Central banks are only part of the solution.

Disruptive influences are here to stay, investors should “look to the evidence”, says global investment manager

“Gone are the days when central banks could pull the levers and set global economies on the right course. Their actions still have an effect, but they have clearly failed to resolve many of the fundamental problems facing world economies post GFC.”

This is the view of John Birkhold, Partner at global investment manager, Origin Asset Management, who yesterday warned investors to take new technologies seriously in their search for investment performance.

Following the GFC, central banks adopted policies which, in Origin’s view, failed to address the real issues facing many developed economies. Aggressively accommodative monetary policy, like quantitative easing in the US, may have staved off disaster in the short term, but is likely to have far-reaching, longer term negative consequences in many cases.

“Together, low interest rates and ample liquidity have allowed many struggling economies to put off addressing the difficult re-structuring decisions that need to be made. And more than that, I would argue that the actions of central banks are in fact creating some of the same economic conditions which led to the GFC in the first place,” Mr Birkhold said.

Nonetheless, investors understand that they must make their calls based on the world they are faced with and not the world they would like to have. And if innovation and disruptive technology are here to stay, the challenge lies in identifying the companies most likely to create wealth for their shareholders going forward.

According to Mr Birkhold, by its very nature, disruptive technology is deflationary and, as with all major change, there will be both winners and losers as a result.

“The consumer often wins as technology becomes better and cheaper, whereas previously profitable companies see barriers to entry diminish and previously profitable markets dissipate. This is particularly true for organisations stuck in the middle of flattening business environment and find themselves disintermediated,” he explained.

Mr Birkhold went on to say that relying on actual evidence and analysing individual companies using a bottom-up approach is the best way to trying to identify long term winners. Origin is invested in a number of areas where current trends appear supportive, including:

• Home builders in the UK, which continue to be relatively cheap while exhibiting strong underlying fundamentals.
• Parts of the global auto industry also appear attractive thanks in part to increasing demand for cars in some markets, as well as technological innovation.
• Information technology firms in industries such as smart phone supply chain, the “internet of things” and cloud-based software providers.
• Bio-technology, which is being helped by aging demographics globally and also from significant advances made in the treatment of chronic disease such as Hepatitis C and prostate cancer.

Mr Birkhold concluded by saying that investors should not fixate on central bank manoeuvrings and instead should try and identify firms that will be able to survive and even prosper in the intrinsically deflationary environment that the developed world is likely to face for the foreseeable future.

“And for my money, firms that are able to adapt and innovate will be the ones that will most likely create significant wealth for their shareholders going forward,” Mr Birkhold said.

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Investors need to stomach fluctuations and understand that’s the price you pay for the performance of premium equities

If investors are to continue capitalising on the gains achieved since the depths of the global financial crisis, they should think twice about trying to remove volatility from equity portfolios.

So says John Birkhold, partner at global equities investment manager Origin Asset Management, as part of a broader analysis of recent global equity trends and their implication for investors.

“Rises in global equity markets over the past 5 years can be attributed to normalisation post GFC. Investors who weathered the freefall and subsequent volatility have seen their equity investments rise on a per annum basis in the order of 10-12% since the GFC market lows,” explained Mr Birkhold.

“In this new “normalised” environment, investors with a long term horizon should continue to favour equities over other asset classes due to the substantial premium on offer. The trade-off is that they must accept equity volatility. That doesn’t mean buy and hold at all costs or not selling overvalued stocks, but it does mean stomaching fluctuations and understanding that it’s the price you pay for the performance premium equities have historically provided,” Mr Birkhold explained.

Mr Birkhold went on to stress that conversations about “winners and losers”, whether these be sectors or regions, can distract investors from focusing on hard evidence rather than prevailing opinion – to their peril. In essence, harnessing volatility through prudent and careful stock selection is the key to success.

“It is well-known that when views about certain regions or sectors take hold, markets can overshoot as investors take their eye off of current fundamentals and lead to periods of volatility,” Mr Birkhold said.

One recent example is the focus on emerging market stocks in the post GFC period. Many investors favoured the region at the expense of developed markets in order to try and capitalize on perceived superior GDP growth prospects. What investors failed to identify was that many emerging market companies were over-spending and accepting incrementally lower returns on their investments.

“In many cases, the reason for this was that companies were either state owned or controlled. And the imperatives which drive state decisions, such as creating jobs and increasing the tax base, are not always consistent with profitable growth,” Mr Birkhold explained.

Another recent example is in the IT sector which has recently experienced a severe sell-off in so-called ‘momentum’ stocks, as investors became spooked that some of the prices being paid for not-yet-profitable technology companies indicated a move into bubble territory.

“A good example of this is the proposed purchase by Facebook of WhatsApp for the staggering sum of $19 billion in cash and stock,” Mr Birkhold said.

“WhatsApp currently has very little revenue, only 55 employees and does not appear to be cash generative, so it’s not surprising that the market was unimpressed with the price tag.”

Mr Birkhold went on to say that whether or not the sale price of WhatsApp is justified remains to be seen.

“What we can be sure about however is that current competitive landscape for most industries is changing at an increasingly high rate. Barriers to entry are falling dramatically thanks to innovation-driven disintermediation and disruption, and this will continue to make life difficult for many CEOs. So, considering the impact of new technology from an investment standpoint means evaluating not just what kind of revenue a new entrant might generate, but also losses that legacy companies might incur as a result.

“In the WhatsApp case, some analysts predict losses to revenue for traditional telcos in the region of $50 billion per annum, as users adopt WhatsApp’s free messaging technology. This helps put Facebook’s offer into perspective,” Mr Birkhold explained.

In conclusion, Mr Birkhold said regardless of prevailing market sentiment, achieving strong performance in equity markets remains a case evaluating available evidence, and not being unduly influenced by perceived market trends or popular opinion about likely winners or losers.

“Equities continue to offer opportunities for reasonable returns, but investors must take a long term view, which means maintaining a focus on what is likely to drive wealth creation over time, while understanding that periods of short term volatility are inevitable,” Mr Birkhold said.

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John Birkhold, based in Sydney, is a partner of Origin Asset Management (‘Origin’). He is a member of Origin’s global investment team and is responsible for developing Origin’s business in Australia and the Asian region. Origin is one of Principal Global Investors’ boutique fund management partners.

According to Mr Birkhold, in addition to the looming issue of taxation reform, a number of areas are worthy of investor attention. Likely upcoming activity in the banking and healthcare sectors are among them. 

“One place to start is the likely effect of a Democrat victory on banking policy and the flow on effects of that,” said Mr Birkhold.

With four more years of an Obama administration now a certainty, Mr Birkhold pointed out that Federal Reserve Bank head, Ben Bernanke, should have the choice of staying on – and if he does, that the Fed may well continue the Bernanke policy of retaining unprecedented control of both ends of the yield curve.

“By that I mean explicit control in the short term through setting interest rates, but also in the longer term through purchases of the majority of US Treasury bond issues,” explained Mr Birkhold, “The net result of such a policy may well be a continuing of the four-year trend in favour of ‘hard assets’ such as gold and silver, a possibility that investors may wish to consider as they plan for the future.”

The Democrat win also ends speculation regarding the future – and potential unwinding – of major pieces of legislation such as the Dodd-Frank banking reforms and the institution of the so-called ‘Obamacare’ healthcare reforms.

“With both now emphatically here to stay, there’s no more holding back or uncertainty. For many investors this means it’s time to consider their potential practical implications,” said Mr Birkhold.

When it comes to Dodd-Frank, Mr Birkhold said that investors may wish to factor in a possible dual result: a fall in share prices as the banks are forced to divide their operations between their lending and deposit taking and investment arms; and, conversely, an increase in profitability due to the flow-on effects of Bernanke retaining his position and associated policies.

“Some investors and commentators may argue that the falls in bank share prices are a knee jerk reaction that’s counter to the longer term profitability outlook and as a consequence may be looking closely at buying opportunities,” said Mr Birkhold.

On the healthcare front, investors are also confronted by a mixed bag of possible outcomes. 

“In the first instance it does seem that there will be winners and losers as Obamacare unfolds. In the near term there are concerns that insurers will be feeling strain as they are forced to bring on a large number of the uninsured with potentially questionable risk profiles,” explained Mr Birkhold.  “Because of the tax funding model of Obamacare, medical device companies are also likely to feel the pinch as higher taxes to fund the initiative come on stream.

“On the other hand, you have those hospital companies that no longer have to bear the losses of taking on non-paying patients and may therefore experience an uptick.”

Mr Birkhold then observed that, lying somewhere between these camps are the pharmaceutical companies, which while likely to experience increased demand as a result of wider funding of healthcare needs, may also feel the effect of the consequent inflows of cheaper, generic products.

“All of this will of course be taking place against the broader backdrop of Congress’s attempts to come to some kind of compromise in relation to taxation reform and the so-called ‘fiscal cliff’,” concluded Mr Birkhold.

“The fact is that there has been no meaningful tax reform in the United States since 1986. There is now a real opportunity for much needed reform and simplification of an extraordinarily complex and burdensome body of law. If there can be no agreement, we will be looking at four more years of uncertainty. Hopefully, wiser heads will prevail.”

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