Regional and Sector Strategy: January Update

by Michael Geraghty

Executive Summary

• Regional strategy — Downgrade the U.K. to Underweight from Overweight.  Our upgrade of the U.K. to Overweight in October 2014 proved to be a “value trap.”  While the U.K. remains relatively cheap compared to other countries and regions, the earnings outlook has deteriorated sharply.
• Sector strategy — Our sector strategy is unchanged and remains “less cyclical, more defensive.”  We maintain our relatively defensive posture given pockets of economic weakness globally.  We are Overweight Health Care in North America, the U.K. and Europe ex U.K.  We are Underweight or Neutral Materials in the majority of regions.

Figure 1: Regional Rankings
Arrows Indicate Change vs. Last Month

Figure 2: Sector Rankings
Arrows Indicate Change vs. Last Month

Regional and Sector Strategy: Monthly Update

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

We downgrade the U.K. to Underweight from Overweight.  Our upgrade of the U.K. to Overweight in October 2014 proved to be a “value trap.”  While the U.K. remains relatively cheap compared to other countries and regions, its earnings outlook has deteriorated sharply.  Among other factors, this likely reflects:

• The fact that the FTSE is filled with oil producers, miners and other companies slumping in the commodities rout;
• The relatively strong pound, which has been hurting exports that were already pressured by economic weakness in continental Europe; and
• Plunging earnings at grocery chains, which have been pummeled by a price war.

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 3 illustrates that the valuation of Japan, which we are Overweight, has become even more attractive.  Our other Overweight region — Emerging Asia — continues to look attractive on a relative valuation basis, even though the region has become a little more expensive.

Figure 4 illustrates that earnings momentum in Japan and Emerging Asia continues to improve, while momentum in the U.K. has weakened further.

Figure 5 illustrates that the earnings revisions trends in three of our Underweight regions — Europe ex. the U.K., Latin America and Central and Eastern Europe, Middle East and Africa (CEEMEA) — remain extremely negative i.e., downgrades by far exceed upgrades.

Figure 6 illustrates that margins in the Underweight CEEMEA region are currently at ten year lows.

Figure 7 illustrates that share issuance is relatively high in the U.K., an Underweight region.

Figure 8 summarizes the current regional recommendations and Figure 9 illustrates the dispersion of the regional scores.

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 Financials sector remains by far the most attractive of the ten GICs in terms of valuation.

Figure 11 illustrates that earnings momentum in the Health Care, Information Technology and Financials sectors — our three Overweights — improved last month.  Earnings momentum in the Materials and Energy sectors, two of our three Underweights, weakened materially.

Figure 12 shows that the Energy sector’s earnings estimate revisions were sharply negative i.e., downward revisions by far outpaced upward revisions.

Figure 13 illustrates that free cash flow margins in Information Technology and Health Care remain materially higher than most other sectors.

Figure 14 illustrates that two of our three Underweight sectors —Utilities and Materials — have experienced a significant amount of share issuance over the last twelve months.

Figure 15 summarizes the current sector recommendations.

Figure 16 illustrates the dispersion of the sector scores.

Combining the Regional and Sector Models

Combining our sector and regional models, Figure 17 illustrates sector Over- and Under-weights by region.

• We are Overweight Health Care in North America, the U.K. and Europe ex U.K.
• We are Underweight or Neutral Materials in the majority of regions.

Appendix 1: Summary Statistics

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