Executive Summary

  • Still defensive — We maintain our relatively defensive posture given pockets of economic weakness globally.  We are Overweight Health Care in the U.K., North America and Europe ex U.K.  We are Underweight or Neutral Energy, Materials and Utilities in the majority of regions
  • Regional strategy — We upgrade the U.K. to Overweight from Neutral, in large part because the earnings outlook has improved materially.  We downgrade CEEMEA to Underweight from Neutral.  Last month’s upgrade proved premature, as the earnings outlook for the region has deteriorated rapidly at the same time that relative valuations have become less attractive.
  • Sector strategy —There are no changes to our sector strategy this month.
Figure 1: Regional Rankings
Arrows Indicate Change vs. Last Month
Figure 1: Regional Rankings
Figure 2: Sector Rankings
Arrows Indicate Change vs. Last Month
Figure 2: Sector Rankings

This month the only changes to our weightings are in the regional model.  Our previous regional and sector recommendations were published in the September 2014 edition of the Cornerstone Capital  Regional and Sector Strategy: Monthly Update.

We upgrade the U.K. to Overweight from Neutral.  Although relative valuations are unchanged, the earnings outlook has improved materially.  Specifically, the U.K. was the only area to experience more upward than downward earnings estimate revisions last month, which coincided with a continued improvement in earnings momentum.  Figure 3 lists the ten largest companies in the FTSE 100.

Figure 3: Ten Largest Companies in FTSE 100
Geraghty_6Oct14_Figure3a
Source: Bloomberg

We downgrade the Central and Eastern Europe, Middle East and Africa (CEEMEA) region to Underweight from Neutral.  As a reminder, the two largest countries in the region are South Africa (43%) and Russia (26%), both of which have heavy exposure to Materials and Energy, two of our three Underweight sectors (the third being Utilities).  Last month’s upgrade of CEEMEA to Neutral from Underweight proved premature — the earnings outlook for the region has deteriorated rapidly at the same time that relative valuations have become less attractive.  Net earnings revisions (upward earnings estimate revisions minus downward revisions) were by far the worst of any region last month.  Not surprisingly, earnings momentum in CEEMEA has continued to weaken.

Regional Strategy Update

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 4 illustrates that the relative valuation of the CEEMEA region has become less attractive.

Figure 4: Regional Valuations (50% of Aggregate Weight)
Arrows Indicate Change vs. Last Month
Geraghty_5Oct14_Figure3
Source: Cornerstone Capital Inc.

None of the relative valuation shifts of the other regions — including the U.K. — were material.

Figure 5 illustrates that earnings momentum in the CEEMEA region continues to deteriorate, while Figure 6 illustrates that the earnings revisions trend in CEEMEA remains extremely negative i.e., downgrades by far exceed upgrades.

Figure 5: Earnings Momentum (33% of Earnings Weight)
Arrows Indicate Change vs. Last Month
Sep14_Geraghty_Figure4
Source: Cornerstone Capital Inc.
Figure 6: Earnings Revisions (33% of Earnings Weight)
Arrows Indicate Change vs. Last Month
Geraghty_5Oct14_Figure5
Source: Cornerstone Capital Inc.

By contrast, earnings momentum in the U.K. continued to improve, and the area was the only one to experience more upward than downward earnings estimate revisions last month.

Figure 7 illustrates that margins in CEEMEA are currently lower than in most other regions.

Figure 7: Margins (15-20% of Earnings Weight)
Geraghty_5Oct14_Figure6
Source: Cornerstone Capital Inc.

Another negative for CEEMEA is that share issuance remains very high — Figure 8.  Given that corporate earnings are reported on a per share basis, a large amount of net share issuance is a drag on earnings per share growth in a region.

Figure 8: Net Share Issuance (15-20% of Earnings Weight)
Geraghty_5Oct14_Figure7
Source: Cornerstone Capital Inc.

Figure 9 summarizes the current regional recommendations and Figure 10 illustrates the dispersion of the regional scores.

Figure 9: Regional Recommendations
Geraghty_5Oct14_Figure8
Source: Cornerstone Capital Inc.
Figure 10: Ranking Regions by Weighting Valuation, Earnings and Governance Scores
Arrows Indicate Change vs. Last Month
Geraghty_5Oct14_Figure9
Source: Cornerstone Capital Inc.

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.

In terms of valuations, Figure 11 illustrates that the Health Care sector is currently the most expensive, followed by two of our three Underweights: Energy and Utilities.

Figure 11: Sector Valuations (25% of Aggregate Weight)
Arrows Indicate Change vs. Last Month
Geraghty_5Oct14_Figure10
Source: Cornerstone Capital Inc.

Figure 12 illustrates that earnings momentum in both the Information Technology and Health Care sectors — our two Overweights — improved last month.  Earnings momentum in the Materials sector weakened, while momentum in the Energy and Utilities sectors was unchanged.

Figure 12: Earnings Momentum (33% of Earnings Weight)
Arrows Indicate Change vs. Last Month
Geraghty_5Oct14_Figure11
Source: Cornerstone Capital Inc.

Figure 13 shows that Health Care was one of only two sectors experiencing more upward than downward earnings estimate revisions last month.

Figure 13: Earnings Revisions (25% of Earnings Weight)
Arrows Indicate Change vs. Last Month
Geraghty_5Oct14_Figure12
Source: Cornerstone Capital Inc.

Margins in Information Technology and Health Care are materially higher than in most other sectors (Figure 14).

Figure 14: Margins (25% of Earnings Weight)
Geraghty_5Oct14_Figure13
Source: Cornerstone Capital Inc.

Figure 15 illustrates that all three of our Underweights — Utilities, Materials and Energy — have experienced a significant amount of share issuance over the last twelve months.

Figure 15: Net Share Issuance = 15-20% of Earnings Weight
Geraghty_5Oct14_Figure14
Source: Cornerstone Capital Inc.

Figure 16 summarizes the current sector recommendations.

Figure 16: Sector Recommendations
Geraghty_5Oct14_Figure15
Source: Cornerstone Capital Inc.

Figure 17 illustrates the dispersion of the sector scores.

Figure 17: Ranking Sectors by Weighting Valuation, Earnings and ESG Scores
Arrows Indicate Change vs. Last Month
Geraghty_5Oct14_Figure16
Source: Cornerstone Capital Inc.

Combining the Regional and Sector Models

Combining our sector and regional models, Figure 18 illustrates sector Over- and Under-weights by region.

  • We are Overweight Information Technology in Japan, Emerging Asia and North America.
  • We are Overweight Health Care in the U.K., North America and Europe ex U.K.
  • We are Underweight or Neutral Energy, Materials and Utilities in the majority of regions.
Figure 18: Combining the Regional and Sector Models
Geraghty_5Oct14_Figure17
Source: Cornerstone Capital Inc.

[1]The Socially Responsible Quant, Deutsche Bank Markets Research, April 24, 2013
[2]A Clear View of Risk and Return, MSCI ESG Research, March 30, 2014

You can download the full report with the Appendix Summary Statistics, MSCI ACWI Weights, and the Conceptual Framework.

Michael Geraghty is the Global Markets Strategist at Cornerstone Capital Inc. He has over three decades of experience in the financial services industry including working as an investment strategist at UBS and Citi.

 

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