European equities
07 Dec 2016 | By Ian Ormiston

Let’s stick to the knitting

Sometimes politics influences economic factors, sometimes it does not. Former President Ronald Reagan was a great champion of supply-side economics, using the work of leading economists such as Friedrich Hayek to provide theoretical justifications for his political actions.

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Sometimes politics influences economic factors, sometimes it does not. Former President Ronald Reagan was a great champion of supply-side economics, using the work of leading economists such as Friedrich Hayek to provide theoretical justifications for his political actions. But I have to admit to a sense of frustration that has been growing steadily all year whenever anyone starts to talk to me in the workplace about politics.

Remind me, at what point did we all become self-styled experts, ready to voice our opinions on issues ranging from Brexit, Trump, the Italian referendum, and the likely fortunes of Marine Le Pen in next spring’s French presidential elections? At what point did stock market chatter over corporate earnings, valuation multiples, and a hearty debate on a company’s outlook make way for the latest opinion-poll gazing? 

Up until very recently, when Mariano Rajoy was returned as prime minister of Spain, the country was without a government for over 10 months. In that time, Spanish GDP growth did not stop, registering 0.8% in the first two quarters of 2016 and marginally lower growth of 0.7% in the third quarter. A prime example, if ever there was one, of there often being no link whatsoever between politics and economics.

Nor is the correlation between underlying economic growth and the performance of equities clear-cut. A company’s earnings are not analogous to GDP growth. Just because an economy is doing well, or badly, does not necessarily mean stock markets should follow the same fortunes.

Just to reinforce the point when looking at smaller companies, here’s how it works in practice. The profitability of Prosegur, the Spanish securities and cash management business, is dependent on the growth in the European alarm market and the cash-in-transit market in Latin America. Revenues for another Spanish group, Viscofan, the sausage skin casings’ manufacturer, are driven solely by the global demand for protein. Get the picture?

Irrespective of the economic landscape, our investment strategy, a blend of value and growth styles, favours companies benefiting from structural growth situations, turnaround positions and cyclical businesses; admittedly the latter are more related to the fortunes of the economy.

A good example of the structural growth theme is in the area of European outsourcing. Large companies, constrained by red tape, have achieved greater flexibility using this method across a wide range of industries, including IT, engineering, software and automotive systems.

Turnaround situations are a particular feature of European building material manufacturers. An industry known for its operational gearing, companies have continued to pare down costs since the global financial crisis. When sales eventually reach levels more akin to their long-term average, bottom line growth should be significant.

At the start of each year analysts tend to start with optimistic forecasts for European earnings growth, only for them to be continuously downgraded in subsequent months. So when I say that growth for European smaller companies for 2017 should be around mid-teens, colleagues start to look sceptical.

But here’s the mathematics. Rising employment is continuing to propel the eurozone region towards 2% growth. Add 1% inflation, the effect of prior year acquisitions, and the general growth premium of smaller companies gets us to around 6% revenue growth. Then add in falling input costs, some acquisition benefits and a dollop of operational gearing and there you have it. An asset class which, despite all the political shenanigans going on around it, is managing decent growth.

So, next time you are tempted to talk politics, opinion polls, and the vagaries of the US Electoral College system, try restraining yourself, however tempting. No one knows how key political events are going to transpire, just as much as no one knows what the stock market’s reaction to those events is likely to be. As investors, let’s try to stick to the knitting and focus on company fundamentals.

 

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