A contrarian case for caution as capital cycles peak

It's “prone to wander, stampede, and even perish if not carefully shepherded.”¹ This movement over time creates capital cycles for different markets, sectors, and companies across the globe. Investors who see potential in a particular area will typically be inclined to reward it by providing capital; if and when the prospects sour, they'll tend to withdraw the capital instead. Stocks of promising companies operating in promising industries get bid up as investors align their capital with their high expectations. By contrast, when consensus expectations for a particular segment are negative, the flow of capital is usually negative, too.

At Wellington Management, our capital cycles investment team strives to identify when sentiment driving capital flows reaches extremes: We look for long and short opportunities across geographies and industries, with a focus on areas in their early- or late-cycle phases, where some of the most interesting investment themes reside. Our investment philosophy favors capital preservation by pursuing:

• Long exposure to early-cycle areas of the market, where capital tends to be scarce
• Short exposure to late-cycle areas of the market, where capital is abundant
• An active allocation to cash

This contrarian style can be especially effective as investor sentiment shifts, and our latest research points to a nearing inflection point in a number of industries. Relative to the consensus, we've also grown more cautious on the market as whole.

On a macro level, we've been struck by how universally bullish most investors and corporate management teams have become over the last few months. A recent survey of senior executives showed that 64% believe the economy is improving, up from just 21% in October 2016.² Today, we see very little of the cynicism or fear that seemed pervasive only a year ago, and we suspect many investors are extrapolating current positive trends too far into the future. On balance, this has led us to pursue a comparatively conservative risk posture.

We still see certain segments where risk taking is likely to be rewarded over time. The downtrodden areas of the market, where capital has been destroyed, capacity has shrunk, or regulations have become onerous, have historically offered good sources for our long ideas, and that's especially true right now. Enduring assets and real estate in India—where it's particularly difficult to put capital to work—provide a case in point. Another portfolio theme, solar energy, represents an example closer to home. While a number of investors, including some of our own colleagues, have been withdrawing capital from the solar industry, we've slowly been increasing long exposure to certain companies. In these situations, returns, margins, or multiples may be low, and market sentiment may be pessimistic, but when we see a compelling fundamental case for companies to increase spending, underappreciated areas of the market may present the most attractive buying opportunities for long-term investors.

Conversely, industries where capital is abundant often find their way to our list of short candidates. When expectations and margins are high, multiples rich, and sentiment optimistic to the point of exuberance, investors tend to make allocations under the assumption that results will remain strong indefinitely. We may be seeing that dynamic today in information technology, where mutual funds dedicated to the sector have seen an asset growth rate of 19% this year,³ “on pace to surge by nearly a quarter during 2017, which would be the briskest growth in 15 years.”⁴ We've observed that spending and returns among semiconductor companies, in particular, are near prior cycle peaks. We also have concerns about the auto industry: Its current cycle is now the longest on record, showing signs of topping out, with declining credit quality, credit-driven unit growth, and record-high margins. We see meaningful downside risk in this segment over the intermediate term.

Many equity portfolio managers stay fully invested regardless of the economic environment, but we recognize that market conditions may not always merit such a posture. Beyond the long and short exposures, maintaining dry powder—an active allocation to cash—helps us cultivate the patience that contrarian investing requires. Buying opportunities with the greatest potential tend to present themselves as an area of the market approaches the bottom of its cycle. We strive to stay prepared for those moments, even when they come unexpectedly. In the meantime, we're glad to wait. With so much capital in the global financial system today, we believe the time has come to exercise a little bit more restraint.

1 The Devil's Financial Dictionary, Jason Zweig, 2015. 2 "Global Capital Confidence Barometer | 16th edition," ey.com/ccb, April 2017. 3 Strategic Insight, Simfund, May 2017. 4 "Tech Flows Surging, Raising Bubbles Fears," Ignites, 5/23/17.