Cherry picking season

Written By: Henry Boucher Partner Sarasin

Achieving good returns from equities may need more than a favourable economic tide. Henry Boucher of Sarasin discusses the benefits of using a thematic approach to find investment opportunities.

Five years of zero interest rates, trillions in asset purchases, unlimited lending facilities for banks and a commitment to keep rates low for another two years have, so far, only managed to achieve a modest global economic recovery. It seems clear that we will not see a return to the pre-crisis patterns of GDP growth, driven by favourable demographic trends and with activity and job creation bolstered by a credit boom and ever-rising government spending. Instead we can expect a large part of future improvements in living standards and corporate profitability to be shaped by productivity gains and different demographic trends.

The scale of fiscal contraction across the developed world this year suggests that it would be adventurous to rely on too strong an economic recovery to drive profits growth – with recession in Europe and persistent unemployment across the developed world, the incoming tide will not be strong enough to lift all boats. Mrs Merkel summarised the medium-term fiscal challenge for Europe in a recent interview with the Financial Times: “If Europe today accounts for just over 7% of the world’s population, produces around 25% of global GDP and has to finance 50% of global social spending, then it’s obvious that it will have to work very hard to maintain its prosperity and way of life… All of us have to stop spending more than we earn every year.”

So there remains a long road ahead for many euro countries to adjust labour markets, tax and benefit systems to restore competitiveness. In common with Japan and China, Western Europe faces challenges to trend growth and rising costs from the deterioration of dependency ratios that come when a society ages. With no scope for devaluation and a central bank with a very limited mandate, policy options for Eurozone countries remain very constrained.

Yet in the last few months stock markets have risen, and the pendulum of investment confidence has swung back from extreme fear. Intuitively this suggests that investors are tentatively moving out of the safe havens of cash and bonds and reallocating to equities. They have also been taking a longerterm perspective in their stock selection and, rather than risk-on riskoff driving investors in and out of the index, their focus seems to be returning to the characteristics driving individual businesses. The consensus of analysts’ forecasts suggests that global corporate earnings will grow by 12% on average in 2013, but this is probably over-optimistic: it assumes a good recovery in companies’ top-line sales growth which was disappointing last year (for global listed companies it is estimated that sales growth averaged only 2.2% in 2012 compared with just under 7% in both 2011 and 2010). If economic recovery does help lift the corporate sales line, then operational and financial gearing could deliver the double digit rise in earnings. However, even with a fair economic tide and average sales growth recovering to say 5%, companies won’t necessarily get an easy run, and will have to work hard to significantly improve their profitability.

So a more nuanced approach to stock picking is required. In this environment the main route to improving profitability is through productivity improvements, and in the absence of strong sales growth, this is made harder as competition intensifies. The slowdown in sales in 2012 magnified the need for companies to respond with operational improvements, and in many cases to consider radical corporate restructuring. Restructuring must deliver sufficiently strong results to improve the competitive position of the business and provide better returns for shareholders. This puts tremendous pressure on management – they need the understanding and imagination to plan the restructuring, the execution skills to implement the plan, manage costs, technology and balance sheet, as well as the leadership skills to satisfy all stakeholders. But once an effective restructuring plan is implemented, the benefits nearly always exceed initial conservative
expectations. Slowing growth and intensifying technological change are ideal conditions for disruptors to introduce new business models and erode the competitiveness of incumbents – for example, consider how fast electrical retailers have been overtaken by online competitors. One fruitful area of our thematic research is exploring how vulnerable some businesses are to disruption but also which business models have intrinsic advantages, allowing them to become disruptors and take market share.

Self-help and the ability to improve their competitive position remain important drivers of company profits but there is a limit to the profits growth that can be achieved from operational efficiency alone. Just because the largest economies are growing slowly, it does not mean that the world is standing still. In fact, in many ways, change around the world is occurring at break-neck speed. This means that, independent of the prevailing economic growth trend, there are opportunities for businesses involved in faster long-term growth trends. One widely discussed “theme” is the potential from the “Smart Planet” covering the growing pervasiveness of smart systems and data in the hands of companies, consumers and government. The scale of some of these thematic opportunities can be enormous – we are all aware of the huge impact of an ageing population, not just in pension provision but also in the potential for futuristic healthcare spending (remote sensing, cheaper tests, new procedures, personalised drugs, regenerative medicine rather than lifetime prescriptions etc).

Another secular trend is the extraordinary structural change in the global energy industry, whether in the infrastructure spend associated with the prospect of US energy selfsufficiency by 2020, new capacity to power the emerging world, replacement of ageing conventional power stations or the replacement of nuclear power stations. In 2012, more than half of the new electricity capacity installed was in the form of renewables such as wind turbines. New supplies of hydro-carbons are coming from increasingly exotic and higher cost sources; oil sands, oil and gas shale and deepwater offshore. As with so many trends, the key to making the most from this opportunity is to be selective. The main beneficiaries of these energy trends tend to be service providers rather than energy producers. For instance, in the US the railroads are beneficiaries of moving oil and materials (especially “fracking” materials).

Farmers are set to respond to recent bad weather and continued high prices of grains by growing potentially record volumes of crops. But grain stocks are low and it will take benign growing conditions for prices to be dented hugely. Meanwhile the rapid change in diet in emerging markets will see demand for protein grow by well above global GDP again this year. The implications of the need to raise agricultural yields and the extraordinary increase in the value of the food chain, driven by diet change, continue to offer a wide range of attractive investment opportunities.

Burgeoning emerging markets are an increasingly potent driver of profits growth for global companies. Over the next 12 years, it is estimated that the emerging markets will see the greatest increase in consumer demand in history, a rise in consumption of $18 trillion per annum, to $30 trillion p.a. No wonder investors and Western companies are so focused on growth in the emerging world.

This remarkable data is driven by the “great convergence” of living standards as billions of people enjoy, in one generation, a change in their lifestyles comparable to that experienced by Europeans and Americans during the industrial revolutions of the 19th and 20th centuries. The global “middle class” is set to expand from 1.8 billion people in 2009, to 3.2 billion in 2020 and 4.9 billion by 2030. The middle class, in this context, is defined as having roughly a third of their income left for discretionary spending after expenditures on food and shelter.

Income growth and development happen at different rates in each society. For example it is estimated that China has created three million US dollar millionaires in the last 10 years (and, according to one survey, on average each owns 4.2 luxury watches!). Yet 528 million Chinese still live on less than $1,000 per year. The rate of income growth depends on a wide range of factors but demographics, urbanisation, technology, education, global trade, credit multiplication, governance and government all play a crucial part.

The $18 trillion p.a. increase in EM consumption offers extraordinary opportunities for businesses, from the humblest local entrepreneur to the largest multinationals. Whether it is Coca-Cola or Nissan, most multinationals have well-developed strategies to meet growing EM demand. European listed companies now derive over a quarter of their revenue from EMs. So not all of the beneficiaries of the EM trends will be EM companies. And while it may seem intuitive that local EM companies will be major beneficiaries of local growth, this is often not the case; many companies listed on EM stock markets make a large proportion of their sales in developed markets and rely on Western demand for their products (often manufactured goods or commodities).

So there is quite a difference between companies that benefit from fastgrowing EM demand and those EM supply companies that deliver to the slower-growing developed markets (DM). Not only do the EM supply companies suffer from the slow growth in the DM but they also have to cope with the fast rise in wages and other costs of the EM.

In conclusion, despite still patchy global economic growth, there are many ways in which to invest in a diversified portfolio of opportunities to achieve long-term growth from around the world. Finding equity investments that can generate healthy, sustainable returns requires careful attention to the potential for sales growth, and a close understanding of the company’s operating strengths. There is strong sales growth potential from the continued rapid evolution of “the smart planet”, enormous change in the world’s energy supply, convergence in living standards across billions of people (with dramatic implications such as diet change) and in the repercussions of ageing populations. It pays to ignore traditional regional biases and to identify these faster growing themes. In 2013, achieving good returns from equities will need more than a favourable economic tide – the key to success remains careful, thematic stock picking.