We live in an era of disruption. New entrants threaten incumbents in almost every sector, spurred on by rapidly changing consumer tastes and the always-on, always-available information age. Cloud computing reduced the cost of setting up a new business dramatically while social media enabled consumer reach like never before. Online retail continues to damage the mall while the entertainment industry has been turned upside down forcing the largest wave of consolidation in history. Zero interest rate policies ensured investors were prepared to accept losses for longer and the “jam tomorrow” model is now well entrenched. This conflux of technological change and extreme monetary policy has produced the most unusual, exciting yet potentially dangerous investing environment for a long time.
The sands may be starting to shift however and the risk of complacency is rising. Investors with differentiated and discerning thinking should be well rewarded in the years to come—but what does that look like in practice?
Firstly, the impact of rising interest rates must be considered carefully. Balance sheets have been under-analyzed for the last decade as central bank purchases (QE) underpinned risk taking. As the environment changes (QT), the importance of appropriate leverage will rise. Unexpected risks can also surface—dollar borrowing by non-U.S. companies perhaps—and for these reasons the fund is underweight indebted companies.
Secondly, pricing power should be valued at a premium as inflationary pressures and rates rise. While sectors such as telecoms offer defensive attractions, the benefits of growth (more subscribers, more data allowances) have been competed away given poor management decisions, a commoditized product and high sunk costs. Our process finds little interest in this area.
Third, investors should take great care distinguishing between good stories and good stocks. The world has experienced a phenomenal period of change in recent years and while this will continue, the pace could begin to slow. Furthermore, incumbents are beginning to react more effectively as they better understand the new environment. This is not a call for innovation nor its leading lights to collapse! We continue to hold sizeable positions in truly disruptive companies such as Alibaba, Tencent, Priceline and Recruit (owner of Indeed.com). However, we are also beginning to see interesting opportunities in some “disrupted” stocks where the outlook could surprise positively as they take the necessary decision to invest for long-run success. The risks are higher but investors are likely to be paid well in the long run, particularly against a late-cycle market.
In this light, we have recently added to positions in BMW and Reckitt Benckiser. The former is dogged by fears that electric vehicles, shared ownership and declining diesel popularity could bring the company to its knees; the latter plagued by an increasing fear that consumer staples companies are collectively subject to fickle consumer tastes and pricing pressure.
Our investment case for BMW centers on the fact it is not at any material or IP disadvantage to its biggest disruptive competitor, Tesla. Battery technology is available to all while BMW’s significant advances in light weighting are world class. In fact, Tesla’s key advantage seems to rest in its investors willingness to accept losses—an unsustainable situation longer term. Excluding financial services, BMW sells for just four times free cashflow—a price we believe will be absurd in the long run for one of the world’s most powerful auto brands with strong returns on capital.
Reckitt’s food and beverage peers face multiple challenges in the form of health-conscious consumers with a desire for small-batch local produce thereby reducing the manufacturer’s scale benefits and profitability. Reckitt’s key brands (Durex, Dettol, Neurofen, Lysol, etc) are not subject to the same pressures however. The shift to online retail is causing modest pricing pressure yet this will abate as the online/offline mix stabilizes. Its premium could be restored as historical attractions return or a trade buyer emerges.
James Gautrey is portfolio manager of the Hartford Schroders International Stock Fund.