Investing as the economic landscape changes

Investing as the economic landscape changes
  • Buy-and-hold strategy risks missing out on economic change
  • Key is to uncover pockets of growth to deliver long-term returns
  • Value in emerging markets, Japan, smaller companies and Africa

A buy-and-hold strategy may make sound investment sense, but it neglects one crucial point: economies change. New industries emerge while old ones fade. Today's hottest trend may be completely forgotten in a year or two. Investors must adapt by ensuring they are not constantly betting on yesterday's growth stories.

With that in mind, it is worth considering how the future might look. Inevitably, crystal-ball gazing is flawed and subjective, but it can be helpful. In speculating about the future, perhaps the first thing to bear in mind is that the past five years have been anomalous. It is easy to forget that we once lived in a time when economic growth was buoyant, inflation a threat, interest rates high and borrowing easy.

HEADWINDS

That said, few economic forecasters are predicting an imminent departure from the current lower-growth trend. Christopher Mahon, director of asset allocation research at Baring Asset Management, points out in a research note that the developed world in particular faces a number of headwinds.

'Demographics will continue to be a drag on growth as developed market populations age,' he says. 'Productivity growth is slowing in a number of advanced economies, while credit regulation, a major consequence of the global financial crisis, will constrain investment.'

There are other considerations. Debt across most developed markets is still high, so without an inflation surge, paying debt off is likely to hold back growth. Commentators such as Cazenove's chief investment officer, Richard Jeffrey, talk of a 'new normal' where trend economic growth rates are considerably slower than in the past decade.

Mahon's analysis suggests the rate of trend growth for the US and UK is likely to be just 2.3 and 2.2 per cent respectively, having been as high as 4 per cent.

This may not look like a promising environment for investors. However, as with a duck gliding across a millpond, there will be much going on beneath the surface. The question for investors is how to uncover pockets of growth that will make them money over the longer term.

Before examining these areas of structural growth, it is worth considering a perspective offered by Nick Kirrage, joint manager on the Schroder Recovery and Schroder Income funds. He suggests that investors should focus their attentions less on those areas that are likely to grow and more on those that offer real value.

In a recent blog, he says: 'In a world where everything keeps changing - politics, economics, thematics and so on - is there anything investors might look to as a constant? Even what we invest in is ever-changing. Back in the 1920s, developments such as the internet would have been regarded as witchcraft.

'We cannot know the future. So, despite the uncertainty in the eurozone, the Middle East and China, is there anything we can rely on? There is. One thing that will determine whether or not investors make money - time and time again - is the price they pay.'

Kirrage adds that targeting areas of growth is largely pointless without a corresponding sensitivity to the price being paid. He says: 'Historically, whatever has helped you justify paying a higher price has been irrelevant. Better business? Stronger economic environment? Higher growth? World-changing new technology?

'It did not matter [because the high price meant it didn't deliver a better return in the end]. What is more, it did not matter even if it turned out you were 100 per cent right about the [beneficial] outcome.'

He uses the example of GlaxoSmithKline to emphasise his point. GSK undoubtedly grew strongly 10 years ago, but this has not been reflected in its share price performance. He argues that even if someone was able to know with certainty that a company would grow, they would not necessarily be able to determine the returns made.

This does not imply that investors should ignore an investment's potential for growth, but just that they should not overpay for it.

In the current environment, this may rule out investments in areas such as the US where growth can be expected but investors are paying a high price for it. It would also rule out much of the fixed-income market, where there appears to be neither growth nor value.

GLOBAL EMERGING MARKETS MESSAGE

Global emerging markets have traditionally been the first ports of call for those looking for long-term growth. The argument runs that their economies, because they are less mature, are likely to exhibit the strongest growth over time, creating a benign environment for companies (and therefore stock markets) to grow.

However, Russia and Brazil have fallen into recession, and China is wobbling. It has become clear that many emerging markets have been dependent on the strength of western economies to grow.

This has been reflected in share prices. Emerging market funds are bottom of the sector performance tables over almost every short and medium-term period.

Over five years, the average fund in the global emerging markets sector is up just 3.9 per cent, compared with a rise of 72.4 per cent for the average UK equity income fund (source: FE Trustnet, 24 July 2015).

This makes emerging markets an investment candidate on value grounds, and they may also still score on growth considerations. Mahon writes: 'Emerging market equities have fallen to relatively inexpensive levels and still benefit from favourable longer-term trends, such as good demographic profiles in many emerging countries.'

Eoin Fahy, chief economist and investment strategist at Kleinwort Benson Investors, also believes there is value in emerging markets, and he holds a high weighting to these areas across the portfolios he manages for his clients. He points out that corporate governance is improving and economic growth remains relatively strong.

But discernment is crucial. Not all emerging markets follow a linear path of economic development. Countries such as Russia, for example, may be cheap, but they could get cheaper. Meanwhile, the jury is still out on whether China will manage to rebalance its economy painlessly.

Tim Cockerill, head of research at Rowan Dartington, singles out Asia as a promising region. He says: 'On a valuation basis, Asia looks strong. There are cheaper markets - such as Russia - but they all have problems. Asia has a young population and fast growth.'

Considering value might also bring areas such as Japan and Europe into the investment picture. They have lagged other developed stock markets, but they may be poised for a change in fortunes.

Garry White, chief investment commentator in equities at Charles Stanley, says: 'Despite the potential for Greece to exit the euro, the recent setback in European equities appears to present an interesting buying opportunity.

'European earnings are likely to benefit from continued quantitative easing and the euro's earlier weakness. Valuations also look good. Japan looks as though it is going to continue to outperform as stimulus measures remain in place.'

Smaller companies have been a popular choice for long-term growth. Their long-term outperformance has been firmly established by academic research, such as Rolf Banz's findings reported in his paper 'The Relationship between Return and Market Value of Common Stocks'.

Recent research by AQR Capital Management suggests that introducing a quality bias to stock selection enables investors to weed out weaker companies that drag down the overall returns from smaller companies, producing stronger and more compelling returns over time.

This would seem to lead investors to favour income-focused small-cap funds such as the PFS Chelverton UK Equity Income fund selected by BMO Global Asset Management (formerly F&C Investments) multi-manager heads Rob Burdett and Gary Potter.

Those wanting a broader approach could look at Marlborough Multi-Cap Income, or Diverse Income Trust run by Gervais Williams at Miton.

TECHNOLOGY TACK

The technology sector is another area offering long-term growth potential, although it has been prone to periods of over-valuation. Nevertheless, if investors can get in at the right time, it is a natural choice, because technology is becoming more pervasive.

Walter Price, manager of the Allianz Technology trust, says technology 'is becoming a more important part of all our lives, growing faster than the market and taking greater share of the market'.

He points to innovations such as the connected car. Ten years ago, cars were considered a new-technology-free zone, but connected cars will now have internet radio and real-time traffic information.

Some more idiosyncratic areas also offer prospects of long-term growth. Fahy points to the likely importance of water in future.

He says: 'Water is the ultimate life-giving substance. We can do without oil, but we can't do without water. There is a massive shortage of clean or treatable water across the planet, even in developed countries. Pollution is increasing and the middle class in the developing world is growing, so demand is going to be very strong. Companies with solutions to water scarcity are likely to be well placed.'

Burdett believes Africa is an area to watch over the next decade. He says: 'Africa is starting to gain traction. Nigeria is a world leader in mobile payment transactions, for example, and the second largest market for Guinness. The cities in many emerging markets have already emerged, with skyscrapers and strong infrastructure, but this has not yet happened in Africa.'

US president Barack Obama's recent presence at an entrepreneurship summit in Kenya is an endorsement of the continent's economic progress.

White highlights the long-term attractiveness of healthcare. 'Global healthcare could be said to be in a perpetual bull market as the world's population ages and gets richer,' he says. 'However, large pharmaceutical groups have not performed well recently.' This may allow investors to buy in at a low price.

Income has been absent from the picture so far. While interest rates remain low, the choices are relatively scarce. But they definitely don't include bonds, where the income available is low and there remains a risk of capital losses should interest rates rise.

Company dividends - be they from UK companies, smaller companies or global companies - appear to allow investors to generate reasonable inflation-adjusted income over time. The UK does not necessarily attract very much attention as a growth market, but White says analysis by Charles Stanley suggests the dividend yields available in the UK stock market are the highest of any major region, which should drive equity prices.

Areas such as property and infrastructure score less favourably for value, given their recent strong run. Peer-to-peer lending may be another source of long-term higher income, but the market will need to become more established before it lures in significant numbers of investors.

The giddy days of strong economic growth and buoyant stock market returns may seem to be over, but investors can still position themselves to capitalise on long-term structural change. However, when chasing tomorrow's winners, it is always important to consider the price of an asset. Nothing is a long-term winner if the price is not right.


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