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Pimco: Growth and Rising Stars

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Pimco sees these "rising star" companies in the US and European auto sector, the gaming, energy and chemical industries, and in sectors tied to the US housing market.

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Pimco's global credit investment process focuses on leveraging our firm's top-down macroeconomic outlook, bottom-up credit research and relative value analysis to identify attractive investments. Our top-down view suggests that while developed market growth in several regions is picking up cyclically from low levels, overall global economic growth is likely to remain subdued over the next several years. Global aggregate demand is unlikely to pick up materially given structurally high unemployment and elevated public sector debt levels. Meanwhile, emerging markets growth could slow due to tighter U.S. monetary policy over the near term as well as the difficult transition of public-sector-assisted to private-sector-led growth over the medium term.

Nevertheless, we do see a few areas of strength. As we discussed in our November 2012 Global Credit Perspectives, "Go for Growth," we continue to favor investing in areas of the market that have above-trend growth dynamics. From a bottom-up perspective, we are also finding companies in areas with fast growth that we feel the rating agencies have misrated. Specifically, Pimco views many of these investments as "rising stars" – credits with improving fundamentals that should see ratings upgrades over time.

Why growth is important

Investors should focus more on growth in their global credit selection. Simply put, growth is a powerful factor in enhancing profits and helping to aid the delevering of a company's balance sheet. Typically, growth in revenue drives expansion in enterprise value (the market value of a firm's debt plus equity), and free cash flow generation reduces net debt. As net debt-to-enterprise value falls, the company's credit fundamentals improve. Over time, there is an increasing likelihood that credit spreads can tighten because the ratio of net debt-to-enterprise value is correlated to credit spreads (see Figure 1), since default risk tends to decline as leverage is reduced. In addition, the likelihood of credit rating upgrades increases as a company's fundamentals improve.


Not surprisingly, the change in net debt-to-EV over the past year varies dramatically by industry (see Figure 2), with housing-related sectors and energy experiencing much stronger fundamental improvement and organic delevering than metals and mining.

Ratings and looking forward

While Pimco's credit ratings are forward-looking and derived independently from credit rating agencies' ratings, we pay attention to credit rating agencies mainly from the perspective of market technicals. Specifically, credit rating agency upgrades can lead to rating migration, for example from a high yield, or BB+ rated credit, to an investment grade, or BBB- rated credit, which then causes benchmark-oriented or passive investors to buy these "rising stars."

Pimco's investment strategy has always been focused on looking forward and anticipating credit rating upgrades before they occur. We look into the future in our credit selection and model company financials by making projections and forecasts out several years from today. Our strategy is to buy companies that are improving from a credit perspective before the market – and the credit rating agencies – anticipates these developments. Our longer-term, secular approach and forward views are designed to help us to capture many rising stars before other investors, who may have a shorter-term investment horizon or orientation.

Globally, we see a few areas where growth is likely to be sustained over the medium term. In the U.S., autos and housing should continue to grow above trend over a cyclical horizon, mainly due to pent-up demand. In Europe, the auto sector is likely bottoming and a few specific credits should benefit from a gradual recovery. In addition to these more cyclical areas, we see longer-term or secular growth in the U.S. energy and chemical industry, as well as in Asian gaming.

Let's turn to each of these areas given our view that many rising star investments may be available in these industries.

Autos

The U.S. auto industry is experiencing strong earnings growth as a result of financial and operational restructurings and significant pent-up demand coming out of the recession. Cyclically, autos are rebounding from a depressed level (see Figure 3), which allows for a strong recovery and healthy growth. U.S. light vehicle sales reached a seasonally adjusted annual rate (SAAR) of 16 million units in August 2013, up 10% versus last year. Ford plans to increase production by 7% in the fourth quarter from a year earlier to meet strong demand.

Supply and demand factors help explain the sector's strong growth profile. On the supply side, American automakers effectively downsized and restructured their business over the past few years to the appropriate level of demand. The industry's focus on healthier balance sheets, cost control and consolidation allowed companies to invest for the future, resulting in new products, fresh car designs, stronger brands and an expanded lineup of fuel-efficient vehicles.

On the demand side, five factors are driving strong top-line auto sales today in America. First, the need to replace older cars and trucks is high, as the average age of the fleet is over 11 years (see Figure 4). Second, consumers are exhibiting a strong preference for fuel efficiency – even within the full-size truck category. Third, credit availability has improved at auto finance companies due to a reduction in credit losses, low interest rates and easier access to credit, which these companies have passed on to consumers. Fourth, consumer confidence has improved due to a gradual decline in the unemployment rate, a rising equity market and higher housing prices. Finally, strong growth in the U.S. residential construction and energy industries is driving healthy demand for new truck sales (Ford sold an amazing 71,115 F-series pickups in August 2013, which the company said worked out to one truck every 42 seconds).


While industry fundamentals have turned in the U.S., the European auto industry remains depressed. For example, car registrations in Europe have dropped by over 25% – and over 50% in some markets – from pre-crisis levels. Nevertheless, we see signs of a modest recovery as Europe stabilizes, and we expect an eventual turnaround for companies that have been able to downsize to today's lower demand levels and manage their balance sheets. We feel a few European auto and auto parts companies are well positioned to benefit from an improvement in profitability and free cash flow as the European auto cycle turns.

Overall, in the U.S., we continue to favor a group of auto and auto finance companies with improving fundamentals. In Europe, we are targeting a select group of companies that have strong competitive positions through their brands and technology. In both regions, we expect over the medium term to see an increasing number of companies demonstrate the ability to grow top-line and bottom-line results. Importantly, through higher profits and increased cash flow, several auto and auto finance companies have improved their ability to delever, which should ultimately result in more ratings upgrades in the U.S. and the start of an upward rating trend in Europe.
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