After the optimism and strong returns of 2017, volatility has stalked equity markets in 2018 as risks emerge. While the US economy appears to be strong, talk of synchronised global growth has waned and the investment outlook for 2019 is less certain.
As the US Federal Reserve began to steadily hike rates on a path towards monetary policy `normalisation’, the market has started to digest the impact of higher yields and withdrawing liquidity on asset prices. For companies trading on high multiples with hefty growth assumptions, the market can be unforgiving in the face of tightening monetary conditions and higher yields. Indeed, US dollar strength and tightening monetary conditions have already impacted emerging markets, where we have seen volatility, in particular in the Argentine peso and Turkish lira. Further risks remain in more fragile emerging markets, where tighter dollar funding conditions are likely to prove challenging for weaker borrowers.
Beyond liquidity withdrawal, investors face a long list of macroeconomic risks. Commodity price volatility, technological disruption, changing demographic trends, escalating trade wars and tariffs, and global debt levels can create challenges for markets.
Going into 2019, against this uncertain backdrop, we believe focusing on structural, rather than cyclical, growth will be key. The fortunes of external factors, such as commodity prices, interest rates, or the economy, cannot be relied upon to sustain growth.
We strive to uncover quality business models that are exposed to attractive categories, and structural growth drivers. Some of the themes embedded in our strategy include:
Meanwhile, we are aware of the potential threats that exist to the dominant market positions of certain quality companies. For example, we pay close attention to disruption in the consumer staples sector. While the impact of the ‘infinite shelf’, made available by e-commerce, is lowering barriers to entry and supporting smaller brands and private label penetration, this impact is not felt equally across all categories. Therefore, the impact will not be felt evenly across companies. In many cases it will likely provide opportunities as well as risks, requiring careful stock selection.
Quality companies can reinvest cashflows for future growth. In sectors such as IT, healthcare and consumer discretionary are capital-light, cash-generative businesses that typically spend the most on research and development (R&D). This investment in R&D allows companies to innovate, which in turn entrenches competitive positioning and ensures the sustainability of growing cashflows.
In aggregate, Global Franchise companies vastly outspend the market as a whole, investing nearly four times more – as a percentage of sales – on R&D.
Figure 1: Aggregate R&D spend by sector
Source: FactSet, based on constituents of MSCI ACWI, as at 31.08.18.
Despite this heavy investment, these companies still generate far superior margins and returns on capital than the broader market.
Figure 2: Superior margins and returns on capital
Source: FactSet, Investec Asset Management, as at 30.09.18.
Considering the macroeconomic and geopolitical risks, and the uncertain investment outlook we have highlighted, it is now more important than ever to invest in companies which are not dependent on cyclical drivers or economic conditions.
We believe that carefully selected quality companies, with long-term structural, rather than short-term cyclical growth drivers, should be well placed to perform in 2019. We will continue to focus on finding these attractively valued quality companies, with demonstrably enduring competitive advantages that are able to grow their cashflows into 2019 and beyond.
2018 was a challenging year in investment markets. Although the US and China continued to grow, concerns about monetary tightening in both markets led some investors to rethink risk exposures after a decade-long stretch of easy money. All the while, trade tensions between the two countries added to uncertainty. Investors initially sought the relative safety of US equities; however, a mixed start to the third quarter earnings season meant that the shelter was only temporary – especially since the asset class traded well above historical valuations.
With this backdrop in mind, where will we uncover opportunities in 2019? While this has been a difficult environment, it has provided an opportunity to focus on key areas that we find attractive. As such, our bottom-up, fundamental investment process has started to identify areas of structural growth with the potential to deliver significant value for investors in 2019 and beyond. One notable area lies in the digital transformation, especially the ‘picks and shovels’ companies that stand to benefit as firms ramp up investments to capture the opportunity.
Investing in ‘picks and shovels’ was coined in the great California gold rush. Individuals that provided tools and equipment necessary for dream-seekers to chance their luck in the Northern Californian hills often mined larger fortunes than the miners themselves. Today’s gold rushis digital.
The digital revolution has been well covered for years. However, much of the discussion focuses on the few household names that have come to dominate our understanding of what embodies a technology firm. Beyond these standard bearers, lies a legion of firms across nearly every sector that stand to see their business upended by technological disruption. Under the ‘winner takes most’ (if not all) approach, inaction is not an option.
The digital transformation that will take place in the coming years is driven by a convergence of several technologies that will impact almost every area of a business. Nevertheless, the goal is clear: improving business awareness, operational efficiency and the customer experience to gain and maintain a competitive edge. Firms that will enable this in the coming years are the proverbial ‘picks and shovels’ purveyors that stand to deliver value for investors – regardless of whether their clients ultimately strike riches with their respective digital endeavours.
To uncover these firms, we must first lay out a few clear pathways to digital transformation and the opportunities they may present in the coming years.
The new digital ‘pick and shovels’
This broad area touches on the entire digital transformation process. Digital enablers are firms that will work with corporates to lay out a framework for digital transformation and then provide the skills and services required to make it happen. This can impact every aspect of a firm’s digital capability, from external-facing websites, to internal business and HR management tools. Since clients will look to refine and reinforce their digital capabilities on an ongoing basis, digital enablers should enjoy long-term and ‘sticky’ revenue streams.
Data is the raw material of the digital gold rush. Successfully managing and processing it will determine success in the digital field. Firms that can help customers successfully marshal, analyse and store data will be invaluable partners in the coming years, helping clients identify critical insights while powering the wider digital ecosystem.
Although data management will be largely based on software solutions hosted in the cloud, we also see scope for firms to offer ‘hybrid’ hosted and managed solutions due to specific customer, regulatory, business and practical considerations.
Manufacturing operational efficiencies in the digital age will increasingly rely on smart factories to limit labour and maintenance costs. We see opportunities beyond obvious automation plays, as firms will look to combine sensors and data across a connected manufacturing ecosystem.
As with many areas of the digital revolution, ongoing service and maintenance opportunities will enable suppliers of smart factories to derive revenue opportunities well beyond the initial sale.
Digitisation will touch pretty much every aspect of the customer management process, from initial prospecting, all the way through to customer support. As this will require a complete overhaul of many established customer engagement processes, we think there are significant opportunities for companies to specialise in this field and offer complete outsourcing solutions.
The information technology sector, particularly software and services, is unsurprisingly home to many of the future digital transformation success stories. The screening part of our process is favourable to the sector overall, due mostly to strength in the software sub-sector.
Figure 1: 4Factor information technologyTotal overweight/underweight steers
Source: Investec Asset Management, as at 21.09.18.
Source: Investec Asset Management, as at 21.09.18.
Accenture offers an example of a long-term transformative digital enabler. Over the past few years, the firm has reinvented its classic consultancy business model to assist companies through their digital ‘journeys’. NetApp offers another example within the data management industry due to it sability to offer end-to-end data management solutions with proprietary hardware and software tools, both in the cloud and on site.
We also see plenty of scope for software solutions in digital customer access. Examples include online travel portal Booking.com due to the increased reliance on booking portals in the travel industry. Recent evidence indicates that customers will look for a one-stop shop for their booking needs.
The industrial sector also offers a variety of ‘picks and shovels’ opportunities.
Two industrial firms that stand out include French call firm Teleperformance and US industrial conglomerate Honeywell. Teleperformance’s legacy business was operating call centres for telecom companies. However, the firm has greatly broadened its scope in recent years and now offers a full range of outsourced customer management solutions.
Meanwhile, Honeywell offers an entire range of smart factory solutions: sensors, connectivity tools and leading cyber-physical software solutions that enable firms to proactively manage theirsoftware solutions.
Not all firms will strike it rich in the digital gold rush. We therefore see greater opportunities in the firms that will empower this digital transformation. While this may mean missing out on some high-flyers, focusing on less obvious investments is a key part of our differentiated investment philosophy. It challenges us to invest in attractively valued companies that deliver fundamentally sound returns.
The tide of liquidity released in the decade since the financial crisis will continue to recede, which will likely lead to more volatile markets. Nevertheless, we still see plenty of structural growth opportunities that stand to deliver significant value for investors in 2019 and beyond.
We believe the defining characteristic of emerging market equities is the inherent cyclicality of the asset class. Measured as one of 10 asset classes, over 20 years, emerging market equities have been either the best-performing or the worst-performing asset class in 15 of those 20 years. After 2017 – a year full of returns with virtually no volatility – 2018 has turned out to be the opposite: packed with volatility, and bereft of return. This makes us inherently cautious of making bold forecasts of the future.
Figure 1: A cyclical asset class
Source: Callan, January 2018.
The investment environment in 2018 has proven to be very difficult. Politically, a muscular US has rewritten the handbook on diplomacy, although some would argue said handbook was thrown out of the window entirely. The normal colourful cast of characters in emerging markets has also expanded in unexpected ways. Examples include:
Economically and financially, the end of quantitative easing (QE) has finally arrived. As the tide of liquidity slowly ebbs away, we are finding out “who’s swimming naked”, to quote Warren Buffet. Argentina and Turkey were clear culprits in this regard.
Changes in perceptions are more difficult to call, but there are grounds for concern. For ten years markets have floated on the calm sea of QE, with central bankers prepared to assist at the first sign of a twitch in the markets. Investors have unsurprisingly become complacent about risk in this environment, not least that market participants are crowded together in a slew of trades that generally offer less compelling valuations to historical averages. The unwinding of QE will be a difficult and painful experience, and there will be casualties.
Market levels are determined by two variables: economic reality and the market’s perception of that reality. The reality is that two large economies now drive our world: the US and China. The markets clearly are pricing in an economic slowdown in the US. They are fearful that a trade war and aggressive deleveraging may trigger a hard landing in China.
We are convinced that over time economic growth in China will slow, for growth to remain towards 7% per year would imply its economy doubling in size every ten years – likely impossible given the iron law of large numbers. However, we see no evidence of any imminent rapid decline in the Chinese economy.
Going forward, we believe China is likely to become a heightened focus of investor attention. The market has been extremely schizophrenic about China in 2018 and commentators have ceaselessly worried about a dramatic slowdown in the Chinese economy.
What investors have actually done, however, is subscribe to more than US$50 billion of IPOs from Chinese companies (as at end September 2018), 65% up year-on-year. This tally represents a third of all global IPO proceeds, putting China on track for the third-highest capital raising on record. China’s IPO proceeds have now been greater than those in the US for five consecutive years. Furthermore, most of the money raised has been in ‘new economy’ companies – electric cars, Internet Protocol Television or IPTV, smartphones, e-commerce related, etc. China and the US now dominate the technology trends driving our world.
In addition, the opening of China’s domestic equity market (‘A-shares’) opens up a very large, inefficient and uncorrelated investment opportunity which most global investors are only just waking up to. This emerging opportunity will drive significant investment flows over time.
Figure 2: USA GDP versus China GDP
Forecasts are inherently limited and are not a reliable indicator of future results. Source: IMF History & Forecasts, at current prices, as at August 2018.
Value is now scarce in today’s financial markets. Since 2007, despite the Global Financial Crisis, the world has added almost 50% (US$78 trillion) to the global debt tally. Much of that debt supports today’s asset markets, either directly (leveraged property investments) or indirectly (US share buy-backs supported by borrowing). We would argue that one of the few pockets of relative value left is emerging market equities.
The current 30% discount on emerging market equities (on both trailing price/earnings ratio [PE] and price/book) compared to developed market equities offers good value in a relative sense. In an absolute sense the c. 13.4x trailing PE as at end of the third quarter 2018 has historically been a good entry point in valuation terms, generating double-digit returns on average over a three-year period (although c. 20% of the time you could also have seen negative returns even from that low entry point). Emerging markets have traded at higher valuations than this roughly 70% of the time in the past 25 years.
We fervently wish for today’s central bankers to return to anonymity, so that real fundamental investors can once again determine where value lies in capital markets. This will likely lead to much more dispersion of stock returns, in a much more volatile environment.
We believe such an environment will increase the opportunities for stock pickers such as ourselves, albeit within a riskier environment. But higher risk should mean higher return, assuming we execute our investment disciplines faithfully and professionally. We might argue in short, when the going gets tough, the tough get going.
Perhaps with trepidation we welcome 2019. After the bloodied nose received through 2018, we are perhaps allowed to show more caution than a year ago. While we remain constructive on European equities, we look to reflect on the past year to give clues to what the new year may bring.
Figure 1: European equity market
Source: Bloomberg, 31.10.18. For further information on indices, please see the Important Information section.
From a corporate viewpoint, 2018 went as planned: earnings rose as expected, balance sheets continued to strengthen and signs of M&A activity increased. However, European markets drew down. So, what happened? Is the market signaling imminent danger, or are investors being given a chance to buy at better prices? Falling prices simply mean a transfer of value from sellers to buyers especially at a time when balance sheets are strengthening.
Of course, a key driver for stock markets is what happens to global growth. Throughout 2018, we witnessed challenges to the upward growth trend:
Actions to narrow the trade deficit between the two largest economies in the world, the US and China.
Brexit uncertainty and seemingly chaotic negotiations.
The new Italian government’s spending plans.
In the US, politics is a key driver, including (still two years out) the US presidential election in 2020, and the Republican’s loss of the House of Representatives, causing political gridlock in the meantime.
Much has been written on each of these subjects, but our central case currently is that of positive but slower growth.
Going into 2019 we continue to focus on strong structural themes that are global in nature.
We are often asked how truly technologically advanced Europe is given it does not have the global technology giants the other markets have. Indeed, this may be a time to reflect on how corporates are adapting the worlds we live in: how the European universe of stocks is changing to meet new challenges and more importantly to reward investors for their patience.
On technology, one only must step onto the high street to observe not just the emerging cashless society, but also contactless technology adoption meaning a device on your wrist is all you need to pay your way through the day. Indeed, the fast-growing payment solutions sector is firmly anchored in Europe through the likes of Adyen and Wirecard, which are leading the way into further innovative ways to pay for everyday necessities. In the financials sector we are witnessing the maturation of fintech onto the stock market. With no legacy infrastructure nor balance sheets, these companies can grow strongly, cherry-picking profitable niche areas such as small-to-medium enterprise lending. This is an underserved market by incumbents, because the opportunity is too small for the c. €1 trillion size of their balance sheets.
We still like the energy sector, though we acknowledge greater oil price volatility at current higher prices. The world is decarbonising, but our role is to engage not avoid, enabling the targets set by the Paris Agreement to be met. The strong cashflows generated by oil and gas need to be reallocated better. We also understand natural gas has a place in a low-carbon environment and will remain so until large scale energy storage is achieved.
We still have exposure to financials, whether through banks or insurance, where these mature sectors rely on economic recovery for growth as market share gains can only be small. For banks, we are seeing returns rise and note improving revenue performance as the economic recovery unfolds. We also note that many banks are back to 2012 lows despite better financial performance. The sector has not had a proper stock market recovery.
Changing regulation is driving insurers away from capital-heavy products, annuities and guaranteed return products towards capital-light stock market-driven products. The transfer of risk to the end client, while reducing system risk, is driving more direct exposure to equity and fixed income products. Insurance companies in turn are freeing up much excess capital to be returned to shareholders as well as focus on other capital light strategies such as digital.
In short, we are seeing the evolution of the investable universe in Europe through competition, regulation or stewardship by investors. Longer-term capital owners should take comfort.
We acknowledge that the risks to economic growth have heightened, with outstanding questions remaining. When will the US and China de-escalate on trade issues? Will the UK leave the EU with no trade deal? How will Italy’s new government deal with opposition to its spending plans?
However, cyclical stocks have generally sold off indiscriminately through 2018, despite structural growth drivers and/or adapted business models that reduce cyclicality in some. Along with strong balance sheets, opportunities have presented themselves.
Regarding the risks, we remain pragmatic, looking to avoid stocks where we are not being paid to take the risk, especially with cyclicals where margins have peaked. We have also worked hard to assess further downside. For example, in the event of a no-deal Brexit, we have avoided industrial stocks which depend on the frictionless movement of components. We also note that on agricultural and food products, port have already been identified as key risks, where customs arrangements need to be established to allow unencumbered movement of goods, similar to how it is in Switzerland. What may be reasonable to expect is continued volatility as politicians tend to engage in brinksmanship.
We remain constructive on European equities. We expect slow but positive growth globally, meaning some cyclical sectors have become attractive, having sold off indiscriminately. We also see opportunities in European multinationals with structural growth drivers offering diversification benefits. We believe the risks to our base case are well known and look for exposure where risk and reward is skewed favourably.
Volatility in the Chinese equities market in 2018 has been driven by tightening domestic liquidity as well as escalating trade tensions with the US.
However, the long-term investment case for China remains clear and opportunities are emerging in this environment. If we look beyond short-term headwinds, active investors with a disciplined investment process should be able to find quality Chinese companies with good long-term growth potential and decent management.
Concerns about China abound, including a build-up of debt, negative demographic trends, state-owned enterprise inefficiency and general corporate governance risk. We recognise the challenges in all these areas. Yet, we should not ignore China’s ongoing transformation, which is being driven by government reform and innovation in the economy. This transformation addresses many of the concerns investors have and supports the development of the equity market over the long term.
Government reform efforts are happening on multiple fronts. Supply-side reform has nearlycompleted its third year, with capacity reduction targets well on track and even exceedingexpectations in certain industries such as steel. Environmental control remains stringent, drivingsignificant decreases in air and water pollution. State-owned enterprise reform is helping to alignthe interest of the state, management teams and public shareholders. Financial reforms continue tofoster better risk control in financial institutions and a further opening of the domestic capitalmarket to global investors.
With a large consumer base and growing wealth, China has seen increasing demand for higher quality products and services. Large numbers of Chinese go on shopping sprees abroad, which is driving domestic companies to innovate so that they can capture more market share. Good infrastructure and efficient supply chains provide the backbone for a more innovative China. An abundant and inexpensive talent pool, significant social capital and supportive government policy also play crucial roles.
An example of this is the World Intellectual Property Organisation’s Seven Pillars of Innovation, where China has generally performed in line or even better than the average high-income country, and is well ahead of what might be a more obvious comparator, the average for upper middle-income countries.
Figure 1: The seven pillars of innovation
Scale 0 to 100, higher score means greater capacity.
Source: World Intellectual Property Organisation, HSBC, December 2017.
Although more and more investors, both institutional and retail are considering strategic allocations to China, they remain underweight despite moves to open capital markets and make investing in China easier.
MSCI is looking to quadruple China A-share weighting in its major benchmark indices from 2019, only one year after its initial inclusion, which is faster than the market expected. FTSE Russell will also start phased inclusion from June 2019, which will see China A-shares representing 5.5% of its emerging market index. If fully included, China A-shares should account for more than 16% of the MSCI Emerging Markets Index and more than 20% of the Russell Emerging Markets Index. China’s onshore and offshore markets together will account for over 40% and 50% of the two indices, respectively.
Given China’s strategic importance, attractive long-term growth potential, increasing index inclusion and diversification benefits, we think global investors’ allocation to the world’s second-largest equity market will grow over time. Increasing foreign investors’ participation should help reduce market volatility and improve pricing discovery in the A-share market.
We believe the market drawdown provides entry opportunities for fundamental investors and will reward them in the long term.
Following a significant pullback in 2018, the Chinese equity market currently trades below its 10-year historical average valuation level from both the forward price-earnings and the price-to-book perspective. The valuation discount versus developed markets has widened despite the more positive growth outlook.
Although we do not attempt to call the bottom without seeing evidence of positive surprises on corporate earnings, an increasing number of opportunities are emerging on the back of the market pullback. As more value emerges, we are finding opportunities in a number of sectors. The evidence suggests that companies with good quality, attractive valuations, improving operating momentum and increasing investor attention tend to outperform over the long term and this remains the framework for our stock selection. Our 4Factor screen currently sees most opportunities in the materials, energy, financial, utility, and communication services sectors.
Clearly, the Chinese equity market faces short- to medium-term risks, most significantly policy execution and growing trade tensions between China and its trade partners, particularly the US. Over the long term, we believe a consistent investment strategy focusing on identifying high conviction ideas, using a bottom-up approach, is the best way to provide long-term risk-adjusted returns to our investors. We remain broadly fully invested in our portfolio as there are abundant opportunities that can be found in a dynamic market environment such as China.
Our bottom-up stock-picking generates ideas from a broad range of sectors, covering both new and old economy segments. Fundamental analysis, combined with objective screening, will continue to drive new investment ideas.
Was Baron Rothchild correct when he said, “The time to buy is when blood is on the streets”?
2018 has produced all the volatility that 2017 lacked. So, what has changed and how is that likely to affect the investment opportunities looking into 2019? As of time of writing, Asian markets have officially entered bear market territory, having fallen more than 20% since the early 2018 highs. Earnings have been downgraded, as have valuations, which have slumped to levels last seen in previous troughs. However, expectations for earnings growth remain positive.
There have been 19 market corrections in Asia since 2003 and only four of these have been more than 20% declines. Among these, the average price/earnings ratio (P/E) at the trough has been 10.4x forward P/E vs. the recent trough valuation of 10.6x forward P/E. Equally, on a price-to-book (P/B) basis, previous troughs have averaged 1.6x P/B vs. the recent valuation of 1.4x P/B. Only once before has the price-to-book ratio fallen below the level seen recently.
Source: Bloomberg. October 2018.
Following these troughs in valuation, there have only been three instances where the index was lower a year later, the most severe of which was during the global financial crisis. Despite the pessimism experienced at each of these troughs, on average the index was over 20% higher in the subsequent twelve months. In terms of well-understood behavioural biases in markets, we are now at the point of fear, with investor sentiment having turned negative and flows out of the region reaching the levels of capitulation last seen in the 2015-16 market correction.
Are we at a point where you can see potential for 20% returns? Or are we in one of the few instances where the market ended up lower twelve months from now? The 4Factor investment team has long believed that neither high returns nor low valuations on their own make aninvestment case.
We need a catalyst to drive an improvement in investor sentiment, or higher earnings upgrades. In the near term, China’s slowdown, US dollar strength, higher interest rates and trade concerns are likely to weigh on investor sentiment, while delayed spending decisions from both companies and consumers are leading to earnings downgrades.
Despite limited spending, recent industrial trade fair surveys in China suggest the desire to invest remains strong. Therefore, an improvement in sentiment – either through a thawing of trade concerns or some sort of domestic stimulus – would send the markets higher as investors sitting on the sidelines start to invest.
Figure 1: Where do earnings go from here?
Forecasts are inherently limited and are not a reliable indicator of future results. Source: Factset, Investec Asset Management, 05.09.18.
How should one position portfolios in this scenario? Some of these positions are counterintuitive and contrary to market behaviour in the past ten years. Earnings are no longer growing across the board, which means that building a more balanced portfolio looks reasonable. Equally, with interest rates rising in the US, discount rates for all assets have risen, which in turn has led to a correction in long-term value assumptions, particularly for growth stocks.
Likewise, high-dividend stocks have been defensive over the last ten years as investors have reached for yield. However, rising interest rates may start to undermine their defensive credentials. Add into this that quality remains expensive and you have a more confused picture than at perhaps anytime in the previous decade.
We also have conflicting signals from both sides of the world. The US Federal Reserve continues to tighten as business conditions remain robust and policy is deregulating. In China, policy and financial liquidity remain tight, as the country tries to address its high debt levels, which is causing a slowdown in demand. These are two very different paths. When deciding which stocks are likely to perform, investors will need to decide which will have the bigger effect.
The good news for Asia is that unlike the previous bear market in 2015-16, corporate balance sheets are healthier, free cashflow has been strong, and margins have been improving. This allows more flexibility to absorb any weakness in demand. Ultimately, the outcome of whether or not markets will be significantly higher in twelve months’ time depends on whether the conflicting economic signals trigger some sort of recessionary scenario.
Longer term, the potential for Asia remains strong. We are still seeing increased investment into research and development, and domestic demand continues to increase as a percentage of GDP. Equally, Asia remains committed to policy reform to address high debt levels and curb excess supply. Despite near-term concerns, these longer-term trends should provide greater stability and higher quality growth.
In this environment, we find it far more convincing to make investment decisions based on bottom-up fundamentals. We continue to believe that it is best to look for high-quality, attractively valued stocks, with improving operating performance and increasing investor attention.
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