A Close Look at Performance Drivers Fundamental investment management is based on analyzing key ratios and characteristics of a company and seeking to determine how that company will perform in the future. In the past two decades, a quantitative approach to identifying which factors contribute to performance has become a key part of the process for many investment managers. Investors wonder what exactly factor analysis is and how it can help investment managers. At its most basic, factor analysis tries to determine the primary contributors to performance and how much they might be affected by changes in the investment environment. Factor models seek to identify the underlying components that contribute to performance by analyzing the sensitivity of returns to different factors. Factors may be fundamental, such as price to book or return on equity or quantitative factors, which relate to either the individual asset or to the financial markets. Broad macroeconomic factors, such as employment, GDP, inflation and interest rates, are also often used in factor analysis. The classic capital asset pricing model (CAPM) uses one variable to quantify the relationship of portfolio or stock returns versus the market as a whole. In the early 1990s, Eugene Fama and Kenneth French introduced the first formal multifactor model, which uses three factors. Based on the observation that small-cap stocks and stocks with low price-to-book ratios have tended to outperform the market over time, the Fama-French model looks at: Excess return over a broad market portfolio Excess return of a portfolio with high book-to-market stocks over a portfolio with low book-tomarket stocks Excess return of a portfolio with small capitalization stocks over one with large market capitalization stocks IN THIS ISSUE: A Close Look at Performance Drivers A Tale of Two Paths For more insights and perspectives on key issues from James Dunigan and other senior PNC investment professionals please visit pnc.com/investmentcorner JAMES P. DUNIGAN Mr. Dunigan is Executive Vice President and Managing Executive, Investments for PNC Asset Management Group. He has served in a variety of client advisory, investment management and executive roles with PNC since 1987.
Identifying Factors There are several attributes that go into identifying good factors. The factor must be quantifiable and historically should have demonstrated a level of correlation with the asset returns. In order to be useful, the factor should display a consistent correlation with an asset, with an underlying logic that can be explained. For example, in fundamental factor analysis, (and in fundamental analysis, in general) financial ratios such as price to book and return on equity (ROE) are often used. They are indicators of a company s financial well-being, so one would expect a company with strong financial ratios to perform well in terms of stock returns. Factor Analysis versus Fundamental Analysis Factor analysis has a great deal in common with fundamental analysis, and most of the information used in factor-based models is also used by fundamental investment managers. Factor analysis goes a step further and allows managers to utilize the information in different ways by analyzing multiple factors on a common scoring scale, adjusting values to see how the variables react and using the results to help determine a systemic investment strategy. PNC s Approach to Factor Analysis We use factor analysis to assess fund and manager performance. Our goal is to identify the connection or correlation between fund and manager performance and the underlying securities periodical factor characteristics. By looking at the individual factors that comprise performance, we can potentially identify those factors that help stocks outperform versus those that are detrimental to stock performance during a given time period. Our analysis is conducted monthly and follows a disciplined process: 1. Rank stocks based on factor scores 2. Create portfolios, putting the top 20% in one portfolio, the second best 20% in another and so on 3. Repeat ranking and grouping for each factor we utilize 4. Calculate return spreads between the best and worst quintile for each factor S&P 500 Factor Quintile Spreads Percent 6 5 4 3 2 1 0-1 -2-3 -4 Sales Growth Low Price/Diluted Earnings If a factor was not a significant driver of performance for the period, we would expect stocks to have relatively consistent performance across quintiles. The bigger the spread between the top and bottom quintile for a factor, the more likely it is that this factor impacted performance for the period. A negative spread value indicates that the bottom quintile for the factor is more favorable for the period. When we look at factors and spreads over time, we have found that no single factor has consistently exhibited similar spread levels and directional changes are typically common among factors. An illustration of this is the top and bottom quintile spreads for sales to growth and low price/diluted earnings ratios for the period from mid-2010 to the end of 2013 shown below. 9/10 12/10 3/11 6/11 9/11 12/11 3/12 6/12 9/12 12/12 3/13 6/13 9/13 12/13 Source: FactSet Research Systems, Inc.; PNC 2
We also look at factors across a range of representative stock universes, the S&P 500, Russell 1000, S&P Mid Cap 400, S&P Small Cap 600, Russell 2000, MSCI EAFE, and MSCI EM. Factor behavior varies across the different stock universes, even those that one might expect to act somewhat similarly, such as the S&P 500 and the S&P Mid Cap 400. As a result, different factors are more important or may have a significantly different impact for the same period, depending on the stock universe one is assessing. A Broad Range of Factors Our approach utilizes a wide array of fundamental factors in our analysis across valuation, growth, quality, efficiency, price momentum and reversion, risk/size, payout and profitability categories. VALUATION Price to book, price to sales and other financial health indicators Factor Spreads Across Indexes, Third-Quarter 2013 Low Price/FY1 Sales Low Price/Book GROWTH QUALITY EFFICIENCY Earnings growth or sales growth Financial leverage-related factors Capital expenditure and earnings efficiency 5-Year EPS Growth Current Ratio Capital Expenditures/Assets Gross Income Margin Return on Common Equity S&P 500 S&P 400 PRICE MOMENTUM AND REVERSION RISK/SIZE Price returns and mean reversion factors evaluated at different interval lengths Downside risk and market capitalization Return on Assets Return on Invested Capital PAYOUT Dividend payout Percent Source: FactSet Research Systems, Inc.; PNC -3-2 -1 0 1 2 3 4 5 6 Predictability of Factors An integral part of factor analysis is evaluating the predictive potential of the factors. The ranked information coefficient (IC), which is the correlation between the factor ranking scores and the subsequent period s returns, helps us determine whether the results observed are a good potential predictor. We are looking for factors that correlate strongly with returns, not necessarily the most consistent factor indicators. An IC of 1 indicates perfect correlation. An IC value above 0.03 is often regarded as a good factor. The chart to the right shows the IC time series of three factors, price to sales, price to diluted earnings and dividend yield. We believe that factor analysis can help us to gain a better perspective on why certain groups of funds may have outperformed for a given time period. On an ongoing basis, we track a robust set of factor groups and have obtained valuable insight into fund performance from them. PROFITABILITY 0.40 0.30 0.20 0.10 0.00-0.10-0.20 3/11 Ratios that focus on return measurement, such as gross income margin, Return on Assets (ROA) or ROE Factor ICs, S&P 500 The seven-year averages of these ICs are shown in dotted lines. IC Value Low Price to Sales Low Price to Diluted Earnings Dividend Yield 6/11 9/11 12/11 3/12 6/12 9/12 12/12 3/13 6/13 9/13 Source: FactSet Research Systems, Inc.; PNC 3
A Tale of Two Paths One of the key themes that PNC sees for 2015 is that of divergence. The U.S. economy continues to expand at a faster pace than other regions of the world, which are experiencing lower or lack of growth. This is likely to continue in 2015, with most analyst forecasts calling for a higher growth rate in the U.S., while growth in other developed countries is forecast to potentially slow. Many investors wonder what the implications are for their asset allocation and what other themes or trends are likely for 2015. The U.S. has benefited from strong corporate earnings and the continued post-recession low-interest rate environment. Some additional developed countries, such as the U.K. and Canada, are also expected to experience stronger growth in 2015. Other areas have had significant volatility, indicating potential higher risk. Geopolitical events in some regions, such as the Ukraine and the Middle East, have been a driver. In other major economies, including the Eurozone, China and Japan, forecasted slowing global growth has particularly impacted the 2015 outlook. Corporate Earnings are a Major Boon to U.S. Markets Despite mid-year concerns over trading multiples in the U.S. in 2014, strong corporate earnings helped to bolster the markets. We feel that the U.S. equity markets at this time are not especially over or undervalued. In 2015, we anticipate that the U.S. economy will continue to expand, with projected economic growth in 2015 of 3.5% year over year, versus our forecast of 2.5% for 2014. Our estimates for 2015 are founded in expectations that: Payroll growth will continue at its current pace of approximately 230,000 new jobs per month Unemployment could decline to about 5.3% by year end 2015 Although corporate earnings exceeded our expectations in 2014, the U.S. markets were not immune to the impact of global geopolitical tension. However, despite volatility and some downturns, the U.S. rebounded and hit record highs in 2014. As we look to 2015, there are several potential issues which we feel may impact investors and the markets: Timing of interest rate increases U.S. politics Jobs, wages and inflation expectations Geopolitical environment Global economic concerns, especially in the Eurozone Interest Rates Expected to Rise Following the Great Recession, the U.S. economy has slowly returned to a more normal pattern of behavior. As this has transpired, the Federal Reserve (Fed) looks to be lessening its extreme support of a low-interest rate environment, with general consensus that the Fed Funds target rate, after being set at 0% to 0.25% since the end of 2008, will go up sometime in 2015. While estimates of timing and the magnitude of the increase vary, we believe that the Fed will begin to increase rates in July 2015. We feel that the U.S. equity markets at this time are not especially over or undervalued. 4
U.S. Political Concerns Loom In February, 2014, the government approved the suspension of the federal debt limit until March, 2015, when it will once again need to be addressed, although other potential measures could enable the government to avoid the issue until late summer. As the end of 2015 heads into a major election year period, other potential topics that could have an influence on market volatility include corporate tax reform, health care and immigration. U.S. Jobs and Inflation Outlook is Positive The overall jobs outlook has shown significant improvement since the depths of the financial crisis, when unemployment peaked at 10% in late 2009. The unemployment rate at the end of 2014 fell to 5.6%, compared to 6.7% for December 2013. This number may be misleading, however, because it does not reflect those that are still under-employed at jobs they are overqualified for or long-term unemployed who have been discouraged and are not actively seeking employment yet. As confidence increases and individuals begin to actively seek employment again, this may affect unemployment figures. Some areas, such as wage growth, remains stunted, with average hourly earnings up only about 2.0% year over year. This is the same rate of growth that wages have been experiencing since the recession. As a result, inflation does not appear to be a concern at this time. The Consumer Price Index (CPI) trended lower in 2014, due partially to lower energy prices, which also indicates a low inflation outlook. We are cautious as always, however, regarding inflation, as markets often overreact to even the perception of possible future inflation. Eurozone GDP Percent Real Quarter-over Quarter Growth 0.3 0.1-0.1-0.3 0% 0% Germany France Italy Eurozone Source: Bloomberg L.P., PNC 2Q14 3Q14 Unemployment with Adjustment for Decline in Labor Force Participations Percent 13 12 11 10 9 8 7 6 5 Official Unemployment Rate Adjusted Unemployment Rate 4 2006 2007 2008 2009 2010 2011 2012 2013 2014 Troubled Eurozone Economy The Eurozone economy continues to stagnate, with relatively slow GDP growth. Russia, with its worsening economic situation, represents a significant risk factor as a trading partner with Germany, which impacts the potential health of the Eurozone overall. In addition, Italy appears to be in a triple-dip recession cycle. We believe that the magnitude of the potential difficulties that exist for the Eurozone pose a threat to global growth. On the positive side, lower oil prices and European Central Bank (ECB) easing have been helpful to the Eurozone in its continued fight against deflation. In addition, both France and Spain are doing better than expected. Source: Bureau of Labor Statistics, PNC 5
Simmering Geopolitical Tensions Pose Threats The year 2014 was witness to several adverse geopolitical situations that remain potentially sources of turmoil. The Russia/Ukrainian conflict continues to percolate after months of antagonism and aggression, and we remain wary, especially in light of the potential impact of sanctions on trading partner relationships. The Middle East, although relatively quiet currently, is a perennial possible source of global tension and market volatility. And, as we have seen from recent terrorist events in France, there is always the risk of unanticipated global events, be they political, geological or meteorological. Cumulative Total Returns Index (100=1/1/2003) 350 300 250 200 150 100 50 0 2003 2005 2007 2009 2011 2013 Source: Morningstar Ibbotson, PNC S&P 500 Treasury Bond Treasury Bill Potential Bond Market Obstacles Lie Ahead Another key area of focus for PNC is the U.S. bond market, especially in light of the likelihood of potential interest rate increases in the second half of 2015. While both stocks and bonds can be said to have been in a bull market environment for the past several years, bonds have had unprecedented returns in the years immediately preceding and following the recession, chalking up double digit returns in 2007, 2008, 2011 and 2014 and positive returns in all but two of the other years from 2007 to 2014. Deleveraging has helped to facilitate a more prolonged recovery, as leverage tends to accelerate the economic cycle. As the economy recovers, the Fed has less need to maintain the extended interest rate policy and low rate environment support it implemented in the wake of the global financial crisis. As discussed, the expectation is that the Fed will begin increasing rates sometime in the second half of 2015, with our view being that the first rate hike will be in July 2015. Historically, both the equity and bond markets have reacted in anticipation of a rate increase, with research by Cornerstone Macro indicating that markets react one to two months prior to an official increase. Bonds, not surprisingly, are generally more sensitive to changes in interest rates. Typically, in the past, long-term bond prices have fallen when the Fed Funds rate has increased. However, in an exception to the rule, the Fed Funds 150 b.p. rate increase in 2004-2005 did not result in an increase in long-term bond yields and falling prices. We do not believe this will occur again, despite some similar circumstances and anticipate that long-term yields will rise modestly. The Deleveraging of America The U.S. has continued its post-recession deleveraging, with household debt falling significantly since its peak in 2007/early 2008. Leverage ratios are now significantly below pre-recession levels, and corporations have also increased earnings while maintaining a conservative perspective on new spending. Deleveraging has encouraged consumer and corporate savings. It has also helped to facilitate a more prolonged recovery, as leverage typically accelerates the economic cycle. On the other hand, lower leverage inhibits borrowing for items such as new homes and other large purchases, which is beneficial to GDP growth. The economy must balance between sufficient leverage to encourage growth and expansion and too much leverage which, as seen during the recession, can lead to overheating and overpricing of the market. 6
Manufacturing Renaissance and Energy Independence The renaissance in U.S. manufacturing and the move of the U.S. toward North American energy independence also supports the theme of global divergence that we are witnessing. Rising international labor costs and lower energy costs in the U.S., lower domestic shipping costs, cultural compatibility and greater controls are all contributing to the increasing competitiveness of U.S. manufacturers. Although manufacturing still represents a relatively small part of the U.S. economy, manufacturing nominal GDP has risen significantly since the recession, as has industrial production. The energy story also has undergone a significant evolution in the past decade, with the U.S. potentially on its way to North American energy independence. This is partially due to the use of hydraulic fracturing and horizontal drilling techniques. The International Energy Agency (IEA) forecasts that by 2020, 87% of U.S. energy needs will be met by domestically produced energy, which could have a lasting positive effect on domestic employment, creating more than 3.3 million jobs by 2020. Manufacturing as a Share of U.S. GDP Percent 30 28 26 24 22 20 18 16 14 12 10 1950 1960 1970 1980 1990 2000 2010 Source: Bureau of Economic Analysis, PNC U.S. Industrial Production 105 100 We believe both of these trends support the U.S. recovery and may also create attractive investment opportunities. As always, we recommend that investors focus on valuation and fundamental factors, keeping in mind longer-term expectations, goals and risk tolerance in determining their asset allocation. Index, 2007=100 95 90 85 80 2007 2008 2009 2010 2011 2012 2013 Source: Bureau of Economic Analysis, PNC 7
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