As bottom-up stockpickers, we believe that while it’s important to look at macroeconomic data points from a particular country or region, it’s even more important to examine each sector and individual company to determine various drivers of earnings. As we look back on 2014 generally, it’s clear that European equities have not been amongst the market darlings. Valuations in the eurozone are among the cheapest in the world today, a result of the European financial crisis a few years ago and the generally risk-averse investment community, which has had a tendency to shun Europe over the past year on the back of generally poor economic fundamentals. However, many European corporations remain relevant and competitive globally, with geographically diverse revenues and high operating leverage. Compared with its developed market peers, Europe also maintains the broadest scope for additional monetary and fiscal stimulus. Therefore, Europe is an area of focus for us and a place where we are currently seeking out bargains.
We believe one bright spot in Europe today—and of particular focus in our Shariah-compliant portfolios—is the health care sector, which we view as having reasonable valuations and good long-term potential. Looking back to the late 1990s and early 2000s, the health care sector was trading on huge multiples, above 30 times earnings. Valuations since then have de-rated and bottomed out in 2009–2010 to low double-digit levels driven by a perfect storm of increasing regulation, declining research and development productivity, and generic competition. We took a more constructive view and identified significant potential for cost-cutting, restructuring and pipeline development at select companies. More recently, we believe the sector has exhibited renewed vigor; there are more new drug approvals hitting the market than there have been in some time, and health care spending in emerging markets has continued to drive earnings in many health care-related companies.
We are also finding selective opportunities among an eclectic group of health care firms outside of the mainstream pharmaceuticals industry that we feel offer undervalued (and often uncorrelated) growth opportunities for long-term investors. In our view, such companies also represent attractive takeover prospects for major pharmaceuticals and biotechnology firms looking to diversify away from patent-dependent products. Indeed, 2014 was a record-breaking year for M&A in the pharmaceuticals industry.
We are also looking at beaten-up sectors for value, including the energy sector, which we are devoting more time to researching as valuations have collapsed with commodity prices. Trying to forecast oil prices in the short term is not a constructive exercise in our view—as it’s nearly impossible to do so. Longer term, as extracting and processing oil become unprofitable at lower price points, capacity will likely shut, and we should see a self-correcting mechanism that will likely provide a floor. Once global growth improves, oil demand should follow, so we are fairly confident that the risk of higher oil prices three to five years from now is likely greater than the risk of a further price decrease.
Select emerging markets have also become more interesting to us following two years of marked underperformance versus their developed world peers. We have found selective value in China for our portfolios, though the environment remains challenging given significant economic imbalances and a highly politicised business environment. Our focus in China is on finding companies with balance sheet strength and capital discipline. Again, you can’t paint all emerging markets with the same brush; you have to do your homework on an individual basis.
Outlook for Japan
In our view, value appears to remain relatively scarce in Japan, where many larger companies are conglomerates with secondary positions in industries we find unattractive. Corporate Japan has traditionally prioritised stakeholders over shareholders, which has pressured equity returns and made the country’s relatively low price-to-book multiple warranted. What we believe Japan needs most are structural, regulatory and corporate reforms to promote higher returns on equity, consumption and capital expenditures. It has been our view that the only lever the Japanese government has full control of is monetary policy. Fiscal stimulus is constrained by national debt levels and the difficulty of raising tax revenue and structural reform. Even if maximised and fully implemented, it would likely take time to show results. We are not surprised that the Bank of Japan undertook further quantitative easing in 2014.
Structural reforms will be difficult to implement in Japan because there will likely be resistance both politically and from entrenched stakeholders who will be disadvantaged by structural reform. In our view, “Abenomics” is partially working in that monetary easing is occurring, but we think stimulus on the fiscal side will not be significant enough due to the constraints mentioned. We think structural reforms are crucial for longer-term success, but the measures announced so far are not forceful enough, and still require the “co-operation” of the corporates and labour market to truly reform.
We are seeing some enlightened Japanese companies initiate changes, which is encouraging to us. We are also encouraged by the government’s efforts to raise awareness through establishing an index of higher ROE (return on equity) companies. We believe these are all positive signs and that the government realises raising returns to shareholders is important; Japan’s Government Pension Investment Fund (GPIF) will likely need to rely less on bond returns and more on equity returns for the longer-term viability of the pension system. However, change on a broad scale will not happen overnight because senior management has to believe that low ROE relative to global comparables is an issue.
The opportunities within the challenges of Shariah Investing
Selecting investments for our Shariah-compliant portfolios follows our same bottom-up stockpicking process, and our general investment views mirror those for our broader portfolios. However, there are some unique aspects to consider. Among them, a company’s balance sheet structure should contain neither too many liquid assets nor too much debt, and a company should not engage in “haram,” (forbidden) industries such as alcohol, tobacco and gambling, as well as specific foods considered “non-halal.”
Since we know what is permissible in Shariah equities, namely, a 5% max on non-halal business and a 33% cap on debt and interest earned from free cash flow, we can determine an appropriate stock selection. Due to these requirements, we believe it actually makes the fund manager scrutinise the stocks further, which in turn results in high-conviction portfolio construction. Shariah advisors who are considered experts in Islamic law are integral to the investment selection and review process. Our portfolios are independently reviewed and endorsed by the Amanie International Shariah Supervisory Board, highly regarded for its extensive and comprehensive board of Shariah members and technical expertise.
When the universe of stocks is subject to more stringent filters (due to requirements to be Shariah-compliant), naturally there will be fewer to choose from, and a Shariah portfolio may end up with a higher weighting of a particular stock than our conventional portfolios. Due to this higher concentration of the stock/sector in a portfolio, the portfolio is put under in-depth scrutiny from a risk-management perspective. At the same time, we think this close examination helps cement our convictions around what we believe to be the best potential opportunities.
We can proudly say we are a true-to-label global equity fund manager in the Shariah space by virtue of Templeton Global Equity Group’s presence on the ground, around the world.
What are the risks?
All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Value securities may not increase in price as anticipated or may decline further in value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets.
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