Are Cyclicals the New Defensives?

Douglas Isles, Investment Specialist, Platinum Asset Management

09 March 2021

In the February 2021 Monthly Update for the Platinum International Fund we noted that: "When we look at long term (i.e. 35 years) valuation analysis, relative to asset values, cyclical stocks still look cheaper than their averages, while defensives were only more expensive at the peak of the technology bubble." This brief note expands on the detail in that valuation comment.

Over time, one simple valuation metric often used to identify stocks, sectors and countries that are out of favour or experiencing a temporary setback, is the Price-to-Book ratio (P/B). Mathematically, a P/B is equal to Price-to-Earnings (P/E) multiplied by Earnings-to-Book (or ROE). A low P/B can capture either a low valuation (on an earnings basis) and/or low returns on equity (coincident with cycle lows, or transient challenges) versus history.

Our quant analyst team has their own classification that we use for cyclical and defensive sectors, which is more granular than the Global Industry Classification Standard (GICS). We split 19 sectors into cyclicals or defensives and track them over time. Today, according to our analysis, around 55% of the global market's capitalisation can be categorised as cyclicals and 45% as defensives.

We classify cyclicals to be: retail; autos; banks; property; commercial services; industrial services; industrials; process industries; energy; materials; and hardware. The balance of the market we call defensives, and include: precious metals; consumer staples; healthcare; insurance; infrastructure; content; software; and communications.

The Price/Book chart is key.

Source: FactSet Research Systems, Platinum Investment Management Limited.

If we compare the cyclicals in aggregate on a P/B basis, while they have experienced a sharp rebound from the lows of the COVID-19 sell-off, they are not expensive relative to historical levels, especially when considering today's near-record-low bond yields, which are often used to justify the case for paying more for equities. While defensives, on the contrary, are higher than most of the last 35 years, excluding the technology bubble.

On a relative basis, the gap between the two groupings is close to its widest level of the last 35 years.

In simple terms, this suggests that investing in cyclicals still makes sense, particularly given our observations in the February 2021 Monthly Update that: "A change in the 'real world' is a move away from monetary policy to fiscal policy, after decades of restraint by governments. This favours real companies over virtual ones, at the margin. With data on the recovery stronger than anyone would have expected in April/May 2020, the market is warming to sectors that were out of favour."

From a performance outcome perspective, over the long bull market from 2009-2020, the best periods for Platinum's global equity strategy relative to market returns were in 2009, 2013 and 2017, which were coincident with the expansion of cyclical P/B multiples. This is a similar phenomenon to recent months. However, prior to the global financial crisis and especially from 2005-2008, cyclical areas, while performing well (particularly financials and resources), were less attractive and hence this relationship with our performance was not the same. In other words, Platinum's global equity strategy has not simply been a play on cyclicals over time, but we have tended to invest well in cyclicals when they are cheap.

On the classification used by the quant team in assigning the 19 sectors and matching them to the portfolio on 26 February 2021, more than 75% of the long book was categorised as cyclical, with less than 25% in the defensive grouping, consistent with the discussion above and our views expressed over time about where there is value in the market.

Thinking about cyclicals (or economically sensitives) as the opportunity rather than the common short-hand of 'value' (versus 'growth') is more instructive and captures a better sense of market dynamics. 

Bringing this back to themes in the portfolio and as the February 2021 Monthly Update notes: "The majority of the portfolio continues to be classified as belonging to the following thematics: Growth industrials, semiconductors, travel-related, Chinese consumer, healthcare, internet-related (though much reduced) and metals."

DISCLAIMER: This article has been prepared by Platinum Investment Management Limited ABN 25 063 565 006, AFSL 221935, trading as Platinum Asset Management ("Platinum"). This information is general in nature and does not take into account your specific needs or circumstances. You should consider your own financial position, objectives and requirements and seek professional financial advice before making any financial decisions. You should also read the latest relevant product disclosure statement before making any decision to acquire units in any of our funds, copies are available at www.platinum.com.au. Past performance is not a reliable indicator of future results. Some numbers have been rounded. The commentary reflects Platinum's views and beliefs at the time of preparation, which are subject to change without notice. No representations or warranties are made by Platinum as to their accuracy or reliability. Commentary may also contain forward-looking statements. These forward-looking statements have been made based upon Platinum's expectations and beliefs. No assurance is given that future developments will be in accordance with Platinum's expectations. Actual outcomes could differ materially from those expected by Platinum. To the extent permitted by law, no liability is accepted by Platinum for any loss or damage as a result of any reliance on this information.

Funds operated by this manager:

Platinum Asia Fund (C Class), Platinum Asia Fund (P Class), Platinum European Fund (C Class), Platinum European Fund (P Class), Platinum Global Fund, Platinum International Brands Fund (C Class), Platinum International Brands Fund (P Class), Platinum International Fund (C Class), Platinum International Fund (P Class), Platinum International Health Care Fund (C Class), Platinum International Health Care Fund (P Class), Platinum International Technology Fund (C Class), Platinum International Technology Fund (P Class), Platinum Japan Fund (C Class), Platinum Japan Fund (P Class), Platinum Unhedged Fund (C Class), Platinum Unhedged Fund (P Class)

China's 14th Five Year Plan

Arminius Capital

25 February 2021

• China's top leaders have set out their top priorities for 2021 to 2025: achieving self-reliance in science and technology, and "dual circulation".
• Self-reliance in science and technology means accelerating the development of vital high-tech industries such as semiconductors to ensure that China can develop regardless of US "threats".
• Dual circulation means encouraging production for domestic markets as well as for export markets, and upgrading China's internal logistics systems so as to build a unified national market.
• China is also committed to restructuring the energy sector and energy-intensive industries so as to meet the target of peak carbon emissions by 2030.
• The investment implications are obvious: China's demand for Australian coal and iron ore will not be rising.

Western voters are used to their governments announcing numerous initiatives and targets - especially around election time - then forgetting these as fast as they can, and hoping that the electorate will do the same. By contrast, the Chinese Communist Party has been diligently preparing Five-Year Plans ever since they took power in 1949, and they are now up to Plan Number 14, which will apply from 2021 to 2025 inclusive.

These Plans are very serious documents. They cover all arms of government and all parts of the country. Their purpose is to get China's army of unruly and self-interested bureaucrats heading in the same direction on the things that matter. To this end, each Plan is prepared with local and provincial input as well as the central authorities' opinions. At the end of each five-year period, the top leaders formally assess their government's performance against the Plan and, while they mostly boast about their achievements, they do also fess up to a few missed targets.

Over the last four months the draft 14^th Five-Year Plan has been making its way around the highest levels of government before getting the final seal of approval from the National People's Congress (China's tame Parliament) in March. As with all Chinese official documents, the Plan contains vast amounts of Communist platitudes and superfluous verbiage. But it also contains some very clear statements about where the Party leadership wants to the Chinese economy to go.

The 14^th Five-Year Plan departs quite dramatically from its predecessors in three key priorities which it sets. Right at the top comes "achieving self-reliance in science and technology" (�'技自立自强) so as to become "a science and technology superpower". Among other things, this means strengthening basic research, emphasizing original innovation, formulating strategic science plans, constructing national science centres and regional innovation hubs, and encouraging entrepreneurs in technology innovation. The Plan sets out a list of cutting-edge industries where it wants China to lead, including AI, semiconductors, aerospace, brain science, and bio-engineered breeding (genetically modified organisms).

Obviously, China's leaders have learned from the various US sanctions and embargos which the Trump Administration placed on the export of its high-tech to China. The Biden Administration has not removed these - instead, it has re-affirmed its intention of limiting technology transfer to China. (For some reason, neither side mentioned the Tiktok video platform.) The Chinese government now believes that the US has a stranglehold over China's future, so the 14^th Five-Year Plan is intended to push China's high-technology sector to catch up with then overtake the US.

The second big change in priorities is the new focus on "dual circulation". This priority needs to be placed in historical context. From 1990 on, government policy actively encouraged production for export markets, mainly because exports generated foreign exchange which could be used to pay for essential imports, but also because Chinese consumers were then very poor - per capita GDP was USD 318 in 1990, compared to USD 10,262 in 2019.

China's exports rose steadily in the 1990s, then rocketed up after the country joined the World Trade Organization in 2001, where it magically still enjoys the trade benefits of "developing nation status" despite being the second largest economy in the world. When calculated by purchasing power parity, China IS the largest economy in the world. But the great export boom slowed down as Chinese wages rose and the government allowed the renminbi to appreciate. From 2015 to 2019, exports were on average matched by imports, with the result that net exports contributed nothing to GDP growth. (It goes without saying that 2020 was a very unusual year, when China's trade surplus returned with a bang because of coronavirus-related demand and the suspension of tourism. Both of these factors are temporary.)

The special term for this new emphasis is "dual circulation" (双循环), which Xi Jinping introduced at a Politburo meeting on 14 May 2020. It is now a common element in the policy lexicon. It means that the government wants to encourage production for domestic markets as well as for export markets. In order to do so, the government intends not only to expand domestic demand, but also to build a unified national market, upgrade supply chains, establish a modern logistics system, and strengthen property rights (including intellectual property).

The focus on domestic demand is long overdue. Private consumption accounted for only 39% of China's GDP in 2019, compared to 66% for the US, so there is plenty of room to encourage consumption.

The third big change in priorities is related to meeting the goal of peak carbon emissions by 2030, on the way to carbon neutrality by 2060. This goal will require the restructuring of China's power generation system, because at present more than 60% of electricity is generated by coal-fired power stations. It will also require the restructuring of energy-intensive industries such as steel, aluminium, cement, and plastics.

All three big changes in priorities have clear implications for the long-term investment outlook. The new focus on high-tech and domestic consumption implies that less government and private money will go to infrastructure and mega-projects, hence China will have less need for steel, cement, and other building materials, therefore less demand for Australian iron ore and metallurgical coal. Housing growth will remain strong for the time being, but China's likely population decline will create headwinds for the housing sector. The goal of peak carbon emissions by 2030 speaks for itself - China will import less thermal coal.

The implications for the world economy and Australian exports are equally clear. China will be using less construction materials and energy minerals, so any global resources boom will not be running on coal and iron ore, but on the essential inputs for renewable power generation plants and electric vehicles - e.g. copper, nickel, lithium, and rare earths.

With the U.S. importing 80% of its rare earth elements from China (14 of the 35 most critical types such as those used in the F-35 are not able to be produced in the U.S.) Australia may have found itself a new resources export market... in the United States.

Funds operated by this manager:

Arminius Capital ALPS Fund, Arminius Capital GMMA Fund