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This month we, upgrade Financials to Overweight from Neutral reflecting the combination of relatively attractive valuations and improving earnings momentum.  In addition, Financials’ earnings estimate revisions are only modestly negative (i.e., downward revisions just outpace upward revisions), in sharp contrast to most other sectors where estimate revisions are strongly negative. Our regional strategy remains unchanged.  We are Overweight or Neutral the majority of developed regions (Japan, U.K., Australia, North America) and Underweight most emerging markets (Latin America, CEEMEA).

Figure 1: Regional Rankings
Arrows Indicate Change vs. Last Month
Geraghty_3Nov14_Figure 1
Figure 2: Sector Rankings
Arrows Indicate Change vs. Last Month
Geraghty_3Nov14_Figure 2

 

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

We upgrade Financials to Overweight from Neutral reflecting the combination of relatively attractive valuations and improving earnings momentum. In addition, Financials’ earnings estimate revisions are only modestly negative (i.e., downward revisions just outpace upward revisions), in sharp contrast to most other sectors where estimate revisions are strongly negative. Figure 3 lists the ten largest companies in the MSCI ACWI Financials Index.

Figure 3: Ten Largest Companies in MSCI ACWI Financials Index
Geraghty_3Nov14_Figure 3

Source: MSCI

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 valuation of the Emerging Markets Asia region, which we are Overweight, has become even more attractive. Our two other Overweight regions — Japan and the U.K. — continue to look attractive on a relative valuation basis.

Figure 4: Regional Valuations (50% of Aggregate Weight) Arrows Indicate Change vs. Last Month

 Geraghty_3Nov14_Figure 4 

Source: Cornerstone Capital Inc.

Figure 5 illustrates that earnings momentum in Emerging Asia and Japan continues to improve, while momentum in the U.K. has weakened somewhat.

Figure 5: Earnings Momentum (33% of Earnings Weight) Arrows Indicate Change vs. Last Month
Geraghty_3Nov14_Figure 5

Source: Cornerstone Capital Inc.

Figure 6 illustrates that the earnings revisions trends in our three 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: Earnings Revisions (33% of Earnings Weight)
Geraghty_3Nov14_Figure 6

Source: Cornerstone Capital Inc.

Figure 7 illustates that margins in the Underweight Latin America region are currently at ten year highs.

Figure 7: Margins (15-20% of Earnings Weight)
Geraghty_3Nov14_Figure 7

Source: Cornerstone Capital Inc.

Figure 8 illustrates that share issuance remains very high in CEEMEA, another Underweight region.

Figure 8: Net Share Issuance (15-20% of Earnings Weight)
Geraghty_3Nov14_Figure 8

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_3Nov14_Figure 9

Source: Cornerstone Capital Inc.

 

Figure 10: Ranking Regions by Weighting Valuation, Earnings and Governance Scores

Geraghty_3Nov14_Figure 10

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.

Figure 11 illustrates that the relative valuation of Financials has improved further, and the sector is by far the most attractive of the ten GICs on this metric.

Figure 11: Sector Valuations (20% of Aggregate Weight) Arrows Indicate Change vs. Last Month
Geraghty_3Nov14_Figure 11

Source: Cornerstone Capital Inc.

Figure 12 illustrates that earnings momentum in the Financial, Health Care and Information Technology sectors — our three Overweights — improved last month. Earnings momentum in the Materials and Energy sectors, two of our three Underweights, weakened materially.

Figure 12: Earnings Momentum (33% of Earnings Weight) Arrows Indicate Change vs. Last Month
Geraghty_3Nov14_Figure 12

Source: Cornerstone Capital Inc.

Figure 13 shows that Financials’ earnings estimate revisions were only modestly negative (i.e., downward revisions just outpaced upward revisions), in sharp contrast to most other sectors where estimate revisions were strongly negative.

Figure 13: Earnings Revisions (25% of Earnings Weight)
Geraghty_3Nov14_Figure 13

Source: Cornerstone Capital Inc.

Figure 14 illustrates that free cash flow margins in Information Technology and Health Care remain materially higher than most other sectors.

Figure 14: Free Cash Flow Margins (25% of Earnings Weight)
Geraghty_3Nov14_Figure 14

Source: Cornerstone Capital Inc.

 

Figure 15 illustrates that all three of our Underweights — Energy, Utilities and Materials — have experienced a significant amount of share issuance over the last twelve months. Share issuance has been significant in Financials too but, in our model, this is more than offset by the combination of attractive valuations and relatively good earnings momentum.

Figure 15: Net Share Issuance = 15-20% of Earnings Weight
Geraghty_3Nov14_Figure 15

Source: Cornerstone Capital Inc.

Figure 16 summarizes the current sector recommendations.

Figure 16: Sector Recommendations
Geraghty_3Nov14_Figure 16

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_3Nov14_Figure 17

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 or Neutral Financials, Health Care and Information Technology in the majority of regions.
  • We are Underweight or Neutral Energy, Utilities and Materials in the majority of regions.
Figure 18: Combining the Regional and Sector Models
Geraghty_3Nov14_Figure 18

Source: Cornerstone Capital Inc.

 

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.