Global stock markets are undergoing a profound global shift.
The duration of this transition remains uncertain. But the direction of the fundamental changes in the global economic and investing environment is becoming clear, as are the potential benefits of taking a long-term view of portfolio positioning for a new equity landscape.
From 2002 through 2007, investors were progressively operating in a wonderful world in which the appetite for risk was increasing, the cost of capital and labour were very low, and profit margins in virtually all regions around the world were at historically high levels.
However, in 2008 the pendulum swung quickly and widely, devastating economies around the world and leaving global equity markets searching for a stable bottom.
Today we are in the midst of a very severe contraction as the global economy deleverages and unsure of the ultimate depth of this downturn. Each passing data point gets us closer to finding the bottom — and the worldwide government stimulus response is a necessary and encouraging part of that process.
Eventually, the global economy will adjust to a lower level of economic activity. However, the timing is uncertain as this deleveraging process is different from anything we have experienced in recent decades, and it is going to have to run its course.
This transition is already evident in the form of tighter credit, higher cost of capital, more risk aversion, restrained consumer spending in developed markets, less corporate expansion, and flat global growth — with economies in the US, Western Europe, and Japan shrinking recently and the rate of growth in some emerging markets slowing noticeably.
This progression will likely take several years, and once the global economy stabilises, we are not going to return quickly to the old norms for growth and profits.
The new norms
The global economy will get worse before it gets better. Nonetheless, I am hopeful that investors will see some signs of economic stability forming in the latter half of this year or early 2010, with global equity markets reacting positively over a two- to three-year time frame.
Eventually, a new backdrop for global investing will emerge from this slow transition, which will be characterised by:
- lower real global economic growth, in the 1 to 3 per cent range, with emerging markets the key drivers;
- slowly rising interest rates;
- moderate consumer spending and recovering fixed-asset investment;
- a gradual return to corporate pricing power and improving profit margins;
- equity risk premiums declining and valuations normalising after hitting rock bottom.
Still, the transition to these new norms may be rocky.
The second-round effects of the large global job losses to date are yet to be felt. For those who think the loss of several million jobs in the US is problematic, just think of the loss in China alone of 20 million migrant workers’ jobs.
As markets establish their own base levels, it is likely we will see several powerful short-term, indiscriminate market rallies — so-called junk rallies — that are followed by disappointment.
On these rebounds, marginal corporate players — just because they have survived — may see sharp gains from their cheap valuations. But in the long term, global investors should not focus on these marginal companies.
Seeking quality
This historic collapse in global equity markets has resulted in extreme dislocations between equity prices and underlying corporate fundamentals.
The realignment of valuations and fundamentals could take two or three years. Investors who seek quality companies may be rewarded by the numerous current opportunities.
While positive trends will return, we are probably not going back to the super-normal growth and stability of the 2005 to 2007 period.
As a result, global equity investors should seek to own the market leaders built to survive the global downturn and — because of their healthy balance sheets and access to capital — that are able to take market share from marginal players which may not survive.
In virtually every sector around the world, quality companies are likely to take market share as the global downturn forces their weaker competitors out of business or into mergers. It is like aircraft carriers versus patrol boats. When things are running fast, the patrol boat can outmanoeuvre the aircraft carrier. When things slow, an aircraft carrier can turn and capsize the patrol boat with its wake.
As such, while the winners will be different from those in the past. Whereas, previous winners were the attackers that benefited from pricing power, excess demand, and tremendous financial and operational leveraging, tomorrow’s winners are more likely the incumbents with traditional, relationship-based businesses, companies that can self-finance, and those that can absorb weaker market competitors.
No one is going to experience the top-level growth that we have enjoyed in recent years.
So a global investor should look to own the number one or two player in any market. The overall market pie may be shrinking right now, but these leaders will likely end up with a bigger market share and more business on an absolute basis, which should grow their future earnings prospects.
Lessons for 2009
The current transitional situation poses very challenging global economic circumstances, and there’s been only modest improvement in the stability of the world financial system. As investors determine how to move forward, it helps to consider important lessons derived from 2008.
One lesson is that company valuation, business model quality, balance sheet, and management are inextricably linked.
Two, companies with the same price/earnings ratio may represent completely different risk and reward opportunities. An investor must study the whole package.
Next, reversion to the mean is a useful concept over the long term, but it can be counterproductive in the short term when sentiment overshoots to bullish or bearish extremes — as in the anomalous markets of 2008.
Buying stocks that are down a lot and look unusually cheap is often a good strategy. But, as 2008 showed, it can take years to play out.
Third, risk management should be holistic, not just data driven. Both Bear Stearns and Lehman Brothers had very robust risk management processes, but they were highly reliant on quantitative systems. Quantitative systems are typically designed to protect against bad outcomes 99 per cent of the time. It often takes qualitative thought to prepare for the 1 per cent chance events. Investors should make risk management a much more holistic process by taking a step back and thinking things through.
Fourth, transparency in corporate governance and financial reporting is always a good thing, and the reverse is almost always a bad thing.
If you can’t understand how a company is making money then you shouldn’t buy its stock.
And last, an effective culture is critical to the long-term success of any company — those which focus on their clients’ interests will do better than those who don’t.
Robert Gensler is a portfolio manager for the Global Equity Strategy, T Rowe Price.
