Background

Australia’s demographic shift is having a significant impact on Australia’s financial markets. The search for income in a low interest rate environment has seen investors, particularly the rapidly growing self managed superannuation funds, develop a love affair with high-yielding stocks.

With bond yields expected to stay at relatively low levels, the demand for high-yielding equity strategies is likely to continue. Investing in just a handful of traditional high-yielding blue chip stocks and holding onto them, may however expose investors to greater volatility than they are prepared for. An actively managed portfolio, comprising a diversified selection of traditional and non-traditional high-yielding stocks that are continually assessed for value, can help reduce this volatility.

How has Australia’s population changed?

Over the past 100 years or so, Australia’s population structure has changed markedly. In 1911, it was a typical pyramid shape – bottom heavy with the population skewed to younger age groups. By 1961, the pyramid had widened reflecting the growth in Australia’s population, particularly in the 0-14 age bracket, reflecting the birth of the baby boomers post World War 2.

By 2004, the pyramid had changed shape altogether, particularly around the middle, with the baby boomers now aged in their 40s and 50s. By 2051, the Australian Bureau of Statistics (ABS) is projecting Australia’s population structure to be more top heavy, with people aged 80 plus representing a significant percentage of the population – more than those being born (ie 0-4 years of age).

What’s causing the change in shape?

In addition to the ageing of the baby boomers, increasing life expectancy is another contributing factor causing the shift in Australia’s demographic structure. According to the ABS, the average life expectancy for females born between 2010 and 2012 is 84.3 years of age, up from 58.8 for those born just over 100 years ago in 1910. The average life expectancy for men is 79.9, up from 55.2.

A lower fertility rate is also playing an important role. Australia’s fertility rate has fallen sharply since the early 1960s. A fertility rate of 2.0 (ie two children) is considered to be the replacement rate for the population – two children replaces two parents. Australia’s fertility rate has been below 2 since the mid-1970s.

Should we be concerned?

While the 65 plus age group as a percentage of the total population is expected to increase to 27% of the population by 2050 (from 15% currently), of greater economic significance is the forecast decline in Australia’s ‘inverse dependency ratio’. The ratio of the working age population to dependents (defined as those aged less than 15 years of age and 65 plus) is expected to fall from around current levels of 2 to 1.5 by 2060.

A shrinking working age population has significant implications for the Australian economy and the share market.  An ageing population places a financial burden on the economy through higher demands on public healthcare costs and social security from retirees; while tax revenue and consumer spending is dampened due to the lower proportion of the working age population.

Japan has experienced the demographic shift already and in a more pronounced manner due to negligible immigration, persistently low fertility rates and rising life expectancy. Currently, Japan has 25% of its population aged 65 plus. Over the last several years Japanese investors have been seeking high-yielding investments around the world due to low interest rates and an ageing population seeking higher income than what is available in their own country. The Australian equity market has been a beneficiary of this demand.

What impact are SMSFs having?

The rise in grey power is impacting the Australian share market quite significantly via the growth in self managed superannuation funds (SMSFs). According to the Australian Tax Office and Credit Suisse, SMSFs received an average of around $15 billion per financial year in net inflows over the nine-year period from 2003-04 to 2011-12.

What’s concerning, is that SMSFs appear to have a distorted asset allocation with a significant bias to direct domestic equities and property.

Anecdotal evidence suggests that the direct equity exposure is limited to the big four banks and a handful of blue chip high-yielding stocks. What’s more, SMSFs are continuing to buy these stocks, regardless of value or where we are in the market cycle.

The boards of companies are becoming increasingly aware of the growth and influence of SMSFs and their increasing demand for higher dividends.

As noted above, the demographic shift will potentially lead to lower economic growth. This, together with the increasing demand for higher dividends by SMSFs could exacerbate this problem as companies feel pressured to meet their demands – at the expense of investing in their businesses.

Does this mean dividend yield strategies will continue to outperform?

This demand for high-yielding equities has obvious implications for yield-driven strategies. Over the past 12 or so years, dividend yield strategies have outperformed the broader share market by a comfortable margin.

There is a strong correlation between the change in the number of retirees and the performance of dividend yield strategies. The yellow line in the chart below shows the percentage change in retirees (with the green line representing the forecast change) and the outperformance of dividend yield strategies (blue line).  As the number of retirees has increased, dividend yield strategies have outperformed.

Sustained demand for high-yielding equities for at least the next two to three decades as the percentage change in the number of retirees continues to increase, suggests that dividend yield strategies will continue to outperform for quite some time yet.

An active, value-driven approach can help to navigate through the volatility

We would however caution against simply investing directly in a handful of well known high-yielding stocks and locking them in the bottom drawer. This is not an ideal way to invest, due to the risk that pockets of yield stocks may become more vulnerable to shocks as their valuations become stretched.

This risk is exacerbated by SMSFs, which tend to hold stocks directly in a relatively passive ‘buy and hold’ manner as well as invest in index funds and Exchange Traded Funds (ETFs).

To minimise the potential of a portfolio of yield stocks being prone to such vulnerabilities requires active analysis and continual valuation of stocks.  Well-resourced active managers, such as Nikko AM Australia, who have yield strategies but with a focus on value, is one way for investors to help navigate through this potential volatile and uncertain period. It may come as a surprise to many investors but a large portion of outperformance in our high-yield strategies has actually been derived from ‘other’ non-traditional high-yielding areas where opportunities have arisen in specific stocks, rather than the traditional high-yielding stocks.

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Disclaimer: This material was prepared and issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). Nikko AM Australia is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

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Lonsec and Milliman launch new retirement website.

Investment research house Lonsec Research (Lonsec), in partnership with global actuarial and consulting firm Milliman, yesterday unveiled a retirement website designed to provide practical and implementable solutions for financial advisers providing advice to retiree clients.

As Australia’s population ages, the funding of retiree pensions represents one of the greatest challenges facing the industry. In response, Lonsec and Milliman have developed a centralised online solution for objectives-based retirement portfolio construction innovation and thought leadership, giving financial advisers the tools and strategies to provide better retirement solutions for their clients.

Lukasz de Pourbaix, General Manager – Lonsec Investment Consulting, said despite increased awareness of the investment issue relating to retirement; there were no real practical adviser solutions in the market.

“We hear about it everywhere – an increasing number of Australians facing retirement and with that brings new investment strategy and investment challenges. However, no one has been working to provide a practical solution for financial advisers to deal with some of these challenges. We have developed an end-to-end solution to help to support advisers faced with the need to provide advice to the ever-growing group of Australian retirees,” said Mr de Pourbaix.

Lonsec Retire (www.lonsecretire.com.au) offers an extensive service to subscribers across three advice modules – Research, Solutions and Industry Panel.

The Research module provides thought leadership, such as white papers and detailed research on topics such as longevity risk, the politics of pensions and sequencing risk. It is aimed at assisting financial advisers in their discussions with clients. This module is home to the second jointly authored white paper from Lonsec and Milliman launched today, entitled: ‘Smiles, Handshakes & Farewells…..Then What? – The changing dynamics of wealth, risk and needs in retirement’. 

“For individuals, as retirement approaches, investment decisions and attitudes to risk naturally change. Building on our initial discussions, this paper looks to provide practical support to financial advisers in offering strategic advice and actively managing changing behavioural factors to produce better outcomes for clients,” said Mr Wade Matterson, Practice Leader, Milliman. 

According to Mr de Pourbaix, despite the growing number of retirement financial products in the market, there continues to be a lack of guidance around constructing objective based portfolios, hence the development of the Solutions module.

The Solutions module has three components focused on providing practical portfolio solutions for financial advisers.

“The first component is a retirement portfolio construction guide, which details the financial planning process and provides a practical guide for constructing an implementable objectives-based portfolio. The second is an approved product list that spans a broad range of quality financial products researched by Lonsec, linking directly to Lonsec’s in-depth research reports.

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SECTION I: LOOKING BEYOND THE SHORT TERM

For investors facing a life cycle of investing to fund their retirements, the task at the outset is to accumulate wealth over a relatively long time horizon. The job of the investment industry is to construct strategies for these investors that generate attractive cumulative returns over these time horizons. While numerous academic studies have demonstrated the value of long-term buy-and-hold approaches to investing,[1] the use of such approaches remain at odds with the short-term behaviour that has become increasingly characteristic of equity markets and parts of the investment industry itself.

Equity markets and investors have developed an increasingly acute focus on the short term. This is evidenced by the decline in the average holding period for stocks on global exchanges. In the US, the average holding period of a share on the NYSE was around seven years in 1940.[2] By the time of the tech bubble in 2000 it had fallen to about one year; the average holding period globally is now under three months (see Chart 1). This is only partly due to the entry of short-term, technically-driven investors; there is also evidence of short-termism among institutional investors.[3]

Source: Goldman Sachs. Average holding period of all market participants by region.

“Human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate.” – J.M. Keynes

It turns out that investors are hard-wired for short-termism. The field of behavioural finance shows us that investors are not the rational agents assumed under Modern Portfolio Theory and the Capital Asset Pricing Model. Instead, investors are subject to a range of cognitive biases that can interfere with optimal decision-making.[4]

One of the most challenging biases investors are subject to is that they value short-term gains more than they value delayed gains. Neuroscientists have shown that different parts of the brain are responsible for valuing short and long-term monetary payoffs.[5] To illustrate, behavioural studies have shown most people would take £100 today over £200 in a year’s time, but would not take £100 in six years over £200 in seven. There is no rational reason for this inconsistency; the tradeoffs are identical in monetary terms.

This powerful preference for immediate rewards is caused by the inconsistent way in which we discount value over time – described in behavioural literature as hyperbolic discounting.^[6] Figuratively speaking, as points in time are pushed into the future, we come to view them as indistinct points on a fuzzy horizon. This helps to explain the challenge of getting people to invest for far-off retirements. A range of other behavioural biases exacerbate short-termism; for example availability and recency biases can both cause investors to give undue weight to prominent or recent events and overreact to current information.[7]

A key issue which feeds short-termism within the equity market is the habit of most sell-side analysts to focus heavily on short-term earnings projections. In fact, while the overall number of analysts covering large-cap global stocks continues to grow, the focus remains disproportionately on near-term earnings forecasts. Chart 2 shows the extent of analysts’ short-termism and the fact that few forecasts exist beyond the third forecast year.[8]

With the greater short-term focus of both market participants and sell-side analysts, the equity market has become relatively efficient at pricing near-term earnings expectations (as measured by a declining error rate in one-year I/B/E/S forecasts 2006-11).[9]

Critically, the corollary to that point is that the market is less effective at evaluating longer-term earnings, showing a relative neglect for the longer-term value of companies exposed to structural growth drivers. This represents a clear opportunity for investment strategies which can sensibly exploit this equity market failing.

Chart 2: Focus of sell-side analysts is on near-term earnings forecasts

Source: DataStream, Goldman Sachs. Number of I/B/E/S consensus EPS forecasts for US$1 billion companies.

Stock outperformance is driven by either superior earnings growth or a higher valuation multiple being applied to the earnings profile of a company. Over short holding periods, changes in valuation multiples are the key driver of returns since earnings expectations do not typically change by large amounts in the short term. However, in the long run the opposite is true. Performance is increasingly explained by changes in earnings growth and the importance of entry and exit multiples diminishes.

The spread of multiples between leaders and laggards tends to be volatile and driven by sentiment, but ultimately multiples move around within a relatively narrow range. Earnings and cashflows on the other hand can diverge and keep diverging over time. This is demonstrated in Chart 3 which shows the proportion of shareholder returns explained by either expansion of the valuation multiple (EV/EBITDA) or by changes in earnings expectations (EBITDA) for 500 of the largest listed companies globally.

We have seen how the focus of the equity market is on the relatively small part of a company’s value determined by the earnings it will generate in the next three years – not on the large part of its value represented by its profitability after that period. However, with the knowledge that earnings are more important than multiples in the long run, how should we go about assessing the long-term value of companies?

Earnings multiples are commonly used to make snapshot comparisons between similar companies within industries or to measure value versus sector or market averages. For companies sensitive to the business cycle, these measures run the risk of overstating the value of the business based on peak earnings in periods of strong economic activity.

Discounted Cash Flow (DCF) analysis is an alternative method of valuing a company where the value of an asset is defined as the present value of its estimated and discounted future cash flows. Instead of trying to project a company’s cash flows to infinity however, a terminal value is applied to cash flows beyond the next few years (at which point forecasts drastically peter out in any case).

In DCF models, 60-75% of the value of a company is typically determined by this terminal value and great care must be attached to its calculation. For many high-quality businesses, the calculation of this rate can be sensibly informed by their exposure to structural growth themes, which, in turn, can justify higher growth rates than GDP.

We argue there is a type of company for which DCF models are particularly useful for establishing a valuation that reflects long-term drivers. Such companies are high-quality earnings growth compounders exposed to structural growth themes and whose earnings are less sensitive to the business cycle.

Exposure to structural growth (such as an industry-leading position in a strongly growing market) allows a company to generate a steady stream of cash which can be reinvested into a growing business. It is the ability of these companies to reinvest that cash into the strong structural growth opportunities in their markets – by increasing capital expenditure, which in turn, enables stronger sales and profits growth – that provides the compounding engine for sustained growth in earnings. A case study helps to demonstrate the point.

Novo Nordisk is an example of a company exposed to strong and sustainable growth in the market for diabetes via its insulin products. It is also a company whose value has been better judged by DCF analysis than earnings multiples. The stock price has risen from 102.25 KR (end 2002) to 945 KR – a compound annual growth rate of 24%.[10]

Diabetes affects more than 371 million people worldwide. By 2030, this is expected to rise to 552 million, a 49% increase.[11] Novo Nordisk has a commanding 49% share of the global insulin market. Having built a reputation for innovative treatments, the company continues to spend around 15% of its sales on research and development of new products.[12]

Chart 4 shows how three-year forward earnings forecasts have consistently failed to keep up with actual earnings growth. Earnings growth estimates at three years and beyond tend to be subject to a degree of earnings fade or mean reversion, meaning the analyst community broadly fails to account for the sustainability of structural growth drivers.

Source: DataStream, IBES.

Chart 5 shows that the PE multiple for Novo Nordisk has gone up substantially during periods of strong market sentiment. Rich valuations (in 2007 and 2010) would have encouraged many investors to sell during a period of sustained growth in both the company’s earnings and its share price.[13]

Using the earnings multiple would have given little thought to the long-term sustainability of Novo Nordisk’s earnings growth. However, a discounted cashflow analysis using a terminal value informed by its exposure to structural growth would have been able to look through short-term sentiment-driven swings towards a longer-term value of the business.

Given the importance of the terminal value, the compounding effect of higher terminal values over time can have a significant impact; it can make earnings growth compounder stocks that look relatively expensive on other valuation measures look cheap, implying significant upside for investors who are simply prepared to be patient. As Warren Buffett says “Price is what you pay, value is what you get.”

Source: DataStream, as 31.07.13.

The interesting thing about the market’s consistent under-estimation of Novo Nordisk’s earnings growth is that it was actually well known in the investment community throughout this period (2005-12) as an ‘earnings growth compounder’. In spite of this, the market still underestimated the ability of Novo Nordisk to sustain its earnings growth.

Why does this happen? Specifically, it is the failure of analysts to properly account for the reinvestment of cash into a compounding business franchise in three-year-plus models. And, the reason for this seems to lie in a flawed but widespread belief in ‘earnings fade’ and earnings mean reversion. While mean reversion is a valuable concept in the context of valuations, it is much less useful in the context of earnings growth. Consensus estimates (I/B/E/S) regularly forecast a decline in returns of companies with high return on equity and an increase in returns for companies with low return on equity. However, the expectation for mean reversion in earnings is in contrast to the sustained bifurcation evident in many industries, where the strong get stronger and the weak get weaker.[14]

The combination of the market’s short-termism and its expectation of earnings convergence creates opportunities for investors who can identify the companies able to avoid mean reversion via exposure to structural growth themes. The next section shows how we can increase conviction around structural growth themes with an understanding of the underlying demographic drivers.

“Demography is destiny.” – Auguste Comte (1798-1857)

We noted in Section I that short-termism is hard-wired into human nature, and this is apparent in analysts’ focus on near-term earnings forecasts. Market participants tend to overemphasise the importance and sustainability of recent events when making investment decisions (and seemingly ‘rich’ multiples can also encourage investors to sell winners too early). While the market is reasonably accurate in making near-term earnings forecasts, it is less efficient in terms of long-term projections. This is because the market tends to overlook the compounding effect on long-term winners’ profits. Investors able to identify earnings growth compounders exposed to structural growth themes can take advantage of these inefficiencies. For this, an understanding of demographics is critical.

Demographic trends describe the historical and projected changes in populations over time. Such a definition is abstract given demographic changes have the power to bring about significant economic and social changes, affecting income and expenditure at all levels: countries, companies, and individuals. The fact they are slow-moving and play out over time means their cumulative impact is not properly discounted by myopic markets.

Demographic trends do not emerge accidentally, but systematically. In fact, demography is one of the few social sciences where projections can be made with a relatively high level of certainty. Looking ten years into the future, we can predict with some certainty the working-age populations of most countries (barring wars, epidemics or catastrophes) and we can do so with greater certainty than the GDP of those countries.[15]

A rapid and substantial increase in population over the last century has underpinned significant growth in the world economy. To the extent that economic output has tracked population growth with a lag, we can expect prevailing population trends to underpin equally impressive growth in global GDP. This is already happening – helping to explain not only the strong growth in global output but, in particular, the structural growth in GDP in many developing economies over the last 30 years.[16]

Developed countries have undergone what is known as a demographic transition.^[17] This describes the progression from the high birth and mortality rates of pre-industrial economies to the low birth and mortality rates of present developed economies.

Source: FIL Limited, for illustrative purposes only.

In the traditional transition model, populations start from a pre-industrial stage where mortality and fertility rates are high and in balance (stage 1). High fertility rates but declining mortality rates (stage 2) produce a mid-stage demographic dividend where populations expand via growth in the younger age groups, leading to a favourable bulge in the working population. At stage 3, population is still growing but the pace of growth slows as fertility rates decline towards mortality rates. Most developed countries are now at stage 4 or 5 of the model characterised by both low birth rates and low death rates, meaning stable or declining populations.

The demographic dividend is essentially a sweet-spot within the demographic transition where the working age population is growing faster than the broad population. This provides a tailwind to economic growth as measured by real per capita GDP (typically at a time when countries are industrialising). Developing countries like India and Nigeria are entering this highly favourable stage.[18]

The global population passed the seven billion mark in 2011, having grown by a full billion since 1999.The current level represents a doubling since 1970; a period of particularly rapid population growth akin to a global demographic dividend. Future growth will take numbers to nine billion by 2050.[19] The overwhelming driver of this population increase has come from developing countries and this will remain the case, as will the general trend for urban populations to expand at the expense of rural populations. This is having a significant impact on the demand side of the global economy, creating opportunities for companies to expand sales and earnings in growing global marketplaces.

Source: UN 2010 Revision of the World Population Prospects

The composition of the global population is also changing in some important ways. The number of people considered to be in the ‘global middle class’ is projected to more than double to 1.2 billion by 2030 (from 7.6% of the world’s population to over 16%).[20] This represents a compound annual growth rate of 5.2%. Most of the new entrants will come from the developing world. In fact, the World Bank predicts that by 2030, 93% of the global middle class will be from developing countries.

Source: World Bank, March 2011. ‘Middle class’ = people with an income between the per capita income of Brazil & Italy.

According to the United Nation’s Population Division, we are living through a period of population ageing that is ‘without parallel in the history of humanity’. This process is a result of the combined effects of declining fertility and mortality rates as countries move through the demographic transition model discussed earlier.

Source: United Nations Population Division.

The trend is most prominent in developed countries, yet as developing countries progress through the demographic transition, ageing will become a reality for virtually all countries in the world. Indicative of this, globally, the number of ‘older persons’ (aged 60 and above) is expected to exceed the number of children (aged under 15) for the first time in 2045. In 2050, one in three people in developed countries will be aged 60 and over, up from around one in five today.[21]

In this section, we highlight just some of the structural growth themes and investment opportunities which are consequences of the demographic megatrends.

One consequence of population growth is that it raises demand for resources, such as food, water, arable land and energy, as emerging economies consume a larger share of the world’s resources. It is reasonable to expect population growth to provide a structural tailwind behind the pricing of many finite assets. The World Bank estimates that demand for food will rise by 50% by 2030.[22] This poses a serious challenge for food production, particularly in light of the fact that the amount of arable land in the world is being reduced due to industrialisation and urbanisation.

Source: Food and Agriculture (FAO) Organisation of the United Nations.

Indeed, in China, a combination of rapid industrial development and population growth is estimated to have resulted in the loss of more than 13 million hectares of arable land since 1952 (total agricultural land is around 111 million hectares at 2011).[23]

With more mouths to feed yet declining arable land, there is a clear impetus to increase crop yields. Given that livestock is reared on grain, higher demand for meat has a multiplier effect on grain demand. According to the UN, grain output needs to rise by 70% over the next 40 years to satisfy growing demand for food, feed and fuel. Since much of the arable land in the developing world is inefficient, significant gains in yields can be made via the use of fertilisers, higher-yielding seeds and agriculture mechanisation equipment. The demand for such products is likely to grow strongly.

Emerging market consumption growth will have a significant impact on all consumer markets. Firstly in basic products, there is huge dollar value potential from emerging market populations moving towards spending levels in staples commensurate with developed markets. Developed markets make up 14% of the global population and spend US$2,041 per capita on consumer staple products. The equivalent figure for emerging markets with 86% of the population is only US$207.^[24]Food, beverages, and household products will all benefit from higher penetration rates in emerging markets.

The growth in the emerging middle class provides strong support for a wide range of discretionary products from phones to fashion, and from electronics to automobiles. Car ownership levels are still a fraction of developed country levels (only c.65 per thousand in China versus c.560 per thousand in the US).[25]

Source: Goldman Sachs.

Healthcare spending is also set to grow strongly as higher disposable incomes allow more people to afford medicines. From around $6 trillion dollars in 2010, healthcare spending could hit $10 trillion in 2020, with developing countries responsible for $2 trillion (a 15.2% compound annual growth rate).[26] The US accounts for 40% of global healthcare expenditure with per capita spending in 2010 at $5,335; global per capita spending (ex US) was only $596.[27] There is clearly considerable scope for other economies to catch up with the US on a per capita spending basis. In many emerging economies, healthcare spending is growing faster than GDP. A McKinsey study suggests that if healthcare spending simply keeps pace with projected GDP growth, the size of the Chinese healthcare market will double from US$240 billion to US$480 billion by 2018.[28]

As populations grow, gain wealth, become more urbanised, and get older, there will be a range of consequences for lifestyles, diets, health and wellbeing, and leisure time.

Rising incomes in emerging economies are enabling changes in diets as consumers move from healthy, low-calorie diets that are high in grains and vegetables to higher-calorie, Western-style diets that contain more meat, dairy and sugar. This change in diets combined with urbanisation, less physically demanding work and greater use of transport has led to less healthy, more sedentary lifestyles for many people. The increasing incidence of Western lifestyle factors is fuelling a concomitant surge in ‘western’ diseases such as obesity, diabetes (see chart 13), hypertension, coronary artery disease, stroke and cancer. Unfortunate as this outcome is, it means many healthcare companies are seeing structural growth in demand for their products.

Source: International Diabetes Federation, 2012 Update

Another prominent lifestyle theme is the use of the internet which is fast becoming an essential part of work and life. Internet access is growing quickly in developing countries with many consumers accessing the internet solely on smartphones. In China, the estimated internet penetration rate of 39% is less than half the c.90% penetration rates that are commonplace in countries like the US.[29] One area of significant change will be in the way people shop, with a growing proportion of sales activity taking place online.

The number of older persons (over 60) has more than tripled since 1950; it will almost triple again by 2050.[30]Although people are living longer than in the past, the functionality of the human body inevitably declines over time, thereby increasing demand for a wide range of healthcare products (drugs, hearing aids, orthopaedics and eye care) and services (private hospitals and care services). This powerful demographic trend will primarily affect developed countries (see chart 14).

Source: UN 2010 Revision.

Chart 15 shows the lifetime distribution of healthcare costs by age in the US. It is clear that as more people move into older age brackets, total spending (both private and public) on healthcare will rise disproportionately. As a result, many healthcare companies can expect to see strong structural growth. For example, hearing aid manufacturers will see higher demand from greater numbers of older people as well as growing replacement demand from those people living longer. Similarly, orthopaedic manufacturers can be expected to gain from growing demand for hip and knee replacements.

Financial services firms could also be expected to benefit from people living longer and needing to fund their retirements. There are problems here for investors interested in accessing the pure structural growth theme, however. This supportive demographic factor tends to be dominated by other (more variable) factors such as macroeconomics, policy and regulation in the performance of financial companies (as evidenced by the global financial crisis). These other factors introduce a higher element of risk that diminishes the structural benefit and the ability of these companies to compound growth over time.

Source: Alemayehu, B & Warner, K.E ‘The lifetime distribution of health care costs’, Health Services Research (2004).

Rising dependency ratios bring a host of challenges for developed economies. The reduction in the working age population means a reduced labour supply. Other negative effects for governments include rising age-related expenditure, in terms of higher public pension costs and increased healthcare costs. These increasing costs put upward pressure on government budget deficits and national debt levels. Generic drug manufacturers, pharmacy benefit managers, drug distributors and health insurers should therefore see rising demand not only from population growth and ageing, but also from government efforts to control the inexorable upward pressure on public healthcare costs.

Source: UN 2010 Revision.

The structural growth themes highlighted are investible now and underpinned by the demographic trends discussed in Section II. By combining an understanding of the themes with the framework from Section I, we can identify earnings compounders and exploit the market’s inefficiency in recognising long-term value. Having highlighted a compounder case study in Section I, we provide two further case studies as validation.

Company: Essilor is the world leader for corrective lenses with a 36% share of global volumes.[31] Responsible for Varilux, the world’s first progressive lens which corrects presbyopia (the age-related diminishing ability to focus on near objects); one in every two varifocal lenses sold worldwide is made by the company.

Structural growth drivers: Four factors should create significant growth in demand for corrective lenses. Basic population growth increases the pool of people requiring vision correction. Ageing not only means that people are more likely to need corrective lenses, it also means they are likely to replace their lenses more times. The emerging middle class should drive strong demand growth in developing countries. Changing lifestyles with more emphasis on computer work is also likely to support demand for vision correction.

Industry outlook: Essilor estimates that 60% of the present global population of seven billion need vision correction. By 2030, this will increase to 72% of the 8.3 billion population (i.e. six billion people) due to ageing and lifestyle changes. Only 51% (1.7 billion) currently have their vision corrected, but this proportion can be expected to rise to around 63% (3.1 billion) due to rising incomes and awareness. This equates to a 3.4% compound annual growth rate in the company’s core market between 2012 and 2030.

Source: Essilor Annual Report – Consolidated Financial Statement (end 2012). In € millions.

Earnings growth: Strong structural growth in the market for lenses has already been reflected in Essilor’s consistently rising revenues (see Chart 17), which were relatively unaffected by the global financial crisis and ensuing recession. Emerging markets constitute over 23% of revenues (as at 2012, versus 15% in 2009), yet penetration rates remain low, meaning there is significant scope for sustained growth. For example, India has only a tenth of the opticians of France on a per head of population basis.[32] The company spends €150 million a year on R&D, a figure in excess of peers which keeps it at the forefront of the industry.[33] Its ability to sustain earnings has positively surprised the market and handsomely rewarded investors (see Chart 19). 

Company: Nigerian Breweries is the dominant player in the Nigerian beer market with close to a 60% market share. The company sells Nigeria’s leading beer brand – Star, as well as a strong portfolio of brands backed by Heineken, its majority shareholder.

Structural growth drivers: Nigeria has a large, young population of 165 million, a fast-growing economy and a rapidly growing middle class. GDP per capita has grown from $390 in 2000 to $1700.[34] By 2030, the country’s population is expected to expand to around 300 million.[35] As incomes grow, consumers will trade up to branded goods.

Industry outlook: Annual per capita beer consumption in Africa is presently under 10 litres per person compared with global average of around 35 litres.^[36] With a significant share of African alcohol consumption being home brew, there is significant scope for growth in branded beer sales thanks to rising discretionary incomes.

Source: FIL Ltd as at 31 Aug 2012, revenues in Nigerian Nairas NGN, millions.

Earnings growth: Nigerian Breweries has produced strong and consistent revenue and earnings growth over the last decade (see Chart 18). Revenues since 2002 have grown at a compound growth rate of 20.6%.[37] Investors in Nigerian Breweries have enjoyed strong growth in the company’s share price (see Chart 19).

CONCLUSION

The demographic trends and structural growth themes we have discussed are happening now and can be expected to play out with a greater level of certainty than the macroeconomic trends on which many investment strategies are predicated. Structural growth themes allow identifiable companies to benefit from strong and compounding cash returns over investible timescales.

Positive structural growth outlooks tend not to be fully reflected in the valuations of companies given the inefficiency of the equity market in recognising the cumulative impact of compounding earnings growth. It is the reinvestment of cashflows back into a business enjoying strong market growth that is the hallmark of an earnings growth compounder. Earnings growth compounders like Essilor, Nigerian Breweries and Novo Nordisk have all significantly outperformed the broader market (see Chart 19).

The evidence supplied in this paper strongly suggests that time spent identifying companies with a strong competitive advantage and valuable intellectual property in industries benefiting from structural growth is time well spent. And, investment strategies that take this approach are certainly worthy of close consideration by investors.

Source: DataStream, as at 5 August 2013.

REFERENCES

African Development Bank, Market Brief, April 20, 2011 “The Middle of the Pyramid: Dynamics of the Middle Class in Africa”

Aiyar, S.A. (2013), ‘Demographic dividend: delayed, but getting better’, Times of India, June 2013.

Arnott, Robert D. and Chaves, Denis B., (2011) ‘Demographic Changes, Financial Markets, and the Economy’, Financial Analysts Journal, Volume 68, Number 1, January/February 2012 .

Bloom, D. E., Canning, D. and Sevilla, J., (2003), ‘The Demographic Dividend: A New Perspective on the Economic Consequences of Population Change’, Population Matters Monograph MR-1274, RAND.

Caldwell, John C. (2006), ‘Demographic Transition Theory’, Springer.

Credit Suisse, ‘HOLT Wealth Creation Principles: Was Warren Buffet Right: Do Wonderful Companies Remain Wonderful?’, June 2013.

De Bondt, W.F.M., and Thaler, R. (1985), ‘Does the Stock Market Overreact?’, The Journal of Finance, 40(3), 793{805}.

Dimson, Marsh and Staunton, (2002), ‘Triumph of the Optimists: 101 Years of global investment returns’, Princeton University Press.

Fidelity Worldwide Investment, (2012), White Paper: ‘The Road to Unconstrained: Why the interest in alternative weighting schemes raises a wider debate about the value of benchmark anchoring”, January 2012.

Fidelity Worldwide Investment, (2012), White Paper: ‘The Age of Income: The growing importance of investing for income in turbulent times’, July 2012.

Frederick, Shane, Loewenstein, George and O’Donoghue, Ted, (2002), ‘Time Discounting and Time Preference: A Critical Review’, Journal of Economic Literature 40 (2): 351–401.

Goldman Sachs Research Paper, ‘The die has been cast’.

Kahneman, D., (2011), ‘Thinking, Fast and Slow’. Macmillan.

Kahneman, D. and Tversky, A.,,(1973), ‘On the psychology of prediction.. Psychological Review 80 (4): 237–251.

Kahneman, D. and Tversky, A. (1979). ‘Prospect theory: An analysis of decisions under risk”’ Econometrica 47: 313–327Keynes, John Maynard., ‘General Theory of Employment, Interest and Money’, 1936.

Knutson, B. and Peterson, R., (2005), ‘Neurally reconstructing expected utility’, Games and Economic Behaviour 52, 305-315.

Lakonishok, J., Schleifer, A. and Vishny, R.W., (1993), ‘Contrarian Investment, Extrapolation and Risk’, Journal of Finance, vol. 49, no. 5 (December):1541-1578.

Lynch, P., (1989), ‘One Up On Wall Street’, New York, NY: Simon & Schuster.

Modigliani, Franco, (1966), ‘The Life Cycle Hypothesis of Saving, the Demand for Wealth and the Supply of Capital’, Social Research, (1966:Summer).

McClure. S.M., Laibson, D.I., Loewenstein, G. and Cohem, J.D., (2004), ‘Separate neural systems value immediate and delayed monetary targets’, Science 306, 503-507.

Montier, James, (2007), ‘Behavioural Investing: A practitioner’s guide to applying behavioural finance’, 2007, Wiley.

MORI (2004), “NAPF/IMA Short-termism Study Report”.

Nwakeze, N.M., (2011), ‘Youth Bulge and the Prospect of Demographic Dividend in Nigeria’, paper published at Sixth African Population Conference, December 2011.

Shiller, R.J., (2000), ‘Irrational Exuberance’, Princeton University Press.Thaler, R. H. (1981). ‘Some Empirical Evidence on Dynamic Inconsistency’. Economic Letters 8 (3): 201–207.

Standard & Poor’s, ‘Global Aging 2010: An Irreversible Truth’, Standard & Poor’s, 2010.

United Nations, (2010 Revision), ‘World Population Prospects’, released on 3 May 2011.

World Bank, (2006), ‘Re-engaging in Agricultural Water Management: Challenges and Options’.

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This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.  © 2013 FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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The use of demographics, the most important driver of our times: Fidelity.

Demographics is the most resilient and significant investment driver of our time, providing investors with greater certainty than many macroeconomic themes and allowing them to identify companies likely to benefit from compounding cash returns over the longer term, Fidelity Worldwide Investment said today.

In a White Paper released titled ‘Investing in Demographics’, Fidelity’s portfolio managers, Hilary Natoff and Nicola Stafford, who are based in London and visiting clients in Australia, discuss in detail the impact of demographics on stock picking and portfolio construction.

“Demographic trends and structural growth themes are happening now and have created clear opportunities for investment strategies for both retail and institutional investors,” said Hilary Natoff, Co-Portfolio Manager of the Global Demographics Fund, Fidelity Worldwide Investment.

“Demographics can be expected to play out with a greater level of certainty than the macroeconomic trends because they don’t just emerge accidentally, they happen systematically. In fact, demography is one of the few social sciences where projections can be made with a relatively high level of certainty,” said Ms Natoff.

“In addition, markets are losing sight of the long-term value of a business with the average stock holding period currently under three months globally. Sell-side analysts focus on near-term earnings forecasts yet earnings – not valuations – drive returns in the long run. A large part of company value is represented by longer term profitability and compounding so those investors able to identify companies exposed to long term structural growth themes such as demographics can sensibly exploit this market inefficiency. “

Ms Natoff said the world is undergoing a dramatic transformation as a result of three demographic megatrends– global population growth, emerging middle class and ageing populations.

“A changing world creates investment opportunities. By 2030, world population is expected to grow from 7 to 8.3 billion, the middle classes will more than double, and the over-60 age group will expand from 0.8 to 1.4 billion. This is having a significant impact on the demand side of the global economy, creating opportunities for companies to expand sales and earnings in growing global marketplaces.”

Ms Natoff said these trends present a number of structural growth opportunities for investors.

“We have more people but a finite world. Rising demand for resources, such as food, water, arable land and energy have a clear multiplier effect on products such grain to feed live stock. With the rapid rise in spending levels across developing markets, we’re seeing opportunity sets emerge in the consumption of staples, global brands, healthcare and education. While with ageing populations, we’re seeing opportunities in areas such as hearing aids and eye care for example.

Click here to read the white paper.

“Time spent identifying companies with a strong competitive advantage and valuable intellectual property in industries benefitting from structural growth is time well spent. Companies such as Essilor, Nigerian Breweries and Novo Nordisk have all significantly outperformed the broader market due to strong structural demographic growth drivers.”

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