Swiss Made Special Edition
Our initial assumptions going into 2015:
Declining to negative rates were going to push investors to look for yield elsewhere such as in defensive growth stocks and looking for returns via stand alone growth stocks, or low valuation cyclical stocks which can be found in the Swiss markets, respectively in the SMI and SPI Small and Mid. Earnings growth was continuing around the same level as in 2014 (circa +8%), with upside potential in the dollar appreciation and macroeconomics improving later in the year.
Last Thursday's decision to let the CHF appreciate to the Euro has pushed CHF interest rates even lower, meaning that a 3.3% dividend yield on a large cap stock is more attractive than 3% following the price correction of 10%. In a CHF frame, the dividend and earnings yields now compares to a risk free rate (10 years Swiss Government bond yield) that is below zero (vs 1.0% one year ago).
Before last Thursday, the valuations were in the upper part of historical range for large defensive companies but not extremely valued, and in the average range for small and mid caps, but risk premium was high from an historical perspective, therefore leaving price increase potential.
Following last week’s correction, earnings will go down due to the FX effect, so valuations might stay at the same level, but equity risk premium has been pushed up to even higher levels; under a mean reversion scenario, the argument for price increase potential still holds or even is reinforced. Earnings progression, that we expect to continue on last year’s pace of around +8-10%, is now facing a forex headwind of around -12% on average (at current rates that have an upside in our opinion).
Before last Thursday, we thought that many company were in a position to increase their dividend.
Today this vision is mixed as it depends on whether companies have already repatriated from abroad 2014 earnings in CHF. If so, dividends are safe. We assume that many companies with an FX imbalance have put in place such repatriation schemes following the 2011 crisis.
Early 2015, we thought that companies had cash to make acquisitions.
After the FX move, targets abroad are now around 15% cheaper and, now that the SNB’s floor has been removed, the incentive to invest abroad is greater still for Swiss companies.
Similarly, companies which had cash to buy back shares are now in a position to buy them back more cheaply and the oil and commodity price drop is additionally positive for margins.
Direct Impact of the FX move on Companies:
The impact ranges from purely translational for diversified company whose revenues, costs, assets and debts per currencies are highly matched, to more severe if costs and assets are predominantly Swiss based.
The increasing USD strength might well resume from current level (equal to last spring’s level) as growth and interest yield differentials are now still larger in favour of the dollar.
The EUR rate of change is back in the analysis with more risk to the downside short term, but a fair value that we estimate at 1.05-1.15, signifying some potential mid term upside.
Pure exporters and pure importers without pricing power are obviously the most affected, mainly the Luxury industry, an underweight in our portfolios except for the Swatch which was a high conviction.
Banks were underweight in our portfolios but this has not helped in the Small and Mid Cap portfolios as the index includes mainly domestic cantonal banks that have outperformed given their domestic nature.
Industrials : a case by case situation. We had reduced European exposed industrials during last summer, and have only bought back a part of it since.
Retailers : we are underweight retailers.
Domestic players : we are overweight Swisscom (value+domestic+yield)
Hit on high convictions : Swatch, Partners Group, U Blox, Lonza, Straumann, Sonova, AMS, Buckhardt, Meyer Burger have been hit hard, painted all red with the same brush, despite very diverse situations. Out all of them, only Swatch, Partners Group, Straumann, Meyer Burger have a Sales / Cost FX exposure imbalance and are subject to be affected as a one off from last week. But for the others, price drop are exaggerated in our opinion : either high growth will compensate mid term once base effect is behind, or natural operational hedge has been underestimated (for instance Burkhardt sources a lot of material and semi-finished products in Euros but bills in CHF for much of its production).
- Translational vs transactional effect : most Swiss champions in international markets, either large or small and mid, have an important natural hedge developed over the years as implementing production capacities in consumption market. Therefore, they face more translational effect on the accounts that are held in CHF (we would not negate the effect on stock prices of headline figures, but underlying fundamentals ultimately drives longer term more than temporary effects.
- Non CHF investors have in fact gained around 5% on their Swiss holdings today as the CHF gained 15% on the currency and lost 9% on stock prices. This might spark a second wave of selling, but also the most prudent and risk averse to stick to their assets to hold Swiss denominated assets, assuming a further reinforcement of the CHF.
We still haven't circumvented all the aspects, and One key element is still missing : ECB’s actions this week and the net combined effect on the value of the Euro and earnings expectations. we will continue to monitor the situation. Nevertheless, we think that some opportunities have been created and will try to make profit out of it.
Some rebound is possible ($ or lowly discerned hard hit stocks).
When a shock happens, it generally leads to overshooting in one direction, which is what we experienced last week.
There might still be some downside potential (second wave, late seller, downward revision of analysts on earnings and price targets, etc…) but unless the world enters recession, the equity asset class keeps its positive aspects and price potential, albeit on a now or soon lowered base.
We will adjust the portfolios based on those arguments and conclusions.
We remain available to answer any questions.