Let’s start with some examples from the macro context.
The problem with Quantitative Easing (QE2 in the US) that aims to reflate asset prices through money creation is that the benefits are front-end loaded; the risks are masked or ignored and the costs (or unintended consequences) are back-end loaded so overall you are giving the impression of progress but the danger is that you are simply running fast to stand still.
Shift priorities
In Europe, the eurozone provision of liquidity and the shift of private to public debt can only be used to buy time; trying to solve a debt problem by replacing or adding new debt on unchanged terms (avoiding default) only keeps the show on the road but there is no genuine movement forward until the problem of insolvency is resolved.
It is hard to make progress in a crisis unless politicians face up to creative destruction and new, proactive ideas for moving forward. It is what Jack Welch, the past CEO of GE used to call “defining reality” to both face up to and then address a crisis.
The context for companies operating in the US and Europe is a demanding one. The consumer is deleveraging and end demand in some areas is subdued. Competition is fierce for whatever growth there is to be found.
Turning to the corporate sector, their profit share as a percentage of GDP is well above the long-run average and operating margins of the main US indices are at highs. For 20 years there have been a number of areas helping overall profitability – improving EBITDA margins; reduced capital needs and low taxation. It is plausible that we should question ‘top down’ how these drivers of overall profitability could possibly continue to all be beneficial.
Margin calls
Another aspect that came out of our recent trip to the US is the key bottom-up fundamental issue was sustainability of growth and margins.
Companies were working very hard to access new avenues of growth to replace declines or stagnation in domestic US or other developed economies. Companies were also facing multiple challenges to margins: cost cutting already done; innovation was getting tougher; input costs rising; supply chains as lean as can ever be; competition fierce where any growth is; pricing power getting tougher.
Many aspects of why profitability had improved in recent years were now in question: emerging markets as a source of better/cheaper production processes or cheap labour; more value-oriented customers; altering supply/demand dynamics; efficiencies already squeezed out and capital expenditure already tightly managed.
We were struck by how important it was to try and find characteristics of top line growth: margins steady or expanding; good working capital management; solid cash conversion; sensible leverage and good free cash flow. These characteristics are not in abundance, even less so at an attractive price for equity.
Corporate headwinds
There were some stand-out examples of the pressures above in the large US companies operating globally. The household and personal products sector includes Colgate-Palmolive; Proctor and Gamble; Kimberley Clark; Unilever and Estée Lauder among others. Meeting these companies brought to the fore the demands of continued cost cutting: ever increasing innovation; the rise of input costs and fierce competition.
We remain of the view that there exist a significant number of headwinds for companies, both in the context within which they operate and within the dynamics of their own industry and business model. Consequently, we have focused ourselves on fundamental drivers and on stock specifics for the past six months. The themes we use as filters have not changed and our work has been highly selective and company-specific.
