James Williams interviews Peter Garnry (pictured) of Saxo Bank on his pair trade research.
Peter Garnry, Head of Equity Strategy at Saxo Bank notes that historically, any time a consumer product reaches a saturation phase in its lifespan, it signals a change in consumer behaviour; specifically that they have become more price sensitive. Could Apple now be reaching such a saturation point with respect to smart phones, he asks, and has constructed a pair trade, going long Samsung and short Apple, to express his view.
The quick rationale, explains Garnry, is based on the fact that the economics, in the smart phone industry, in terms of hardware and software, are converging. The software used in Android smartphones, although slightly more fragmented, is now broadly on a par with iOS software in the iPhone. Moreover, Chinese smart phone manufacturers such as Huawei are producing phones that are equal in terms of hardware, but only half the price compared to the iPhone.
In short, Garnry points out that Samsung’s recent rise in mobile sales against Apple’s declining sales, and the fact that in the Asian market both Huawei and Samsung are eating into Apple’s market share, does not augur well for the US tech giant.
According to website 9to5mac.com, Apple iPhone sales in May pushed it down to fifth place in China’s smartphone market, falling behind local brands Huawei, Vivo, Oppo and Xiaomi. Apple’s market share is 10.8 per cent, down from 12 per cent one year ago.
“When Apple’s CEO, Tim Cook recently talked about there being temporary factors at play in China, we didn’t agree with that notion. We think it’s a more permanent situation where Apple increasingly finds itself in a position where their price points are too high given the convergence taking place between hardware and software.
“That plays into the hands of Samsung, which has cleaned up its pipeline and streamlined the number of products – the Galaxy S7 is seeing a massive uptick in demand in Asia, for example. We think Apple is getting squeezed in Asia and we are seeing market share gains for Chinese manufacturers and Samsung. Eventually, Apple will have to change its strategy somehow,” suggests Garnry.
The average iPhone cost USD687 at the end of 2014. Last year, according to World Bank data, the average Chinese salary was USD7,400. The iPhone is still, for many, an expensive luxury.
Going forward, as Samsung develops its OLED technology, Garnry thinks that Apple could even become one of its customers.
“If you look further into the future with respect to this saturation phase for smart phones, it will likely mean lower margins and only players with high volumes will survive. We think that plays into the hands of Samsung. They are used to being a high volume-low margin business, for which the same cannot be said of Apple. It controls a bigger part of the supply chain with respect to hardware and we think that will make it easier for Samsung to produce components more efficiently at lower price points,” says Garnry, who views Samsung as a poster child.
He notes that while many large technology companies are reluctant to increase their capital expenditure and take a long-term view of investing for the future, “Samsung is doing just that, despite a low growth environment”.
Sticking with technology stocks, Garnry favours Microsoft on the long side but is yet to include it in a pair trade although he notes that firms such as IBM and Oracle could be considerations for investors. Garnry is impressed with Microsoft’s Q4 earnings (through 30 June 2016), which ended up being much better than market expectations with revenues of USD20.6 billion.
Revenue in Intelligent Cloud grew 7 per cent to USD6.7 billion; specifically, Microsoft Azure revenue grew 102 per cent with Azure compute usage more than doubling year-over-year.
The company did miss the target of one billion Microsoft 10 users, but Garnry says that the price earning is not high given the return on invested capital. He thinks the stock looks attractive and says that the share price could reach USD60.
“If you look at the penetration and adoption rates of the Azure platform and Amazon Web Services, they are just staggering. I don’t think anyone else can catch them. That’s why we are very positive on Microsoft,” says Garnry.
Amazon Web Services recorded revenues of USD2.6 billion in Q1 2016, representing 64 per cent growth year-on-year.
“We think the new CEO of Microsoft Corporation, Satya Nadella, is doing all the right things. In our view, the future of technology infrastructure will be divided across two or three key players: right now it seems as though Amazon Web Services and Microsoft Azure will conquer the whole market. The jury is still out on whether Google can make it,” says Garnry, who continues: “A position that comes to mind as a possible short relative to Microsoft is IBM, which has been left behind. There has been speculation that Hewlett Packard Enterprise can make it. I think it is very unlikely though.”
Microsoft Azure is the firm’s enterprise-grade cloud computing platform. The disruption in technology is such that people are moving away from on-premise software sales – the old model that SAP and Oracle were built on – towards cloud-based on demand services.
“Microsoft is probably the most successful of the established tech giants that is moving in that direction. The newer business model will mean higher volumes at lower margins but overall aggregate profits could be higher. We believe that over the next two years, you’ll begin to see the effects of this turnaround at Microsoft as its cloud-based business revenues accelerate together with profits.
“The roll out of Windows 10 is a little behind the curve but that’s the only slight disappointment in an otherwise very bright looking trajectory for Microsoft,” states Garnry.
One sector level pair trade that Saxo Bank is holding is short consumer staples and long consumer discretionary. The rationale for this is based on two drivers. Firstly, the valuation spread between the two sectors has reached an historic high.
Secondly, some of the leading macro indicators have improved recently that should benefit consumer discretionary stocks.
Garnry notes that consumer staple companies have a low sensitivity to the stock market. This has, as a result, attracted significant inflows from low volatility, low beta ETFs.
“These ETF inflows have led to Procter & Gamble, Cocoa Cola, etc – very stable consumer businesses – being bid up with forward P/E ratios of 25, 28, despite close to zero revenue growth, because of the macro environment. It tells you about some of the dynamics that are working through equity markets with the whole trend towards smart beta investing in low volatility ETFs,” comments Garnry.
He thinks this trend could unwind in the coming year: “If we start to see leading indicators turn for the better, which we believe would lead to consumer discretionary stocks trading higher and at a lower discount relative to consumer staples.”
Another pair trade that Saxo Bank has is a long position on Biogen against a short position on the biotech sector.
“We think the downside risk is somewhat limited because Biogen’s portfolio is strong and its cash flow generation is strong. We think Biogen is better insulated from the negative sentiment that investors have towards the biotech sector, generally speaking,” explains Garnry.
Within the financial sector, Garnry says that Saxo Bank is currently long the Italian bank, UniCredit, which has just raised EUR1 billion by selling stakes in Polish subsidiary Bank Pekao and FinecoBank as new Chief Executive, Jean-Pierre Mustier, moves to shore up the bank’s balance sheet.
“We are up 21 per cent on that position. We think the current price to book ratio at 0.25 is too low. The obvious thing to do would be to go long UniCredit and short one of the smaller Italian banks. However, financing that short position could be quite substantial so we’re not engaging in any European bank pair trades at present.
“That said, we are bearish on the Spanish banks because of their exposure to Latin America. Also, the biggest inflows to Spanish real estate over the last two years have come from UK citizens. It’s pretty evident that with Sterling where it is today against the Euro following Brexit, UK buyers have pulled back and in a worst-case scenario you could see UK owners of Spanish real estate selling their assets. That could cause house prices to fall, increase loan losses and negatively impact the Spanish banks,” concludes Garnry.
