Investing For Growth

Recent months have proved challenging for active investors. Picking consistent winners amidst market turmoil and constant rotation has been tough. As markets oscillate between extremes of fear and optimism, sectors seem to move in and out of favour randomly. But there are some helpful underlying trends that are continuing to work in investors’ favour. Funds aligned with these patterns – emphasising strategic and balance sheet strengths in global companies – have performed well this year. Understanding the underlying themes will be the key to performance in the coming year.

Strong balance sheets and growth strategies are steadily winning out against weaker businesses. Normally, investors would expect the weak to get fixed or recover, but this is not happening in today’s tough credit environment. Hanging on to losing companies is hitting investment performance. What investors are seeing is a continued re-rating of credit quality.

For strong businesses, financing is easy, with open credit markets. But, securing support for challenged businesses – that have weaker balance sheets or are losing market share – is near impossible. The banking system has ceased to support these businesses, as de-leveraging accelerates. Banks need to shrink their lending and to improve loan book quality. As a result, many small and medium sized businesses are finding it hard even to rollover existing facilities on acceptable terms, and do not have easy access to raise money through equity issues. The refinancing boom of 2009 will not be repeated.

This means that businesses with a weaker strategic position are paying considerably more for their finance. Their competitive position is steadily deteriorating, as lack of finance prevents acquisitions or restructuring. Businesses with low growth now, are likely to continue to see their growth potential restricted. This makes it more likely that today’s winners, will also be in front tomorrow. Fund managers are usually inclined to sell stocks that have outperformed and re-rated, but this process could continue much longer. We may be only half way through the trend to value credit quality more highly.

The winners are global businesses, sharing in US economic recovery and with the potential to benefit from stimulation in Europe. Intervention in Europe to print money seems likely, matching the US and UK tactics to mitigate deleveraging. While printing Euros might be bad for the currency, it is likely to stimulate growth and a move into prime assets, both property and large capitalisation global equities.

Global growth businesses at attractive valuations are more likely to be found with UK and European listings. Wall Street has outperformed, as the US acted more promptly and comprehensively to stimulate and address the banking sector problems. US listed blue chips are now expensive relative to their counterparts in France and Switzerland, for example. This divergence is surprising, when underlying global exposure and strategic strengths may be similar. Dividend yields are also attractive in many major European stocks, with good growth potential. In the search for income, many investors are concluding that these growth shares are more attractive than the miniscule yields on sound sovereign debt. The bond bubble may not yet burst, but gradually some of the search for income and security is finding its way into blue chip equities.

This may be bad news for small cap investors. In a parallel with the two tier property market, where money printing has spilled only into prime assets, investors may continue to focus on the best large cap shares. These may not all be defensive shares, such as tobaccos, food and pharma. Industrial businesses with exposure to global growth and the potential for some self-help through restructuring or acquisitions could continue to do well. Indeed, quantitative easing in Europe could encourage some switching from defensives into more economically-sensitive sectors. But, overall the pattern will favour strong global businesses that may already be enjoying above average margins and some top line sales growth. Even if global growth stalls, well financed businesses could be able to grow by buying up weaker competitors.

Investors should focus on businesses that have potential for self-help, by restructuring or acquisitions. Some businesses achieve growth by a steady flow of new products, working closely with customers to identify opportunities to add value. And, many multi-nationals are steadily divesting low growth or low margin divisions, particularly in the industrial and chemical sectors. That means that investors should not think of quality in terms of representing purely defensiveness or a bet against global growth. There are a number of businesses with material exposure to US recovery, such as Experian and Ashtead, that can grow even in this challenging environment. Investors should look closely at company updates, and look for signs that margins are holding up as well as overall sales.

It is tempting to chase short term market direction, but that means taking a view not only on global economics, but on the politics driving that. Investors cannot rationally analyse this, but should recognise the pressures on European politicians and central banks to stimulate. Politicians have no magic solution to saving the Euro, but they do need to encourage growth in order to be re-elected. Investors should worry less about guessing at the unknown, and focus on the company characteristics they can analyse. Even if growth slows globally, stronger balance sheets will give companies an edge.

Performance this year has come from portfolios that have stepped back from day-to-day volatility, rather than trying to trade daily market moves. Instead, the key is to focus on companies with strong balance sheets and stable margins in sectors where they have a good global strategic position. If European stimulation comes, Europe’s major stocks could re-rate dramatically, whilst leaving weaker businesses behind. It is tempting to look for value amongst second-liners, and what might appear to be temporary setbacks. But the lesson for growth fund investors is that the strong might continue to get stronger. Over the next year it may prove right to back today’s winners.

Full disclosure : long Experian & Ashtead

This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.

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