“The big unsettling dynamic in US markets is volatility. Since late 2011, as markets moved higher, volatility has trended lower.
“The market’s extraordinary calm is illustrated by the S&P 500’s daily return, which has not exceeded +/- 1% for 51 consecutive trading days up to 30 June 2014, a period of some two and a half months.
“This is the longest period of calm since 1995. Though low volatility is not by itself a requirement for future market weakness, we believe it is a good barometer of elevated market risk.
“Only time will tell when world markets will see an upswing in volatility, but there is plenty in the mix to suggest its near-term possibility.
“One source may be disappointing US corporate earnings later this year. Consensus expectations anticipate earnings per share to increase approximately 14% for both 2014 and 2015. Given the long-term trend is around 6%, we see this as an unlikely outcome, especially with the backdrop of a rising rates environment,” Mr Padowitz says.
Whether they are assessing market volatility, or assessing regions and sectors, it is important for investors to think differently and look through the immediate data, and take a smoother, less risky approach to international investing, Mr Padowitz says.
By way of example, he cites the recent renaissance in the US energy industry, which has been driven by growth in shale oil and other unconventional sources, as an area where many investors are not undertaking a critical “look through” of the available data.
The dramatic upswing in US shale oil production is having a significant impact on the global energy market, he says.
“As well as the related domestic economic benefits, advantages include geographic wealth diversity, reduced foreign policy risk and increased local manufacturing competitiveness. If not for this supply change, our view is that oil prices would have risen significantly, as conventional production has declined over this period.
“Despite the good news on production growth, we believe the immediate investment opportunity is less compelling.
“In this instance, it is critical to understand that the characteristics of the shale oil wells used in production mean capital requirements to achieve growth are significantly higher than for conventional production”.
Mr Padowitz explains that the average decline rate of a US shale well ranges between 35 to 60 percent a year, therefore, within four to five years, most wells become almost obsolete.
“Faced with such high decline rates, it’s a challenge to continue increasing production and producers are consistently drilling more and more wells to maintain and grow supply.
“A secondary feature, and a compounding one from an investment perspective, is that the bulk of new shale oil growth is coming from smaller companies. By their nature, these have less diversified sources of cash flow and inferior access to capital. So it’s no surprise that debt levels are more elevated in this industry.”
He says this creates an unsettling investment dynamic.
“Because every spare dollar of cash flow has been thrown at capex, overall production has rapidly grown. But the industry, we believe, will ultimately approach a tipping point, where production growth must slow as the declining existing inventory starts to exceed the growth rate of new wells.
“Call it an ‘emperor has no clothes’ moment, but it’s difficult to see earnings doing anything but declining, particularly with relatively leveraged balance sheets.”
Despite this, analyst ratings do not on the whole reflect this inevitable long term decline, he says.
“The take out for investors is this: be it prolonged levels of low market volatility or increasing capital intensity in the US shale oil industry, risk never takes a permanent holiday. This is why investors need to take a smoother, value-orientated approach to their international investment portfolios,” Mr Padowitz concludes.
*The VIX index is the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.
Chad Padowitz – CIO, Wingate Asset Management
Ph 03 9913 0704
Wingate Asset Management is a boutique international equities fund manager that invests in a concentrated portfolio of high quality companies from around the world, diversified across sectors and geographies. It was formed by a joint venture between Australian Unity Investments and Wingate Group in 2008.
A value manager, Wingate seeks to pay less than intrinsic value for stocks and invests in companies with high cash flows, strong balance sheets and typically large market capitalisations.
Wingate’s flagship fund, the Wingate Global Equity Fund, utilises an innovative implementation approach that enhances returns and creates a buffer against losses. The benefits of this approach are equity upside with less downside risk, lower volatility of returns and income generation.