The constant drip of economic data points are manna from heaven for the world’s economists, often wheeled out to give their latest forecasts and predictions for global growth. Unfortunately, a recession cannot be predicted through a crystal ball. A study by Fathom Consulting examined 30 years of economic forecasts by the International Monetary Fund covering 469 recessions globally. Despite having hundreds of full time economists, the IMF only forecast 25% of recessions in the year in which the recession happened. So, while the current economic forecasts may be less than rosy, we would do well to remember that tough times do not last, but tough companies do.
Given the unpredictability of the economic environment and the difficulty of forecasting recessions our investment processes target companies that we feel can survive and ultimately thrive whatever the circumstances. In a nutshell it means looking for companies with sustainable barriers to entry. Specifically, companies that are lowest cost providers in their industry; companies that have high levels of intellectual property such as patents or brands that prevent others copying their product; businesses with high levels of repeat sales such as subscriptions or contracts which give stability to revenues in a downturn; or companies that have excellent sales networks or distribution systems allowing them to outsell their competitors.
Recessions are a necessary part of the capital cycle and as investors we must accept that they will occur at some point. We shouldn’t necessarily fear them as long as the companies which we are invested in don’t experience a permanent loss. We believe that by investing in the lowest cost providers, that more difficult trading conditions help to clear out the weaker and often less disciplined competitors.
The UK motor insurance market is an exceedingly commoditised industry. Over a cycle the industry generates an underwriting loss of roughly £10 for each £100 of premium it takes in ¹. Yet a niche player like Sabre Insurance prefers not to underwrite mass market risks where prices are low. It concentrates on keeping its costs to a minimum and insures in those areas where others fear to tread such as younger drivers or drivers with impaired records. It charges an appropriate price that compensates for the incremental risk. As a result, it has been consistently profitable and uses this profitability to pay an attractive dividend.
Intellectual property such as patents or unique content allows companies to protect against competitors copying their products. An example here is Games Workshop with a 30-year history of producing miniature fantasy figures used in table top gaming. It consistently brings out new designs complete with detailed back stories to delight its worldwide player base.
For some sectors, external economic conditions have much less impact on profitability than other factors. The biggest drivers of profitability in the pharmaceutical sector are the rate of new drug discovery and government pricing negotiations. Both AstraZeneca and GlaxoSmithKline have endured a difficult last ten years with sales falling due to patent expiries of major drugs. However, a change in management accompanied by renewed investment in Research & Development and recruitment of talented scientists means that we might be seeing tangible evidence from both companies that the future might be brighter. Recent trial data from several new drugs have shown improved patient outcomes across a range of cancers, chronic kidney disease, heart disease, and HIV. Better understanding of the diseases and use of bio markers also means treatments can be administered in a more targeted, patient specific manner. For governments this means reduced waste and thus more efficient use of health budgets.
We continue to look for companies that can survive whatever the economic environment. Fears of recession provide opportunity in the form of lower valuations. The UK equity market is trading at a 30% discount to its developed market peers and the dividend yield is its biggest premium to UK Gilt yields since the World War II ². No doubt there will be casualties from changing consumer habits and an unpredictable socio-economic environment. One just has to look at the retail sector to see the carnage that the internet is inflicting on those retailers with an over exposure to the high street. As active fund managers it is our job to try and avoid those companies most at risk from disintermediation and invest where we see businesses with strong barriers to entry and that could pay a growing dividend.
Simon Young manages the AXA Framlington UK Equity Income Fund and lives in Hampshire.
¹ Sabre PLC, January 2019.
² Morgan Stanley August 2019.
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