World economies have shown lacklustre developments in the years following the 2008 crisis. Central banks are trying to generate a virtuous cycle of demand growth that would ideally absorb the massive oversupply weighing on many industries. However, this is proving hard to achieve as one by-product is the fact that cheap capital is delaying the necessary capacity closures. The inevitable end result – low growth – is likely to stay with us for many years to come.
And the effects are starting to become evident. Looking at European equities, analysts are no longer forecasting any earnings growth for the average company in 2016. If this is correct, it would be the sixth year in a row with no growth in earnings. Can this be positive?
One effect of the generalised lack of earnings growth is a more profound differentiation between the performance of the few companies that show strong growth and surprise positively (thanks to internal dynamics, growing niches or management actions) and those companies that cannot escape the negative drag from the external environment and excess capacity. This provides strategies that are capable of differentiating between winners and losers with an excellent hunting ground.
Take, for example, last year. In a year in which cyclical companies’ earnings struggled due to the weak economic environment, Brembo, an Italian manufacturer of braking systems for the automotive market, grew its revenues by 15%. Its earnings at the end of the year ended some 30% above the level they were forecast at the beginning of the year. This was due to their successful accumulation of market share in premium brakes. Contrast this with the environment faced by many companies exposed to the global capex cycle, particularly within oil and mining services. Here earnings were in many cases decimated. It is no surprise that the difference between the performance of Brembo (+65%) and some of the oil and mining stocks was very material.
This was also the case among traditional defensive stocks, normally more predictable and hence theoretically allowing a lower spread in performance. In Switzerland for example, pharmaceutical producer Actelion raised guidance several times throughout the year thanks to better-than-expected developments in their two new drugs, Opsumit and Uptravi. By the end of the year it produced 16% more earnings than forecast at the beginning of the year. The situation could not be more different for some electric utilities in Europe. Investors bought them as many were attracted by the apparent safety of high dividends. But the challenges posed by excess capacity in the European electricity markets were such that numerous companies had to cut their dividends. Those stocks fell precipitously. Finally, differentiation opportunities like these were evident even in financials. For example, many Italian banks rallied thanks to positive revisions supported by favourable equity markets that boost their commission revenues and a small recovery in lending. But their Spanish peers, relying much more on the carry trade based on high government bond yields, fell as this earnings opportunity narrowed.
We believe our current portfolio is well positioned to benefit from such differentiation. Our longs are gathered around growth stocks with ample earnings visibility. These are stocks that do not need the help of a fleeting macroeconomic recovery to beat consensus and produce interesting growth rates. We find them in many areas, such as wind turbine manufacturers (Gamesa and Vestas), healthcare (Galenica, Actelion, Orpea, Korian), transport (Atlantia, Vinci, Eiffage, Aena and Carnival) and defence (Thales, Rheinmetall). Take for example the latter two. After many years of austerity, governments are now pushed to revise and extend their defence spending plans due to the various geo-political tensions. By contrast, our short book is biased toward companies besieged by excess capacity that would need a big acceleration in world demand to be cleared. Examples can be found within general industrials, electric utilities, some banks in Spain and UK, as well as luxury stocks.
What is interesting, though, is that after a steady expansion in stock markets, allowed by ever-rising valuations (and no earnings growth), the markets are now more vulnerable to set-backs and volatility has increased tremendously. This volatility is also emerging among themes and sectors. In the year to-date, we witnessed a sharp rally among many of the companies most impacted by the above-mentioned problems of overcapacity, led by a more positive sentiment for emerging markets. But such rallies have occurred in the presence of relentless negative revisions. They have pushed many stocks to valuations that now appear unsustainable, often above 20 times earnings. As such, we believe our short book offers a particularly interesting entry point, once people realise that yet again, the speculated recovery in Chinese trends and global economies will give rise to the same old result: a lacklustre economic environment, unsupportive of earnings growth.