on a number of assumptions. Cornerstone makes no representations as to the reasonableness of such assumptions or the likelihood that such assumptions will coincide with actual events and this information should not be relied upon for that purpose. Changes in such assumptions could produce materially different results. Past performance is not a guarantee or indication of future results, and no representation or warranty, express or implied, is made regarding future performance of any security mentioned in this publication. Cornerstone accepts no liability for any loss (whether direct, indirect or consequential) occasioned to any person acting or refraining from action as a result of any material contained in or derived from this publication, except to the extent (but only to the extent) that such liability may not be waived, modified or limited under applicable law. This publication may provide addresses of, or contain hyperlinks to, Internet websites. Cornerstone has not reviewed the linked Internet website of any third party and takes no responsibility for the contents thereof. Each such address or hyperlink is provided for your convenience and information, and the content of linked third party websites is not in any way incorporated herein. Recipients who choose to access such third-party websites or follow such hyperlinks do so at their own risk. 14