Equity markets have produced decent returns since the lows of the first quarter of 2009. There have been good reasons for this recovery: fears of a depression at the time proved exaggerated, interest rates have been kept close to zero, bond yields have collapsed and there has been a huge amount of quantitative easing by central banks.
Despite all this financial pump priming, however, the result for the real economy has been disappointing. Global real economic growth forecasts have been consistently too optimistic and the emerging economies, which before 2008 were growing strongly, no longer make a substantial contribution to world growth. As the environment has also been a disinflationary one, we have seen low nominal growth.
For companies, that means “top line” sales growth has been hard to achieve. This matters because it affects corporate behaviour, dampening the incentives to invest in plant and equipment for expansion on the one hand and encouraging capital returns and M&A on the other. This is fine for equity investors for a time but, ultimately, margins may come under pressure either through the lack of operational leverage or a rise in the share of the pie demanded by the labour force.
It is no surprise central banks, particularly the US Federal Reserve, are attempting to create conditions in which the world can return to “normal” inflation levels of over 2 per cent, more robust demand via growing employment incomes and an expansion of bank lending.
This “cure” for the current stagnation, if achievable, comes with downside risks for markets in the short term. The trajectory of stockmarkets is the net result of the momentum of earnings and the expansion or contraction of the P/E. So if we were to emerge into a phase of revival in top-line growth, there is a risk mainstream stocks would get de-rated as monetary conditions eventually normalised.
Rising inflation, rising bond yields and some legacy issues for over-leveraged players does not sound like a recipe for a rising P/E, even if nominal growth is accelerating. This is not a prediction on my part but simply an illustration of the conundrum we face in the search
for value that can endure in a variety of scenarios.
There are three ways in which we can still find opportunities in this environment.
1. Pricing power
The first is to search for companies with pricing power. Such companies have the ability to defend their earnings in periods of low growth and to move prices up when growth accelerates and rising costs threaten to squeeze margins. It is the reason high values are placed on companies with promising intellectual property rights, strong patents or brands.
I would include companies providing essentials and value. Pharmaceutical and tobacco companies, a number of support services stocks, and the aerospace and defence sector all fall into this category.
Such characteristics can also be found in areas of the financial sector, such as life insurance, specialist consumer lending information services and stockmarkets themselves.
Although I am cautious about the demand picture for commodities generally, I have in the past year introduced a position in the oil and gas sector in BP as the company is well placed to drive up the cash flow per barrel and reduce costs in a more challenging environment.
The second route is to broaden and deepen the set of companies in which we invest. The UK equity market has a variety of global industries in it and international sales represent around 70 per cent of the total for the FTSE 100 index. When we look at industries like pharmaceuticals, oil and gas and tobacco we naturally consider non-UK stocks as alternatives or complementary to the UK quoted players. With this in mind, we currently hold Roche and Novartis, as well as GlaxoSmithKline and AstraZeneca, and Reynolds American alongside British American Tobacco and Imperial Tobacco.
Finally, look for more attractive risk/reward in more innovative companies within an industry. This can be true of a number of sectors but is most obvious in technology and science-based industries.
Despite managing large portfolios, we can still find ways to gain exposure to the more dynamic and innovative parts of the economy: for example, by inves-ting in smaller, more specialist pharmaceutical companies where there is more volatility than in the major pharma stocks but potentially more upside. Another way in which we achieve this essential diversity is via our approach to early stage investments. We seek to create value via the quoted Intellectual Property Commercialisation groups, including Imperial Innovations, IP Group and Allied Minds, by investing in such groups and by co-investing in their unquoted spin-outs.
Mark Barnett is head of UK equities and portfolio manager at Invesco Perpetual