July 31, 2019
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By Neil Robson, Head of Global Equities, Columbia Threadneedle
After a bearish end to 2018, financial market participants have been asking whether a global downturn is imminent – despite equity indices staging a recovery this year. Yet they should be asking a different question: have they accounted for the way that technology and other factors are transforming business models?
The average company’s earnings have moved sideways for a decade but technology firms are among the few ‘superstars’ that have famously grown earnings in this time (though there are less well-known companies in almost every sector that have done so).
Management consultancy McKinsey & Company coined the term ‘superstars’ for these businesses. It recently published research showing that the top 10% of companies capture 80% of all economic profit among companies with annual revenues greater than US$1 billion. Investing in these companies can be rewarding over the long term.
Overstated risk of recession
We would argue that the global economy is only half way through its current cycle – certainly, financial markets are not showing the signs of stress to be expected at the end of a cycle. Growth may be slow, but there are no real reasons why it should stop.
Are common assumptions about the nature of economic cycles correct? By most reckonings, the global economic recovery is a decade long, which would make this one of the longest cycles on record. But given flat growth in 2010, 2011 and 2012, did the recovery really start in 2013?
Additionally, the nature of the cycle is changing. In the 19th Century, economies were predominantly agricultural and weather dependent and so recessions happened every other year. Today’s service economy sees individual sectors experience recessions frequently without precipitating a widespread downturn.
While we do not expect an imminent recession, these are uncertain times. Consequently, we are looking to invest in tomorrow’s superstars – companies with a robust competitive advantage, with significant barriers to entry and the ability to gain market share. Many harness transformational technology.
Two major geopolitical factors prompted the big sell-off during the final three months of last year – and when we look at these in aggregate, it is easy to see why markets are growing fearful about rising recession risk.
The first was the changing political landscape. Over the past few years, a group of nationalist strongmen has taken charge in major global economies and adopted a more assertive approach to international relations – one of them, President Trump, remains a domineering and unpredictable figure. This is not a recipe for stability in world markets.
The second factor is the ongoing trade war. The US feels threatened by a resurgent China that has doubled its share of GDP from 4% to 8% since it acceded to the World Trade Organisation in 2001. It justifiably resents China’s restrictive practices. Donald Trump likely desires a zero-tariff world, but he also wants fair access to
China’s markets. Brexit is of course another obvious challenge for companies. As an open, internationally connected economy, the UK is deeply embedded in many of the cross-border supply chains along which trade flows.
These will be disrupted by such geopolitical change and it will become unclear where companies should invest.
Looking for game changers
One should not be fooled into thinking cheap companies represent an attractive buying opportunity. Innovators are disrupting markets, undercutting prices and driving down profit margins. A well-known example is retail. Consumers are turning away from the high street and to the convenience of online shopping – Amazon and Alibaba’s sales account for more than 1% of global GDP. Bricks and mortar retailers are cheap for a reason: society is changing.
Mastercard is a good example of a superstar company. Mastercard and Visa control around 85% of the global card market, excluding China. Because the industry structure is so advantageous, Mastercard makes north of 40% return on invested capital and its revenues are growing in the high teens, as the number of purchases made using plastic increases by over 10% a year.
Meanwhile, Mastercard is large enough to be relatively unaffected by local shocks such as Brexit, though it must guard against challengers.
Investing against the noise
When we reach the end of this cycle, there is no way of knowing whether we will enter a major downturn or a relatively short period of slower growth before the economy picks up. The biggest question for investors will in any case be the same: when the next downturn does eventually take hold, how much room for manoeuvre will central banks and governments have to protect and stimulate their economies?
Against all this ‘noise’ we remain dedicated to pinpointing companies that successfully operate in difficult to access areas. They are overwhelmingly harnessing societal change and technology, instead of swimming against the tide.
* Superstars: The dynamics of firms, sectors and cities leading the global economy, October 2018: https://www.mckinsey.com/featured-insights/innovation-and-growth/superstars-the-dynamics-of-firms-sectors-and-cities-leading- the-global-economy.
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