Some Stocks May Actually Benefit From Slow US Growth

By James Kostohryz  AUG 03, 2010 8:45 AM

Good fundamental stock pickers may have the best shot at investment success under a scenario of slow GDP growth in the US and developed world.

 


It's become part of the conventional wisdom to assume that the US is facing a decade or longer of slow GDP growth. However, even if this proves to be true (I take no position on that issue here), this doesn't mean that equity markets will necessarily become boring or that there will be few opportunities to make money in the stock market in the coming years.

Indeed, over the course of the next decade, certain types of stock investments should do extremely well despite, or even because of, slow growth in the US. Investors that comprehend these trends may be able to do extremely well.

Emerging Markets Stocks

The first group of stocks that could benefit powerfully from slow rates of growth in the developed world are emerging market stocks.

Low growth implies low interest rates and abundant liquidity. If the demand for corporate financing (equity and debt) is low in the US and the developed world due to muted growth, and if returns on capital are low due to the relatively low demand for capital, liquidity will tend do flow to markets where there's a greater demand for capital (equity and debt) and where returns are perceived to be potentially greater.

One of the defining characteristics of emerging market economies is the scarcity of capital. Thus, some of the primary beneficiaries of abundant global liquidity and low interest rates will be emerging market companies that will finally be able to acquire the necessary funding to finance high-margin and high-growth business plans. This bodes very well for emerging markets investing.

Growth Stocks

There are several reasons why growth stocks (including many emerging market stocks) should do well in an environment of slow growth in the US. This might seem contradictory, but it's actually quite logical.

First, slow growth implies low interest rates, slow overall EPS growth rates, and low overall rates of return on investment. Under such circumstances, many investors will feel compelled/tempted to achieve greater returns by venturing a bit further out on the risk spectrum. Investors will “stretch” for growth, thereby causing the PEs of growth stocks to expand.

Second, the scarcity of growth will make growth more valuable. The result is that the PE’s of growth stocks will tend to expand. It's the law of supply and demand.

Third, low interest rates favor high duration over low duration. Growth stocks have relatively high average durations and value stocks have relatively low average durations. Why? In the case of growth stocks, a greater proportion of their cash flow and therefore value is derived from the out years. Low interest rates favor high duration over low duration -- growth versus value -- because cash flows further out in the forecast are discounted at a lower rate. Thus, low interest rates cause more multiple expansion in growth stocks than in value stocks. Fourth, growth stocks are favored disproportionately by low interest rates given the relative capital intensity of their business plans. Mature companies aren't expanding their capital base by much and generally require capital only for maintenance of their existing capital base. Mature companies tend to fund their maintenance costs through internally generated cash flow and therefore don't require outside financing. On the other hand, growth companies require large amounts of capital (derived from debt and equity markets) since they're expanding their operations. Low interest rates favor virtually all companies. However, growth companies are benefited disproportionately.

How Can There Be Growth Stocks If GDP Growth Is Slow?

First of all, slow growth in the US doesn't imply slow growth all over the world. For example, despite very slow projected growth rates for the US and Europe in 2010 and 2011, the average rate of projected growth in the developing world for 2010 and 2011 is well over 5% per annum. Some of this growth is due to demography. Most of it is due to improving productivity, which in turn, is driven largely by capital availability. High GDP growth rates in less developed countries imply that many companies in those regions will be growing their revenues and earnings rapidly.

Second, if we focus on US equity markets, the fact of the matter is that a large portion of the earnings of publicly traded companies in the US -- probably over 30% -- are attributable to foreign sales. This percentage has been growing very quickly over the years, and particularly sales to emerging markets. For technology companies, the global sales figure is around 50% and growing. Thus, many US-listed companies will benefit from growth in emerging markets. Many growth stocks in the US will be growth stocks precisely because they sell a major portion of their goods and services outside the US where demand is growing fastest.

Third, in a mature economy characterized by slow growth and low margins, the demand from companies for cost-saving and efficiency-enhancing technologies will be acute. In go-go times, inefficiencies can be masked by high revenue growth. But when revenues are stagnant and competition is fierce, profitability must be attained through efficiencies. And this is where technology companies come in. In many ways, in a slow-growth environment, the demand for technology won't wane -- it will actually be enhanced. Furthermore, given the relatively low cost of capital, companies will feel that they can afford to be aggressive in acquiring efficiency-enhancing technologies and they'll thereby fuel high-tech product demand. The bottom line is that many high-tech companies that fulfill the corporate need to increase efficiency will be able to attain high growth rates. Fourth, the fast pace of technological change creates its own demand in the consumer space. Human beings are always going to want the next best thing. That is simply human nature. And no amount of economic malaise is going to change that. People are going to continue to do whatever it takes to acquire the latest compelling tech products as they're brought to market. These products are perceived to add value (including status) to people’s lives. There's no end in sight to the innovation cycle in consumer products. Therefore, growth opportunities will abound in this space. It's possible that the life cycles of many consumer companies may be shortened, but this will only occur as a result of new companies growing at very fast rates.

What Gives?

If we take as our premise that GDP in the US will grow slower in the next decade or two than it did in the previous three decades, then it seems counter-intuitive that there would be many growth stock investment opportunities. Simple arithmetic suggests that something must give.

This observation leads us to a key insight. If it's true that many companies will grow briskly in the face of slow GDP growth, then the pace of change and disruption in the future must necessarily be extremely high. For example, if companies that make high-tech gadgets are growing fast in the face of low-income growth, then other companies in the economy must be contracting or even disappearing. Here we may distinguish between two types of scenarios that should become commonplace.

One scenario involves old-line companies providing traditional goods and services either contracting or going out of business. Examples: newspapers, fixed-line phones, paper books, physical toys and games replaced by online content, cell phones, e-books and online articles, and computer games. The growth of Google (GOOG), Apple (AAPL) and Nintendo will come largely at the expense of the traditional companies. Therefore pace of change will be high and the amount of growth stock opportunities will be high even though GDP growth will be slow.

The other scenario involves shortened corporate life cycles among growth companies. In the old days, a single consumer product innovation could assure profitability in a company for decades (think of toothpaste, toilet paper, diapers, etc). Today, a single product innovation might assure you a year or two of profitability at best. Thus, a slow GDP growth scenario in a world of rapid technological innovation implies a great deal of cannibalism amongst high-tech companies. This means that many high-growth companies will indeed appear on the scene and provide opportunities for long-side stock pickers. The problem is that many of these same companies will also disappear fairly quickly as new innovators displace them. This will provide opportunities for short sellers. Stock Pickers Could Make a Comeback

In a prosperous economy where “a rising tide lifts all boats,” returns among investments may tend to be undifferentiated. But in a dog-eat-dog world of the future in which growth and profitability are difficult to come by, there will be greater differentiation among winners and losers. Fundamental stock pickers, long and short side, should be able to thrive in such an environment.

Furthermore, in a prosperous economy, index funds, quasi-index managed funds, and broad ETFs provide a lazy means of achieving acceptable returns. In a scenario of low GDP growth, the returns on index funds, quasi-index managed funds, and broad ETFs will be concomitantly low. In addition, commissions and fees will represent an ever greater portion of the meager returns thereby negatively impacting the attractiveness of these investment vehicles.

Finally, a slow-growth scenario in the developed world will probably imply a general tendency towards dampened stock market cycles, once the current adjustment phase is completed. Think of the 1960s and 1970s. This implies less value added from market timing strategies employing index funds and ETFs as the primary investment vehicles. Conversely, the implication is more value added derived from stock-picking strategies that employ individual stocks.

A potential consequence of the aforementioned trends is the return to prominence of the fundamental stock picker. A premium will be placed on professionals that are able to pick out winners from the losers among individual stocks and who are able to value equities correctly.

Conclusion

US GDP growth might potentially slow in the next few years as a result of demographic forces and/or as a result of debt reduction, but it won't happen because of a slowing pace of technological change. Due to the nature and stage of the current technology dynamic, the pace of technological change will only continue to accelerate.

Similarly, slower growth rates in the US and the developed world due to demographic factors and high debt won't stop growth in developing countries where demography is more favorable and debt levels are low. It will also not stop the citizens of less developed countries from aspiring to achieve the standard of living enjoyed by people in the developed world. Indeed, the high availability of global liquidity implied by the demographic and financial situation in the developed world implies the opportunity for high GDP growth rates in the developing world that's starved for capital.

In sum, certain types of growth-oriented stocks, and certain types of emerging market stocks in particular, should be major beneficiaries of a slow growth environment in the US and the developed world. Good fundamental stock pickers (an extremely rare breed in any age) should be able to thrive in such an environment.

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No positions in stocks mentioned.

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