White Papers

In this second part of our two-part series, we demonstrate that deglobalization implies trend increases in capex and the labor share, as well as a higher weighted average cost of capital (WACC). This constitutes a secular headwind for margins and free cash flow (FCF), especially for tech and manufacturing. With companies facing greater macro volatility and an elevated WACC, we expect lower average multiples. This will prove especially challenging for longer duration assets, such as venture capital and speculative tech companies that are years away from generating FCF on a sustainable basis.

Global supply chains are being overhauled to reduce vulnerabilities and to restrict Chinese imports of “dual-use” products that can be used for both commercial and military purposes. In Part I of this two part series we show why the initial focus is on semiconductors and energy, and where it might go from there (AI, quantum computing, and other advanced tech). We also demonstrate the challenges for Chinese equities and U.S.-based multinational corporations, which have been the two biggest beneficiaries of globalization.

Until recently, we had been living in a disinflationary environment that started in the 1980s. We believe three factors – Deglobalization, Demographics and Decarbonization – have led us to a secular reflationary environment. As a result the next decade is going to look quite different than the 2010s, with a number of critical implications for investors.

The transition to net-zero emissions (NZE) involves a fundamental change in the structure of the economy, and will likely be messy, implying periodic supply shortages and even more volatile energy prices. Further, inflation and nominal interest rates will probably be higher and more volatile, especially relative to the levels of the last two decades. This has not yet been priced into markets.

China has launched a new policy framework, “Common Prosperity,” which escalates government steerage of the economy and features two critical initiatives. First, Beijing is taking action to tame the country’s real estate obsession. Second, the “summer blizzard” of regulatory actions has targeted a wide range of tech-related sectors including fintech, social media, online tutoring and gaming. Here, we examine the implications for investors of the pendulum swinging ever further in favor of the state.

Our latest piece is an update to a 2020 white paper titled “The Epoch Core Model: Our Proprietary Stock Model.” The Epoch Core Model is a systematic, rules-based expression of our free cash flow investment philosophy. In 2017, we implemented substantial changes to the model and created three industry-specific versions of it. More recently, we developed three machine learning versions of the Model and will introduce a new signal derived from activity in the securities lending market. In this paper, we describe these model enhancements as well as our research agenda for the next three years.

The recent surge in start-ups and unicorns reflects the broadening of the digital revolution across industries, and suggests improving productivity and free cash flow. Further, although the digitization of the economy is still in early earnings, we expect digital platforms to represent the majority of market cap by 2025, with tech, health care and communications the most promising sectors.

Inflation risks are at a four-decade high due to today’s combination of a generous Treasury, an overly tolerant Fed, and a reopening economy. While our base-case scenario assumes only a brief period of above-target inflation, investors should brace themselves for more inflation scares, which will likely remain a key driver of equity markets well into 2022.

Both sides of the political spectrum have been increasing their calls for regulatory action on the Big Tech companies. Here we explain why tech will continue to be the most dynamic sector of the economy, and why we expect greater breadth in tech market leadership and the emergence of entirely new sub-sectors.

The last six months have been profoundly transformational, with the COVID shock acting as an accelerant for the digitization of the economy. This radical transition is especially advantageous for asset-light business models. All companies will be acutely affected, although the biggest winners are platforms, with their economies of scale and low marginal costs.

The dispute between the U.S. and China is clearly not just about trade, or even technology. At stake are the values that will determine the architecture and governance of the global world order.

The current hype about two-sided digital platforms, blitzscaling and winner-takes-most markets has fueled a surge in IPO listings and produced stratospheric valuations that are difficult to reconcile with free-cash-flow (FCF) fundamentals. The big question is, are we repeating the excesses of the dot-com boom? In this paper, we look at the reasoning used by those who think history is repeating itself including IPO supply, profitability and VC funding. We also look at the weaknesses in those arguments and why some believe that the current situation is different from the dot com bubble, such as median age of tech IPOs and sales growth. Finally, we explore how investors can look at these companies through a free cash flow lens.

Does a stock’s price and its P/E ratio tell you how much a company is worth? Conventional wisdom says yes, but we think otherwise. In this paper we explore:

• The theory behind the discounted cash flow (DCF) valuation model and the underappreciated role that ROIC plays in the model
• The P/E ratio and find that it does not tell us what most people think it does, nor does its offshoot, the P/E to growth (PEG) ratio
• How we can use what we have learned about the DCF model to deconstruct P/E ratios in the real world to better understand what they do tell us

Three developments (the unwinding of QE, the soaring US budget deficit and the impending wall of maturities, especially of corporate bonds) will engender higher volatility and wider credit spreads. There is also a risk that interest rates will start rising for “bad” reasons (that is, an increase in fixed income supply). Each of these outcomes would be a headwind for high duration strategies.

Modern Portfolio Theory (MPT) dominates investment thinking today, but the pre-MPT view of the world still holds valuable insights. Our new white paper explores the limits of MPT in aiding successful investing.

The Digital Age and the transition from “atoms” to “bits” implies a capital-light economy in which technology is being substituted for labor and physical assets. Its impact is widespread and stretches beyond the technology sector. In the third part of our technology focused series we explore:

• The evolution of technology and why it is so noticeable today
• The key differentiator between the first and second machine ages
• Technology’s impact on microeconomic factors such as demand and marginal revenue
• Why the digital age entails a radical reevaluation of macroeconomics
• Implications for investors

While regulators and many investors are focused on leverage, we are more concerned with liquidity risk, which was at the core of the 2007-2009 crisis and will likely be again at the next one. As central banks move toward “quantitative tightening,” higher interest rates and waning liquidity are the most significant global macro risks, especially given that many assets are trading toward the high end of their historical ranges.

It has long been common practice in the investment world to divide the market up into “value stocks” and “growth stocks.” What do these labels really mean? “Value” connotes that the stocks in this category are undervalued, and should therefore outperform over time, while “growth” implies that these are stocks with faster earnings growth.

The rapid expansion and implementation of technological innovation has become a key factor in the behavior of the economy and capital markets. In this paper, Investment Strategist Kevin Hebner and Co-CIOs Bill Priest and David Pearl explore how tech has become the new macro, including a look at how:

• Tech is positive for all three return on equity (ROE) components
• Profit margins have soared over the last two decades
• Asset utilization improves with technology
• Tech impacts leverage and payout ratios
• Platforms and their network effects have resulted in a winner-takes-all market
• Disruptive innovation will affect all economic sectors

The rapid expansion and implementation of technological innovation has become a key factor in the behavior of the economy and capital markets. In this paper, Investment Strategist Kevin Hebner and Co-CIOs Bill Priest and David Pearl explore how tech has become the new macro.

Passive ETFs have influenced the informational efficiency of the stock market: trading costs have risen, stocks are more correlated with each other than they used to be, and valuation is now partly affected by whether a stock is in a widely traded index or not. Read this paper to learn more about the impact that passive investing has had on market efficiency and what active managers must do to in such an environment.

Epoch’s investment philosophy can be summarized by saying that it is the ability to generate free cash flow that makes a company worth something to begin with, and it is how management allocates that free cash flow that determines whether the value of the business rises or falls. In this paper, we address the former of this statement and answer two questions: 1) Why does free cash flow matter more than earnings in determining the value of a business, and 2) do free-cash-flow metrics help investors identify stocks that outperform the market?

Return on Invested Capital (ROIC) is a crucial metric in evaluating companies, yet investors pay more attention to growth in earnings, which can be misleading. In this white paper, learn more about the opportunity for investors to earn superior returns by focusing in a systematic way on harvesting the benefits of owning companies with high ROIC. Our Capital Reinvestment strategy focuses on companies that use their free cash flow to reinvest and acquire, and in doing so have a persistently high level of ROIC well in excess of their weighted average cost of capital.

This continuation of our previous paper furthers our examination of the recent performance of active managers and considers both the theoretical and empirical arguments.

In our most recent whitepaper, we discuss the case for active management. The paper looks at the recent performance of active managers and then considers both the theoretical and empirical arguments.

At Epoch, we invest in companies that we believe are good capital allocators. This means finding companies that have a track record of successfully investing free cash flow for profitable growth and returning excess free cash flow to owners. If management does not have high-ROIC projects to pursue, including acquisitions, the “next best use” of that cash is to return it to the owners. We see dividends, share repurchases and debt pay-downs as equivalent ways to achieve that objective.

Bill Priest, David Pearl and Ken Hightower outline how the “power of zero” (quantitative easing and ultra-low interest rates) and the “power of the word” (the most significant being Mario Draghi’s “whatever it takes” statement) have held sway over equity markets. The paper describes the perils and opportunities ahead as these influences wane.

Dividend strategies are regaining popularity. But pursuing dividend yield alone can lead to poor results. Investors need to understand a company’s sources of cash and should view cash dividends, share buybacks and debt repayments collectively in assessing management’s strategy to create shareholder value.

Value, a word commonly used in our profession, means many things to many people. We share our perspective of value, as reflected in our free-cash-flow methodology, and how it relates to the conventional concept of value.

In a world likely to offer 6-8% long term equity returns on average, we discuss a strategy that should weather the challenges that lie ahead and provide a “9% Solution” with lower volatility over the long term.

Dividends really matter; and capturing them in a low cost, diversified manner is both important and rewarding for investors.

An examination of Epoch’s investment philosophy which is based around the changing order of the sources of equity return.

Why dividends are an important source of equity returns.

The growing significance of free cash flow and shareholder yield as a dominant driver of future equity returns.