Investors misunderstand the potential of this kind of company because they are constantly recalibrating what they see right in front of them, grazing on the same short-term information, without ever really looking to the longer-term horizon which will ultimately determine the success of their investments.
Data shows security analysis is biased to the next two years, with a dramatic falling off of the number of earnings estimates for subsequent years. This is important because it suggests that portfolio managers are not really interested in determining which companies have a sustainable competitive advantage which can be expected to manifest itself in superior returns relative to their peer group.
As a consequence, some analysts do not have a clear understanding of the long-term drivers of returns within a particular industry or how they will be impacted by the long-term macro trends reshaping the global economy. Instead, they tend to fall back on a mean-reversion model which inevitably understates the competitive advantage of market leaders.
Industry winners
As a result, real industry winners are undervalued by the stock market. Goldman Sachs pointed out in a recent strategy piece on this topic that the gap between first quartile returns and fourth quartile returns is widening and the average time that market leaders are sustaining their advantage is lengthening. For an investor, highlighting industry winners and patiently holding the shares of these companies is as sensible a strategy as ever.
A key reason why sticking with winners makes sense is the widely understood, but oft-ignored power of compounding. Persistently higher-than-average returns on equity and revenue growth allow companies to re-invest the resulting cash flow into generating yet more superior returns and revenues, which is even more relevant in today’s post-financial-crisis world. Over time, this allows industry winners to put clear blue water between themselves and their peer group.
In my view, there are three sectors in particular where investors are ignoring excellent long-term prospects by over-emphasising short-term issues. In the first of these, the banks, I believe that the strongest franchises are already delivering premium returns on an underlying basis contrary to the established bearish view.
Earnings
Our analysis of recent trading statements points to stronger underlying returns on equity, which seems inconsistent with the consensus opinion that there has been a fundamental deterioration in the sector’s earnings power. On the contrary, I think that recent earnings disappointments have predominantly been driven by management choice and short-term interest rate levels which have wrongly been treated as permanent in market forecasts.
Second, commodity shares trade on low earnings multiples despite an obvious secular growth in demand, especially from the industrialising emerging world, a lack of leverage in the sector and little sign that supply can rise quickly enough to normalise the market in any reasonable forecasting period.
Again, the market is focusing on short-term issues such as efforts by the Chinese authorities to cool domestic inflation and an imminent rolling over of leading indicators in western economies and failing to adequately price in the long-term earnings potential of the sector leaders which control the most valuable resources.
Finally, in support services, the long-term case for outsourcing – UBS claims that the current £80bn UK market for government outsourcing represents less than 30% of the potential – and the fact that Capita and Serco are in some areas the only real choice is at odds with the valuations of these two companies. Again, the market has focused excessively on short-term pricing pressures at the expense of the long-term volume growth argument.
I think the time has come when investors – in particular those who are now less comfortable with their exposure to sovereign risk – will see the long-term earnings and dividend growth prospects of industry winners as an attractive home for their money. In the UK, we are fortunate that so many of the world’s global winners have chosen to list here.
