How Innovation Creates Opportunities Late In The Cycle

Karen B. Hiatt | 05/10/2017
Learning about tech and using a 3D Printer

Summary

In high-priced markets, there are good reasons to look for innovative companies that thrive on disruption. Karen Hiatt says many are highly valued with good cash flows because they have essential products and services, which could bode well in a downturn.

Exiting too early can lead to loss

It is hard to ignore the fact that the US equity market is trading near record highs, with the S&P 500 Index more than tripling in value since its 2009 lows and price-to-earnings multiples near all-time peaks.

While some investors are still enjoying this run-up, others worry they might hold on too long. There is of course no way to identify the best time to buy or sell, but it is important to point out that some of the largest gains in an investment cycle are left to the end. Exiting too early can mean a sizable loss of opportunity.

In addition to maintaining one’s positions, there is another approach for investors to consider late in an economic cycle: Investing in companies that thrive on disruption can create significant value for their customers. Many of these firms are highly valued precisely because they have vital products and services that consumers consider essential, which could bode well in a downturn.

Innovation drives value

Consider for a moment the productivity-enhancing high-tech innovations that powered the growth of social media, cloud computing and ecommerce. These disruptive technologies triggered an interesting inflection point that is very different from the one seen during the tech bubble, which was fueled by red ink. Today’s most innovative companies have growing levels of free cash flow and the ability to drive their own profitability expansion, which makes them that much more valuable to customers and shareholders alike.

For example, the largest social media advertiser in the world continues to add value for its customers by improving the visibility of returns for every ad dollar spent. As advertising budgets become tighter in a downturn, their clients are more likely to invest their last ad dollars in a channel that can target engaged consumers and generate sales.

Also consider the largest providers of cloud computing, who offer the opportunity to reduce costs and increase productivity without requiring their customers to invest big capital budgets behind massive data centers and enterprise integrations. This flexibility is exactly what their customers need as economic tailwinds subside, when they look to optimize costs.

Finally, the largest ecommerce company in the world continues to invest in new services to improve the value of its annual membership: music, media, free delivery, books and digital storage. So when it raises subscription prices by 25 per cent in a single year, after many years of adding content to its service, there was very little pushback from customers even as the company enjoyed a significant boost to revenues.

The importance of active stock selection

Clearly, there are many options for managing portfolios in the later stages of an economic cycle. Shifting portfolios to more defensive sectors or cash is one traditional option, as is investing across a broad basket of securities to improve diversification.

However, given that a rapidly falling market has the ability to drag down entire asset classes, an active, focused approach may be beneficial during the late stages of a bull market. While no investment strategy can guarantee a profit or protect against a loss, investing in companies that offer differentiated consumer services and measurable returns could add the diversification investors need as the debate over market tops intensifies.


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Expert-Image

Karen B. Hiatt

CFA, Managing Director, Senior Portfolio Manager, CIO Focused Growth Equities
San Francisco, California
Ms. Hiatt is a senior portfolio manager, a managing director and CIO Focused Growth Equities with Allianz Global Investors, which she joined in 1998. Ms. Hiatt manages all focused-growth strategies. Prior to joining the team, she served as a senior research analyst, sector head of the US Consumer team and US Director of Research. Ms. Hiatt was previously a vice president and analyst at Bioscience Securities, a boutique investment bank. She has a B.S. in finance, cum laude, from Santa Clara University. Ms. Hiatt is a CFA charterholder and a member of the CFA Society San Francisco.

UK Election: Uncertainty Piled on Uncertainty

06/13/2017

Summary

The election was never going to put an end to the uncertainty facing the UK, given Brexit and the deteriorating economic picture. But the result piles uncertainty on uncertainty.

Key Takeaways

  • The UK election result may augur a more pragmatic approach to Brexit and increase the likelihood of a "soft" Brexit, perhaps even retaining access to the single market.
  • Our high-conviction view is that the Bank of England will put rate rises on hold for the next 2-3 years, or longer. The election reinforces such a view.
  • Speculation about another election puts downward pressure on sterling but economic data is likely to be the key driver.
  • A weak government or coalition probably means that fewer contentious manifesto pledges can be enacted – although there may still be action on utilities.

Initially billed as a tactical shoo-in for the UK Prime Minister, Theresa May's decision to call a snap election turned into a high-stakes gamble. One that failed to come off. Mrs. May called the election with the express aim of securing a stronger mandate – and bigger parliamentary majority – going into the Brexit talks that are due to begin on June 19 .

Instead, her Conservative party was left with insufficient seats to secure an overall majority. The result: a hung parliament.

In other words, a very different picture to the one anyone envisaged when Mrs. May emerged from No.10 Downing Street on April 18 to announce the election.

What went wrong for Mrs. May? She led a disastrous election campaign – compounded by opposition Labour leader Jeremy Corbyn's strong performance on the campaign trail, galvanising his core vote and attracting new, younger voters. He increased his party's share of the vote more than any other Labour leader in any election since 1945.

The Conservatives are likely to lead a relatively weak government through a deal with the Democratic Unionist Party in Northern Ireland.

Mrs. May's position is weakened and she may be replaced as leader of the Conservatives. Her credibility to negotiate Brexit is seriously undermined.

Investment implications

'Hard' vs. 'soft' Brexit, and the future of the wider United Kingdom
The exact Brexit implications are not immediately clear, although the result may augur a more realistic and pragmatic approach. Any deal will now have to be ratified by parliament, rather than simply waived through on a Conservative majority. But the process will be even more complex. The path of the Brexit negotiations will depend on the actions and views of the other 27 EU member states, and the two-year deadline for completing Brexit looks increasingly challenging.

The chances of a soft Brexit may have risen, which should be seen as positive. The dangers of a hard Brexit, with the UK failing to secure a trade deal – and having to rely on World Trade Organization rules instead – have diminished. Many hard Brexiteers preferred this route on day one, but it is fraught with uncertainties for almost all industries.

Elsewhere, the second Scottish independence referendum now seems very unlikely in the short term. The "Conservative and Unionist Party" fought a successful campaign focused solely on preventing a second independence referendum – the so-called IndyRef2. Labour also won back some seats from the SNP.

Sterling should remain fragile, although economic data will be the key driver
The British pound sterling was down more than 2 percent in the immediate aftermath of the vote. Markets had been trading on the dynamic that a larger majority would mean a better negotiating stance for Mrs. May and a softer Brexit. This was perhaps a false assumption, but in any event we now are in a new and unexpected environment.

Any possibility of another election – and uncertainty over who will lead the next government – puts downward pressure on sterling in the short term. Gilt yields are likely to rise somewhat.

Our high-conviction view is that the Bank of England will put rate rises on hold for the next 2-3 years, or longer – especially with gross domestic product growth falling back and household spending slowing as higher inflation bites. The election reinforces such a view, and this is ultimately negative for sterling. But we would need to see economic data continue to soften for sterling to weaken materially again.

Signs of a softer Brexit – and potentially a faster Brexit if the UK were to remain in the single market – would be good news for sterling.

Conservatives will set the agenda, and sector implications will be limited
Domestic stocks will be weak, but perhaps not too soft in the event that the Conservatives continue to lead the government. International earners (i.e., large parts of the FTSE 100) are likely to be stronger.

A weak government or coalition probably means that fewer contentious manifesto pledges can be enacted. Policies would face more parliamentary scrutiny, and this may mean proposals track more closely to the centre ground. And the uptick in voters aged 18 to 24 suggests that the younger generation are intent on making their voices heard in the democratic process.

There will be a risk of economic weakness from higher uncertainty. Higher bond yields may put a constraint on policy and spending, and investment into the UK could suffer from uncertainty –although, again, it will depend on how Brexit negotiations go.

Policy on reforms of corporate governance may take a back seat for a while, especially if May is no longer leader.

Looking at specific sector themes, price caps or other intervention on utilities may also be pushed back. But given that these fairness topics resonate with both main parties, we would expect some policy intervention on utilities.


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