Markets assume the worst

Ad Van Tiggelen, the head of European equities at ING Investment Management, believes that the markets are currently assuming the worse case scenario: a deflationary recession. Morningstar spoke to him about this and his investment philosophy, which rests half way between value and growth investing.

Fernando Luque 18.10.2002
What is happening to the stockmarkets?

The markets are currently discounting the worse possible scenario: a recession. The markets are also discounting that US consumption will fall sharply because in order to have a proper recession, the economy needs to offer figures that show a sharp decline in consumer spending. But currently there are no clear signs that such a decline is occurring. The US consumer is still spending at a considerable pace. It is, nevertheless quite clear that this rate will be reduced and that the US consumer will tend to spend less. But the question is: how much less?

The markets, on the other hand, think that consumer spending will drop substantially. But in a low interest rate scenario, normally this is not the way things happen. I think that the changes in the consumer spending patterns and in the real estate markets will be more gradual than what the markets are discounting.

What about the risks of deflation?

The markets are also discounting the risk of deflation. It is the most reasonable explanation to what is happening in the markets now. We can only justify the dramatic falls in equity [share] prices if we think that there will be a deflationary recession, or at least, a recession with lower inflation.

How can you explain the fact that although most asset managers prefer European markets, these have underperformed against the American market?

The relative optimism with respect to the European markets may be explained by the fact that in terms of valuation, European stocks [shares] are trading at more attractive levels than US stocks, both in terms of P/E as well as dividend yield ratios. In Europe the dividend yield ratio is in the 3–3.5% range with respect to 1.7% in the US.

On the other hand, we must also take into account that the most important bubbles that we have experienced lately - US consumer debt levels, fiscal deficit in the US, public deficit in Japan etc - have occurred outside the European continent.

Then, why are investors less pessimistic about the performance of the US market in the short term? The flow of funds could be one of the reasons. In Europe many defined contribution pension funds have been short selling [betting on falling prices] quite actively. The same has occurred to some large insurance companies that have an equity exposure much higher than the exposure of their US counterparts.

Furthermore, many investors are not happy with the way in which some European governments are behaving. For example, many investors do not agree with the way in which the German government has acted with respect to Mobilcom or in which the French government has acted towards France Télécom. These attitudes are more similar to the behaviour of the Japanese government than to those of the European governments.

In any case, I think that in terms of valuation, European equities are cheaper than fixed income assets. If the US does not enter into a new recession - a scenario which we give a 50% probability - we estimate that the European equity markets could increase in the 15-20% range until December 2003.

How do you define your investment style?

Our investment style is based on fundamental bottom-up analysis that is supported by quantitative tools. We think that the income growth is the variable that can better explain the performance of an individual stock. But our objective is to invest in stocks that offer an attractive balance between growth and value investing. It is a GARP style of investing - that is growth at a reasonable price.

We use a proprietary stock rating system that gives a 60% weight to growth variables - short term and long term growth, competitive environment, management, free cash flow - and a 40% weight to value factors - ratio comparisons, capital structure, dividend yields. To each stock we give a score which enables us to under- or overweight that stock with respect to its weight in our benchmark.

With respect to our European portfolios, it is important to highlight that we have always been fully invested. I think that when someone buys shares of a European equities fund, we have to give them what he or she is expecting, that is a European equities fund and not a product with 30% in cash or in fixed income.

Have you always maintained a weighting of 60% growth and 40% value?

Yes. During these past years this system has worked well but in extreme markets such as this one, it is not as efficient. In bull markets we have managed to outperform value investors and in bear markets we have managed to outperform growth investors.

But in the current situation value stocks such as those in the following sectors - metal, automobile, mining or chemical - are currently too expensive. That is why we are underweight the more cyclical sectors in our portfolio. These sectors are already discounting a recovery that we think will come at a lower pace.

On the contrary, we are overweight the oil sector - our model implies that these companies are trading at a price of $18 per barrel - the telecoms sector - the fundamentals are improving and valuations are reasonable - and the financial sector.

How do you control the risk in your portfolio?

First, we have a specific department dedicated exclusively to risk management. It provides us, on a monthly basis, [with] a detailed analysis of our tracking error. But we also apply sectoral filters. For example, we will never have a sector underweight/overweight of 2.5% with respect to the benchmark’s weight. Furthermore, we will never have a 3% overweight /underweight on an individual stock.

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Fernando Luque

Fernando Luque  es el Senior Financial Editor de www.morningstar.es