Portfolio management in an age of economic crises and structural change

Chris Selth asks whether the financial crises we've been witnessing were about punishment for past indulgence, or simply about structural change.

Technological progress drives change.

In the development of business processes capturing the various elements of those new technologies and their impact on underlying societies, there are winners and losers.

Famed economist Joseph Schumpeter coined the expression ‘Creative Destruction’ to capture this dynamic. This process, which springs from very basic drivers, shapes the evolution of the economy at broader levels. 

Productivity improvements drive down inflation, lowering borrowing costs. Credit expands. This underwrites economic growth even as the initial impetus fades.

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Employment losses in declining sectors are absorbed by the winners, but also other parts of the economy stimulated by low interest rates.

Contra-cyclical economic policy by authorities can assist in the short term, but does it help facilitate the ultimate repositioning of economic resources, displaced not by an economic cycle, but structural change?

These broader forces sit at the heart of Schumpeter’s work. Financial capital moves faster than physical capital, which moves faster than human capital.

This sits behind the structure of our economy, our social institutions and our politics. Struggling with this dynamic reflects the adjustment process that can be seen as a wave-like pattern over history.

These waves, referred to as Kondratiev Waves (Figure 1), have been understood in a number of ways, given a collection of labels.

Schumpeter looked at them through the prism of technology, but Irving Fisher and Hyman Minsky tracked them in terms of debt formation.

The current cycle is driven by the nexus of information technology (IT) creating not just new products and services, but revolutionising how traditional products and services are manufactured and distributed.

China’s industrialisation was significantly underpinned by its integration into global supply chains, a revolution not just of production, but of transport and inventory management.

Moore’s Law – the doubling of computing power per price point every 18 to 24 months produces a geometric improvement in IT power – is just one proxy for the scale of the IT driver.

This has fundamentally altered not just computing but processes across the globe. 

This is interesting set against the phenomenon of labour mobility.

In looking at the United States, the world’s most diverse economy with fluid capital markets and flexible labour practices, labour is taking systemically longer to re-position after each recession.

The lag time between when recessions end and when non-farm employment returns to its pre-recession levels has been increasing sharply after recent recessions.

If the 2011 pace of job growth was to continue, non-farm employment would return to its 2007 peak at the end of 2016.

This poses a question for consideration: Is labour re-training as quickly as IT is shifting the structure of the economy? 

In order to understand this phenomenon, we must first consider the changing structure of US employment.

While manufacturing jobs have been steadily declining as a percentage of total employment since the 1950s, post 2000 saw a dramatic decline both in absolute as well as real terms.

An increase in unemployment has been masked by a decline in the participation rate, similar to Australia. 

Incomes for middle America have been challenged over the past decade.

Despite the structure of US employment changing and household income under pressure, home ownership rates have re-accelerated – another factor lending itself to the sub-prime lending crisis in the US.

Low interest rates underwrote credit expansion despite deterioration in income quality and structural questions about the US economy.

Over the same period, there was a spike in commercial property development, particularly retail. 

These inconsistencies inevitably produced the denouement seen in 2008.

The US Government and Federal Reserve intervened to prevent the collapse of the US economy and engineer a more gradual transformation.

That intervention saw the deleveraging of one part of the economy replaced by an expansion of debt by government.

The question is whether government debt expansion is holding back or facilitating the repositioning of resources in the US economy.

This is the crux of the global debate. The US has adopted an essentially Keynesian approach, even if the scale of its intervention is held by Keynesians such as Paul Krugman as being inadequate.

Europe’s sovereign debt crisis is being met at present by demands for the opposite policy, shock therapy through enforced austerity, combined with labour market reform.

This is a repeat of policy debate dating from the Great Depression. Will businesses invest in creating new jobs if demand collapses because of austerity?

Or will they invest if they think government stimulus is unsustainable as it increases debt? 

China also has challenges.

It is attempting to shift from an export/fixed investment-focused economy to a domestic consumption-focused one.

Question marks hang over returns to a number of the projects undertaken to support the economy in the 2008-2009 crisis, so a repeat of this kind of stimulus to support the economy through this transition seems unlikely.

And while it is true that the Australian government debt position is the lowest by a significant margin of major mature economies, long-cycle credit expansion is also evident in Australia.

Low interest rates drove debt expansion by households and financial institutions.

It went hand in hand with the increase in property prices, leaving Australia now constrained by mortgage debt and property prices out of reach for new entrants.

A study by Stephen Cecchetti at the Bank for International Settlements concludes that debt turns “bad” at roughly 85 per cent of GDP for public debt, 85 per cent for household debt, and 90 per cent for corporate debt.

If all three break the limit together, the system loses its shock absorbers. The good news is Australia has plenty of shock absorbers.

The capacity for the government to act and interest rate decreases leave the Australian economy in a reasonable situation.

Over-leveraged consumers cannot splash out, but cutting their interest payments can support activity.

The risk is that of job losses from a high Australian dollar.

Behind these troubling concerns sits the primary driver on which this paper focuses - innovation.

Economic challenges are the culmination of a Kondratiev wave, driven by the operations of economic agents implementing business strategies, driving differentiated outcomes.

It is not a homogenous environment where everyone is a loser, but rather one where the market is currently pricing heavy risks on the downside, yet winning companies may re-define both the economic environment and create new opportunities, and where any economic improvement will benefit cyclical companies.

In order to see this point, it is useful to consider the drivers of productivity growth at the business level, rather than the aggregate level.

The IT sector experienced the strongest productivity growth over a 10-year period from 1995 to 2005. Other sectors seeing significant productivity growth are retail and manufacturing.

Just as telling are the sectors seeing little or no productivity growth including health, education and construction, where cash-strapped governments are the main employers.

The productivity of construction (the beneficiary of cheap funding) has actually gone backwards.

Health, demanding huge increases in resources which our economies can barely afford as populations age, is yet to see any improvement.

In an era where labour needs redeployment to quicken, education productivity is stagnating.

It is important that we remember that change is accelerating. The impact of digital technology, biotech, and the demands of the developing world are not stopping. Paradigms are moving faster.

Two low productivity growth sectors yet to be meaningfully transformed by digital trends are the large employers who sit at the heart of our economies – health and education. 

How are these trends viewed by the market?

What is clear is the market is pricing economically sensitive stocks at historic lows.

The themes of structural change are clearly already showing up in the price of stocks.

What does this tell us about how money should be invested?

The current market has been driven by the outperformance of winners – that is, the change agents in this creative destruction process – but also mega cap defensive names with strong dividend streams.

This is only natural with low, long rates and company survival being an issue, as economic uncertainty and radical business model changes cloud the outlook.

The market is pricing economically sensitive stocks at historic lows. 

The underperformers in this creative destruction storm are the declining business models – the value traps. Given prevailing economic conditions, it is understandable that concerns about the survival of businesses enter into the reckoning of company valuations.

The market has also been powerfully marked by the poor performance of smaller mid cap names with high economic sensitivity.

This is consistent with fears of a protracted downturn, as implied by long bond rates. What should we make of these moves?

A study by AllianceBernstein (picking up on work by Reinhardt & Rogoff ) of the nature of economic recoveries post-credit bubbles suggests the recovery could be up to nine years.

On paper, we are half way through this process.

What is interesting, however, is the technological drivers of creative destruction are not on hold, they are accelerating.

The impact of digital technology, biotech and the demands of the developing world are not stopping. Paradigms are moving faster.

This means new investable business opportunities will continue to proliferate.

The most important new product of recent times, the Apple iPhone, was launched in the heart of the crisis. Sales boomed despite the economic uncertainty. 

Is it better to buy structural winners, even though they are more expensive, or cheap economically sensitive stocks, even though some of them might be in decline?

How much of this important thematic of creative destruction is already in the price?   

A case study

The retail sector is one where IT is already having a significant impact.

The US Bureau of Economic Analysis identifies the retail sector as having leading productivity growth.

Yet the Internet cannibalised a number of traditional trade areas, most notably books and music.

It then moved to challenge business models for other standardised products, particularly electronics.

Where standard products were sold between different distribution channels, the consumer was left free to compare prices online, and ultimately order the product online.

As a result, profit margins became increasingly challenged.

Retail formats distributing third party product are losing their capacity to differentiate themselves on range or price. This reaches right into the business model for department stores.

On the other hand, retailers controlling product design, manufacturing and distribution, using information from customer interactions – both in their physical stores and online – to modify design, stock and pricing, have shown themselves to gain cumulative competitive advantages.

These retailers can respond quickly to changes in consumer tastes because they have embedded technology into their processes.

They are a facilitated feedback loop.

A classic example where this has been evident is Spain’s Inditex, which recently opened its first Zara store in Australia.

Big box retail was a killer format in the 1980s and 1990s, enabling consumers to compare a vast selection of inventory under one roof.

The format generated significant supply chain efficiencies resulting in lower prices.

Best Buy is America’s largest electronics retailer with 1,300 stores, and until recently was adding floor space at 5 per cent per annum despite weakening revenue growth.

Last year, amidst falling sales and strong online competition, it announced it was to reduce nationwide floor space by 20 per cent, in part by cordoning off parts of its 45,000 square foot big boxes and subleasing to smaller retailers.

Best Buy is also shifting to smaller format mobile stores, focused on phones and tablets. Staples, Office Depot and Walmart are all now building smaller stores.

In Australia, Myer has announced it will scale back store openings and Harvey Norman is under increasing pressure to consolidate its footprint.

Given the large investment in retail floor space, this trend has profound consequences for retail rents, property valuations, bank credit quality and retail employment.

Given these structural changes, simply referencing historical averages can lead one to quickly fall into value trap. Investors must constantly ask ‘what is in the price?’

Valuation dispersion is expected to increase as digital disruption moves into other sectors.

Given strong forecast growth profiles for eBay and Inditex, the reasonable growth rates implied in current share prices help put their higher Price-Earnings Ratios into perspective.

Conversely, both Myer and Macys are being strongly buffeted by e-retail.

Despite attractive valuations versus historic averages, it is unclear whether they can hold margins at the levels implied in current share prices.

Conclusion 

The current economic environment is ultimately the product of innovation behind good businesses.

The macro-economic headwinds the market is pricing are not an overlay independent of underlying businesses, but a product of them.

To understand the investment environment, it is essential to consider the structural issues at the business level.

In considering the unquestionably profound structural significance of these factors, the question which remains is, ‘what is in the price’?

Innovative companies are likely to be as important as any government policy in how economies navigate difficult transitions, but they can also be priced expensively.

The question is ‘when to own them?’

Alternatively, some of the businesses buffeted by economic uncertainty and priced for decline, may represent outstanding opportunities as many are priced for failure. 

It is essential to understand these changes as they will impact you, your associates, clients and entities with which you do business.

But it is also essential as an investor to appreciate that some elements are already in the price of some companies.

A solid portfolio must capture this truth while also looking for opportunities neglected in this wave of change.

This is an abridged version of the paper by Five Oceans Asset Management which was the basis of the Due Diligence Forum presentation that won the Delegates’ Pick Award at the 2012 PortfolioConstruction Forum Conference.

The full paper and presentation are available at www.PortfolioConstruction.com.au.