Being brave at the bottom of a bear market

A concentrated equity market dominated by a relatively small number of banks and mining companies means investing globally is often a necessity for Australian investors.

Indeed, it is not surprising that global equities now generally account for a significant share of investors’ equity holdings. This clearly shows the importance of selecting the right global equity strategy.

Normally, a broad mix of overseas assets will bring exposure to economies, sectors and companies with different growth rates and at different stages of the economic cycle.

However, the global economy is far from normal. The credit crunch has triggered a global economic slowdown. Stock markets have slumped, falling faster and further than at any time in most investors’ memories.

While global equities have performed much better than Australian shares over the past year, the declines have been severe. Some sectors have been particularly hard hit, such as financials and materials. The financial sector accounted for about 22 per cent of global market capitalisation 12 months ago, but now is under 15 per cent.

If investors believe in the ability of the market economy to generate economic growth in the future, then there are potential bargains to be had.

There are a number of sound businesses that are priced at attractively low levels as a result of these market falls.

Identifying the future winners at the bottom of a bear market may lead to handsome rewards for brave investors.

An examination of very long-term market movements gives us hope.

The chart of 10-year compound annual returns from the US equity market shows an encouraging long-term pattern for investors (see graph page 22).

Since 1900, there have been four troughs in the market cycle when the annualised 10-year return has been negative: 1920, 1946, 1974 and now.

On each previous occasion, the market has recovered and investors have enjoyed a sustained period of attractive returns.

While no two crises are ever exactly the same, this may give a clear message to long-term investors who are saving for their retirement.

But there are caveats to be applied when using the past to predict the future; each downturn is subtly different. For one thing, we are in uncharted territory and markets may go sideways for some time.

Parallels have been drawn with Japan’s ‘lost decade’ of growth in the 90s, although policymakers in two of the worst affected countries, the US and the UK, are determined to avoid this and have made aggressive interest rate cuts and shown a willingness to pump money into the economy.

The possibility of stagnating markets makes it doubly important for investors to develop an appropriate investment strategy. Within the context of global equity investing, investors may well benefit from allocating to managers with strong stock-picking skills, based on high quality research and analysis.

By identifying the future winners, investors may be well positioned to benefit from current conditions, as stronger companies generally benefit from the opportunities created when weaker players downsize or exit markets.

The characteristics of the future winners are likely to include strong cash flows, high barriers to entry in a market, diversified sources of funding, high levels of capital, a strong balance sheet and reserves together with high quality management.

More than this, in a stagnating market fund managers will probably need to avoid ‘dead’ money, or stocks that look cheap but that do not bounce back.

There needs to be a catalyst that forces the market to recognise the value of a stock. Investors also need to consider whether to pick stocks across a range of sectors to maintain diversification, as some sectors will take longer to recover than others.

For example, in the automobile industry, Toyota is likely to be held back because weaker companies, such as General Motors and Chrysler, are propped up by government support. In a pure free market, struggling companies would go out of business and the survivors would increase their market share, but government action has created a barrier to exit, impeding market forces.

Nevertheless, there are many winners that are being recognised by the market.

As an example, biotechnology company Gilead Sciences, which specialises in treating HIV patients, is benefiting from its ability to produce combination therapies by licensing third-party drugs and using them alongside its own medication. This is an approach that health professionals prefer to prescribing a cocktail of drugs.

The stock also has an additional catalyst, as increased HIV testing, due to regulatory change, and wider medical insurance coverage of its treatments are increasing usage of the company’s products, although its share price does not fully reflect this yet.

Another example is Autozone, a retailer of car parts in the US that was perceived to have a mature business. However, the current recession has revisited its growth prospects because as sales of new cars have fallen, consumers are purchasing more car parts to keep their old cars on the road. As a result, there is a catalyst for markets to recognise Autozone’s mis-pricing, as it was ignored in favour of luxury goods stocks in the past.

Something similar has happened at McDonalds. It has revamped its menus and décor and introduced competitively priced coffee to challenge the likes of Starbucks. These changes have increased footfall to outlets at quieter trading times, boosting profit margins. Here, the change in customer behaviour brought about by the recession has also acted as a catalyst, with McDonalds positioning itself to benefit from customers trading down.

A different illustration of how a strong company can continue to lift its earnings in poor conditions is provided by Japanese games manufacturer Nintendo. Its recent innovations, the interactive Wii game and hand-held DS console, have successfully broadened its appeal beyond traditional gamers to include more female users. Wii and DS games are now even being used by the elderly in retirement homes for exercise. Nintendo is also benefiting from the recession, as its games, which can be played repeatedly, are seen as good value compared to other leisure activities such as a meal out or a night at the cinema.

There are plenty of other examples of corporate survivors that are now well placed in their respective markets.

JP Morgan in the banking sector should be able to benefit from its strong capital base and its ability to lend, while in the US construction sector, we have identified CRH plc, the Irish-based international building materials company, as a potential winner from President Barack Obama’s stated wish to renew America’s physical infrastructure.

In these times, investors can choose to stay in safe havens such as cash, but this allocation may look increasingly unappetising as interest rates fall. Recent market events have dented investor confidence to the extent that strategic allocation has become more challenging than ever. However, we believe that a concentrated global equity portfolio consisting of strong survivors, where there is a tangible catalyst for value recognition, offers the potential for long-term growth prospects.

For the long-term investor, the road ahead may be bumpy at times, but in the future we could look back at this period as a great opportunity to invest in high quality companies at cheap prices.

Habib Subjally is head of global equities and Perry Winfield is senior analyst at Colonial First State Global Asset Management, UK.