Views from the Floor - Survival of the Fittest Company as Pricing Power Falters

It is not surprising that the last five years – marked by pandemic, wars, inflation, high borrowing costs - have seen significant stock market rotation where regional, sector-related and thematic considerations have been in the ascendant.

So-called “style factors” have also been in the driving seat. An abnormally low risk-free rate of return drove valuations higher for longer-duration or growth-oriented names, only for a correction to ensue when sovereign debt yields shot up again (Figure 1).

We believe this ding-dong rotation is largely behind us. For example, it seems as if we are settling into a period of relatively stable bond yields, led by a Federal Reserve unlikely to make any material changes to its benchmark borrowing rates.

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But, more importantly, we expect there to be a significant divergence in share price performance between companies, almost irrespective of whether they “belong” to a style (e.g. growth vs value) or sector. In other words, share price performance is likely to be increasingly defined by each company’s idiosyncratic fortunes and its ability to navigate a difficult world.

There is nothing new to intra-sector or intra-style bifurcation; indeed, it remains alive and well beneath the surface of the last five years’ broad-brush strokes. But we have reason to believe that dispersion is about to play an even bigger role.

Why so? Because earnings growth has of late been flattered by an outbreak of corporate pricing power which came on top of a post-pandemic rebound in demand. Both higher prices and volume growth combined to boost top lines and margins thanks to operating leverage.

Companies have exhausted pricing power

When faced with higher input costs, companies were determined not only to defend their gross profits, but also their gross margins, citing exceptional circumstances. Such arguments are becoming stale, with growing resistance from customers and increasing evidence of demand elasticity into a stalling economy. Pricing power is now largely exhausted while cost pressures persist, most obviously relating to labour where skills shortages are increasingly structural rather than cyclical.

We thus expect margin erosion to stymie earnings progression across our equity universe. Debt servicing costs will also not lend themselves to any relief below the EBIT line in a stable rate environment. Meanwhile companies are operating in a geopolitically challenged world where de-globalising or multi-polar forces have already led to desynchronised growth. A Trump presidency would only accentuate such an environment.

Given that we cannot rely upon higher equity valuations, particularly in these uncertain times, we must instead look to earnings growth as the future driver of equity returns. But, as we have argued, robust and repeatable earnings expansion is going to be hard to find. But search we must.

Which characteristics are likely to enable companies to be on the right side of the likely bifurcation between the winners and losers in an increasingly Darwinian world?

Controlling their own destiny

These will be companies which control their own destiny and rely little upon the macro-economy or any sense that all boats rise. Market share expansion will lie at the heart of this, as rare companies harness a unique set of competitive strengths when winning business.

For some companies it is part of their DNA to exhibit genuine pricing power when others are losing theirs, thanks to highly innovative product or service offerings which bring measurable benefits to their customers. ASML's new Twinscan NXE:3800E EUV lithography tool is purported to come with a throughput of 220 wafers per hour, an uplift of 37.5% versus its predecessor. 

Ferrari has just unveiled the 12Cilindri, the successor to the 812 Superfast, which comes at close to a 30% higher price thanks to its revamped design, next generation interior and elevated horsepower.

L'Oréal's Dermatological Beauty and Luxe divisions are at the forefront of serum and formula development in premium skincare, innovations which ultimately cascade down to its largest division which serves the mass beauty market, underpinning the premiumisation which drives mix improvements and higher selling prices.

Agility and regional breadth

But, on top of this, agility and regional breadth will be qualities that come to the fore. Companies which rely too heavily on one region will be vulnerable in a de-synchronised world characterised by trade disputes and currency volatility. Both revenues and production need to be diversified. A good example is the speed with which L’Oréal pivoted its advertising and promotional spend from a slowing China to Europe, a dexterity underpinned by three-quarters of this communication expenditure now being digital.

Assa Abloy's decentralised structure empowers its country managers to quickly take costs out of the business when faced by a local drop-off in demand.

Investors do well to look for companies which have the financial strength to be able to reinvest back into their competitive strengths, thus reinforcing their ability to maintain the value creation which has characterised their track records. One such example is diabetes and weight-loss jab maker, Novo Nordisk for increasing its capital expenditure seven-fold over the last three years, because this is how it will widen its moat and successfully fulfil the growing demand for its products.

In summary the winning companies in a new almost Darwinian landscape will be those able to control their own growth, have genuine pricing power, demonstrate agility, and maintain a broad regional presence.

 

Modi Safe Pair of Economic Hands but Prepare for Some Period of Weakness

In elections, as in much else, India is a unique case. The 18th Indian General Election is the largest democratic operation ever staged, with almost 1 billion people eligible to vote. While the first votes were cast on April 19, the process to elect the 543 members of the Lok Sabha won’t conclude until June 4. The outcome is not in question – Narendra Modi will certainly join Nehru in serving a third term as Prime Minister – but this does not mean that the election is without interest for the investing world.

India has – finally – had some time in the sun as far as the equity markets are concerned, with the BSE SENSEX climbing relatively steadily since the COVID recovery.

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Modi’s previous two elections have seen his victories greeted with relief by the markets. Viewed as a safe pair of economic hands, his success in integrating India more fully into the global economy and addressing the most glaring structural challenges has raised expectations – as evidenced by the stock market’s significant appreciation. We think it’s possible that things may play out rather differently in the coming months.

Our base case over the longer term is for continued strong performance from India, but we need to recognise the vast distance covered over a relatively short time and the potential for some periods of weakness.

Post-election disruption

We must firstly acknowledge the inevitable disruption that comes from an election. There will be huge changes in the various ministries, the new people will need to work out how to operate in the heart of a massive and enormously complex bureaucracy. The government has already imposed controls on bank liquidity, cognisant of the possibility of being caught up in a broader global slowdown and not wishing to hit any potential speedbump travelling at 80 mph.

More than anything, expectations are high and leave little room for error. EPS estimates have been continuously upgraded over recent months. India has risen from 4th to 2nd largest constituent in the MSCI Asia ex-Japan Index. If it is not a market priced to perfection, it is not far off.

Reforms – whether balance sheet clean ups of non-performing loans or cutting of red tape – have been implemented and the benefits largely realized. There may not be so many low-hanging fruit to harvest in the coming months and years. India remains overly bureaucratic and while GDP growth has been impressive (currently running at 6.5%), the thriving economy has been unable to drive job growth. Unemployment remains a significant challenge and one that Modi must tackle if the positive momentum is to continue. Official employment figures are unreliable, but estimates place unemployment at somewhere around 8%, following a decade of what some have called “jobless growth”.

Potential for moderate slowdown

We would not be surprised to see a moderate slowdown in the near term, a slight tempering of the exuberance that has surrounded all things Indian in recent years. We also think this wouldn’t be the worst news for the longer-term outlook of the Indian economy.

India is structurally well-placed for the coming decade. Whatever your views of his politics, Modi has negotiated the move to a multipolar world with admirable adroitness. He has positioned the country well for the China +1 era and Apple is the most high-profile among a long list of global organizations striving to diversify their manufacturing base away from China and towards India.

India is also onshoring itself, seeing a burgeoning middle class increasingly buying local. Whatever near-term hurdles it needs to clear, we are confident that India’s economic story in the years ahead still has significant promise and potential to surprise.

With contributions from Rory Powe, global equities portfolio manager at Man Group, Anand Agarwal, analyst on the Asia (ex-Japan) equities team and Andrew Swan, head of Asia (ex-Japan) equities, Man Group.

All sources Bloomberg, unless otherwise stated.

The organisations mentioned are for reference purposes only. The content of this material should not be construed as a recommendation for their purchase or sale.