This article comes from our research partners at the Capital Group. The original authors are Gerald Du Menior, Steve Caruthers, and Emily Tillman. We hope you enjoy.
Finding growth in a slow-growth world KEY TAKEAWAYS
- The coronavirus outbreak may present a challenge in the next few years, but long-term trends should persist.
- With communities still grappling with fallout from the pandemic Ill and many still under shelter-in-place orders Ill entertainment and health care are areas of investment opportunity.
- Look to China as a key driver of growth as it slowly reopens its economy following COVID- 19 shutdowns.
- Developed international markets offer many investment opportunities with growth potential despite the disrupted trade.
- Market indexes present a skewed picture and can miss key investment opportunities.
Finding disruptors in unexpected places
When we went to see U.K. online grocer Ocado at their headquarters in Hatfield in 2015, we were amazed at the technology and logistics they had developed to deliver groceries all over the country without having a single brick-and-mortar retail store. It reminded us of Amazon in its early days. In the ensuing five years, Ocado’s substantial growth came not just from expansion in the U.K. — where it altered the dynamics of the grocery business — but also from licensing its technology to businesses in many markets outside its home country. As it evolved and expanded its footprint, Ocado’s stock was quite volatile as investors calibrated whether the business model would be viable over the long term.
Ocado is a prominent, but by no means unique, example of the dynamism that exists in the European corporate culture and in areas of Japan, not just among startups but also in companies across the market-cap spectrum. European pharmaceuticals are innovators in immunotherapy and dominate many areas of health care. Japanese companies manufacture the robots, sensors and vision systems that automate the world’s factories. A health services company in Ireland is a leader in helping pharmaceuticals around the world take their drugs to market. Semiconductor chips that power today’s mobile devices and push the boundaries of Moore’s Law are largely manufactured in Europe and Asia.
As society attempts to deal with COVID-19, the disruptive culture found in those companies should play an important role in helping the world economy emerge from the current slowdown and cope with whatever new normal is created in the short term. And these are the sort of companies unlikely to be found in international market indices that are dominated by old-line heavy industry, materials and energy firms.
China consumers have been key drivers of growth in the developed world
Europe’s mercantilist past has created a culture of trade and economic linkages across the world that remain vibrant. European companies derive 58% of their revenue from outside their borders, with 8% coming from China, as of December 31, 2019. The flipside of this phenomenon is that China’s travails have come to have an outsized influence in many industries and companies Ill something we saw when the virus, which began its global spread in China, began to shut down suppliers and manufacturers key to multinationals. The market volatility resulting from business shutdowns and restricted travel is a reminder of just how interdependent economies have become.
Still, we believe that as China’s vast middle class continues to move up the consumption curve, China will continue to be an important driver of growth for a broad swath of European companies. European luxury names remain the aspirational brands of choice, and while these companies have taken a hit in sales in the last few months, early indications are showing that these top-end names are seeing demand come back pretty strongly in China, says Rob Lovelace, Capital Group’s vice chairman, in a recent webinar on what recovery could look like.
How the global economy fares in the short term depends on how well countries can reduce the number of infections, while caring for the sick. (In the long run, developing a vaccine can help prevent serious economic and market disruptions caused by the coronavirus.) That said, secular trends — the transition of Asian consumers up the value chain, the evolving preferences of consumers at large for experiences rather than things, and the profound impact of technology across industries — are themes that we continue to explore and invest in across our international equity portfolios. We discuss a few of these investment themes, but before we do that there are a couple of points about international markets worth making here.
The backdrop for international equities appears positive
One point is that markets remain attractive on valuation. The equity risk premium Ill or the excess return that investing in the stock market provides over a risk-free rate Ill of the MSCI EAFE Index is at one of its widest relative levels compared to the U.S. It is also near an all-time high on an absolute basis, as valuations over the last year have been topped only by its 2008–09 peak.
The ultra-low interest rate environment partly lifts the equity risk premium. The equity bull market in the U.S. had been fueled by years of strong earnings until, of course, this past February. Despite the recent volatility, we support the idea that international equities could still have a long runway ahead of them. In general, equity valuations have become more attractive and bond yields have decreased, both of which should contribute to higher equity risk premiums.
The other point to make about international markets is the quality of the earnings and management of the capital structure. The corporate culture of share buybacks, which at times results in excessive debt on the balance sheet, has been less prevalent outside the U.S. In the U.S., there has been tremendous focus on buybacks to sustain a steady growth of earnings per share (EPS). Companies have been taking on debt to buy back stock. As a result, the EPS has grown much faster than the operating profit. That has not been a common tradition outside the United States. Certain companies have done it, but on a far smaller scale and with less frequency. And even when they do, they don’t often cancel the stock on balance sheets, so it does not translate to EPS growth.
Companies cannot borrow indefinitely to pay dividends. They also cannot take too much of their operating cash flow to pay dividends to shareholders, because that usually comes at the cost of the reinvestment cycle. (And in the current pandemic-induced economic slowdown, many companies have been slashing dividends.) But a well-balanced company is one that can take some of its operating cash flow, deploy it to the needs of the business and then look at other sources of growth — whether through acquisition or a different means. At the end of the day, there should still be some cash left to service a stable, but growing, dividend policy. There is a discipline both to the management of the business and the capital structure. In our experience, those companies that are able to balance both tend to have very good stock price growth over extended periods of time.
Take LVMH, the holding company that owns, among many others, the iconic Louis Vuitton brand and has announced a planned acquisition of Tiffany’s. The company has exhibited a highly disciplined management of its cash flow. It has redeployed much of its cash flow to expand its portfolio of brands while simultaneously pursuing a policy of growing the dividend initiated by the controlling Arnault family a dozen years ago. When we look at operating profit rather than EPS, the growth rates of many European companies are comparable to those in the United States.
It’s noteworthy that even as the benchmark MSCI EAFE Index has lagged the S&P 500 Composite Index by a notable margin over the past decade, an average of 75% of the 50 top-returning companies each year are headquartered outside the United States. In 2019, 45 of the top 50 stocks came from international markets. Despite the muted growth reflected in aggregate GDP numbers, attractive investment opportunities exist in this ostensibly slow-growth world in Europe, Japan and other developed Asian markets.
It’s not about things … it’s about experiences
A long-term secular shift is taking place among global consumers, especially the middle and upper-middle class, who have moved beyond basic necessities to more discretionary spending. This has translated into a boon for areas such as health care, travel and recreation. Nowhere is this more apparent than in China, whose massive population and economy are significant contributors to consumption trends across the world.
On its own, this trend is nothing new. Multinationals have tapped into the growth of consumer products for years. But there is another significant change taking place. Consumers are now putting a premium on experiences and lifestyle consumption over the accumulation of physical goods. Among the companies to benefit from this evolution are those in the entertainment industry.
The sector is growing rapidly on multiple fronts, including online gaming, music, audio books and streaming content. To meet the demand, companies have increasingly shifted to subscription-based models and this demand has only intensified since we have adjusted to shelter-in-place policies to help prevent the spread of COVID-19. Subscription-based streaming content satisfies consumers’ preferences for ease and convenience in a progressively digital world, while also generating a more stable source of recurring revenue for the providers
Digital platforms and the advent of cloud computing have added a new dimension to the subscription model by providing smart, nimble companies with three potential benefits: expanding their addressable markets, providing repeatability of cash flow and deepening client loyalty.
The fastest-growing segment of the $1.5 trillion global media industry has been video games, where revenue rose 11% in 2018. As interactive gaming becomes a more popular form of mainstream entertainment, that kind of healthy growth trajectory could continue.
Japanese console manufacturers Nintendo and Sony are well entrenched with strong fanbases and portfolios of intellectual property. They can benefit from the shift, but may need to be adaptable to customers’ changing preferences. Tencent doesn’t have the same extensive history, but has become the world’s largest gaming company by tapping into the explosive growth of mobile gaming. The Chinese conglomerate pulled in over $18 billion in gaming revenue in 2018, comprised mostly of inexpensive mobile game sales and microtransactions made within free games.
Product pipelines are key to health care
Health care is another area of continuing interest for us. COVID-19 only underscores this. As of March, the MSCI ACWI Index’s health care sector held up the best among major sector categories, declining 11.4% compared to the S&P 500 Index, which lost 21.4% in the first quarter.
Europe is home to many high-quality pharmaceutical companies that are leading in immunotherapy, an area with applications ranging from treatment of various types of cancer to obesity. It’s important to get a very detailed and in-depth understanding of products and drug pipeline for each company. A firm that may have a good pipeline for a few years may not in the subsequent four or five years, so getting a grip on the cycle is equally valuable. Many are familiar with the larger players like Roche and Novartis. But smaller companies can also be leaders in innovation and drug development.
Danish biopharma Genmab has found commercial success in its blood cancer treatment Darzalex, and royalties from licensing the drug have contributed to six years of profitability. A strong cash position has helped fund the company’s robust R&D efforts, which it has used to build a deep pipeline of other early-stage cancer drugs. The risk with smaller companies without a strong pipeline is that they can turn into one-trick ponies and become more highly dependent on the results of clinical trials.
But it’s not just the pharmaceuticals themselves influenced by the wave of innovation within the industry. For example, Ireland-based UDG Healthcare partners with pharmaceuticals and biotech firms, assisting these companies with non-core activities such as supply chain, sales and marketing to help get drugs to market. UDG is typically paid a fixed fee, regardless of a drug’s success or pricing. This allows them to tap into the immense growth potential of the industry, but with more limited risk.
Moore’s Law is back
When thinking of technology, people often focus on the end products, but some of the greatest investment opportunities could be with the chip and chip-equipment manufacturers that make these products possible. Moore’s Law — the doubling of chip capacity approximately every two years — would not be possible without companies like ASML, Keyence, and SK Hynix, industry leaders that are based outside of the United States.
Consolidation has been an important theme in the industry. In 2003, there were 25 chip manufacturers competing to make the smallest and fastest logic chip available. Today,following a wave of M&A activity and some timely exits, the business is dominated by three companies, including Taiwan Semiconductor Manufacturing and Samsung Electronics.
But these companies likely wouldn’t have gained their dominant positions if it wasn’t for the equipment manufacturers providing them with top-of-the-line tools and automation systems. In some segments there is only one supplier, such as ASML. Used to produce the most-advanced chips in the world, ASML’s extreme ultraviolet lithography machines cost upwards of $100 million. In Japan, Keyence develops sensors, measuring instruments and other components crucial to factory automation, improving the efficiency and output of chipmakers.
The rollout of 5G will be another key area to monitor in the coming years. It may feel like an evolutionary shift at first but, in our view, it will lead to revolutionary technological advances. The limits of 4G, primarily latency due to slower speeds, will be largely eliminated. Devices will be able to “talk” to each other almost instantaneously. Artificial intelligence applications and virtual reality devices will proliferate in this environment — and will require advanced chips to power innovation.
Europe dominates the luxury goods market
European brands have been successful at establishing themselves as luxury, capturing the imagination and fascination of consumers worldwide. It remains a growth area as income levels have historically risen across a host of Asian countries. Their dominant position and expertise in building powerful brands gives the companies almost unmatched pricing power, which has become increasingly important in a low-inflation world.
Two good examples are Kering, the parent company of Gucci, and LVMH, which has become one of the world's largest luxury goods companies through organic growth and acquisitions. In late 2019, it offered $16.2 billion to acquire New York-based Tiffany & Co. The largest-ever deal in the luxury sector is expected to close by mid-2020.
Spirits companies are another growth area in the luxury spectrum. European conglomerates Diageo and Pernod Ricard combine to own more than 200 spirits brands. Using a very different strategy, Kweichow Moutai may be far from a household name outside of China but has become the world's most valued spirits company. Nearly all of its revenue comes from a single product, the Moutai Flying Fairy, which costs more than $200 for a half-liter bottle and is seen as a status symbol in Asia.
Keeping an eye on the current environment
The outlook for 2020 has become muddied by the outbreak of the coronavirus in China and its subsequent spread throughout the globe. The thesis that we are in a reflation of the global economy that began with the Federal Reserve’s pivot to an accommodative monetary policy last year has been put into question. China’s growth rate is expected to slow into the low single digits and it could even turn negative, according to some estimates. The Chinese government has several tools at its disposal to stimulate the economy, including a loosening of credit conditions and providing additional liquidity to markets and the banking system. Outside of China, governments and central banks throughout the world have put in place monetary and fiscal policy designed to help cushion the economic fallout. The extent of the economic slowdown will become clearer as more official data are released.
While the near-term outlook is uncertain, the longer-term trends are expected to hold. In addition to strong fundamentals of many companies and supporting valuations, the macro environment for equities remains supportive. Interest rates remain near historic lows, and central banks around the world have returned to easy monetary policies. Against this backdrop, any significant market volatility could present buying opportunities, especially when company prices become misaligned with their fundamentals. At the same time, we remain vigilant to any shifts in the dynamics of companies as the economic environment evolves.
Gerald Du Manoir is an equity portfolio manager with 28 years of investment experience. He holds a degree in international finance from the Institut Superieur de Gaston in Paris.
Steve Caruthers is an equity investment specialist with 24 years of experience. He has an MBA from the University of Missouri-Kansas City and a bachelor's from the University of Kansas. He is a CFA charterholder.
Emily Tillman is an equity investment director at Capital Group. She has 16 years of industry experience and has been with Capital Group for seven years. Earlier in her career at Capital, Emily was an equity investment product manager. Prior to joining Capital, Emily worked as a manager of product and program marketing at Brandes Investment Partners. She holds a bachelor's degree in sociology from the University of Chicago. Emily is based in New York.