With the exception of two bampots with silly haircuts facing off across the Pacific Ocean, equity markets have not had a huge amount of big picture concerns over the summer months. In the short term, the political administrations here and across the pond have curiously managed to hamstring themselves through their own incompetence. A minority government in Westminster must tread carefully within the very narrow channel that placates both the pro and anti EU elements of its party. In the US, Donald Trump is becoming a lame-duck President by his own hand, ostensibly alienating everyone except his most rabid followers. From an investment perspective, this is not necessarily a bad thing; we have said for many years that the less power politicians wield (whether by design or misadventure) the less damage they can do to the case for financial, business and household investment.
Yet, many investors may look back at the last few weeks and feel a little punch-drunk over what has passed. Big share price moves in big companies is always newsworthy; since the start of July, the scribes have had lots to write about.
What is intriguing about the raft of recent collapses in share prices in very large companies is how independent they appear to be from each other. The reasons which caused the savage correction in Provident Financial’s market cap had nothing to do with the profit warning from Dixons Carphone, which in turn was independent WPP’s cautionary outlook. The issues affecting the AA Group were fairly unique, and the fears over the regulatory status of tobacco in the United States is confined pretty much to tobacco stocks.
In most cases, the share price response to these issues has been severe. With Provident Financial, this was perhaps understandable given question marks over the viability of the business in its current form. For the remainder, many investors may have felt that the punishment was too harsh for the crime. Yet, this is always likely to be the outcome when markets are valued on the basis of success, rather than failure. For over a year now, earnings revisions have been in positive territory. That implicit assumption – that not only will earnings grow, but they will grow by more than current forecasts suggest – is, to our mind, fully baked into market valuations. Which means that the consequences of missing these expectations is all the more painful.
When the incidence of profit warnings rise, the natural question one asks is “are we missing something?”. Is this the early sign of some deeper malaise about to affect economies and companies more generally? At this stage, we think the answer is a cautious “no”. As discussed earlier, most of the issues affecting the companies we are referring to are pretty specific to the individual corporate concerned. And throughout the summer, aggregate earnings revisions have improved slightly, maintaining the positive trend. Whilst equity markets may not be give-away cheap, there is still upside if corporates can continue to drive earnings and dividend growth from here.
All of this said, there are two broad themes running through many of the profit warnings we have seen. One is the impact of technology cycles, the other the impact of regulation.
Game Digital (and Game Group in its previous stock market incarnation) has had a tumultuous stock market history as its business cycle has struggled to cope with the maturing and changing nature of the underlying computer hardware cycle. It is likely that Dixons Carphone is seeing much the same trends in the mobile phone market. As the improvement in handsets becomes more incremental, so the buying patterns of consumers change. It can take a long time for business models to adjust. WPP’s concern over future prospects is partly due to the disruption caused by digital advertising to more traditional media. The threat from technology is mainly framed as an examination of what happens when technology displaces mainstream, established ways of doing business. Less attention is paid to what happens when the new technology itself matures.
The other theme is one of regulation. Regulators covering telecommunications, medicines and financial services have all been mentioned in recent dispatches explaining trading disappointments. Regulatory risk is now an integral part of any investment due diligence process. The business world is becoming ever more regulated, and none more so than our own industry. Over the summer, the required legislative processes were finally completed so that the rules effecting MiFID II were placed on the statute book. MiFID II lands on 3rd January 2018. When the bulk of the Directive was presented some three years ago, it looked at first glance to be much less disruptive to those in equity markets than the original MiFID directive almost a decade ago. And whilst it is true that the modus operandi of businesses already subject to MiFID don’t need to change, the sting in the tail has been the small number of regulations that have the potential to substantially raise costs across the industry. At the start of the current calendar year, a CEO of a large investment management company was dismissive of any cost impact on his business from the unbundling of broker research from execution services. Today, he recognises there will be a cost, but as yet cannot quantify it. With only four months to go until the implementation of MiFID, we have yet to receive from any sell side firm a definitive description of its service or cost. How this industry will function on 3rd January 2018 remains a mystery. To an investor, mystery means risk.
This is obviously of interest to our own business, but as an investment management firm that turns over its client portfolios infrequently and generates the vast majority of its research internally, we are not particularly vulnerable. What is of more interest from our clients’ perspective is making sure that we fully factor in the impact such costs and dislocation might have on the companies we invest in. The financial services industry is used to this. The past few months have shown that regulators are increasingly impacting the economics of other industries too.
Historically, we have tried to limit our references to that hoary, old chestnut – the “stock picker’s market”. Returns over the last decade have been dominated by getting the big macro and political calls right. Yet, this summer has reminded us that when general market conditions are relatively benign and stable, the stock picker’s art returns front and centre. It is not always about finding the next Apple or Microsoft. It is equally about not stepping down too many rabbit holes.