Alpha Opportunities In The Global Marketplace
By: Flemming Madsen & Fiona Leonard
Global equity investors buy the worldʼs best companies irrespective of geography. Dynamic structural change, as a result of rapid economic and technological developments, is eroding barriers to entry across markets, allowing for best practices to be replicated across sectors and industries.
Since the mid-1990s, cross border merger and acquisition activity has risen sharply. Multi-national corporations comprise an increasing share of foreign direct investment flows, particularly in Latin America and emerging Asia. Trade liberalization, lower transportation and communications costs, and technological advancements have accelerated the forces of globalization, bringing fundamental change to how businesses operate.
Companies are increasingly ʻdeverticalizing ʼ their business models in their efforts to expand market share, take advantage of cheaper labour costs, and increase overall levels of productivity. De-verticalization segments different stages of the business process – from production to distribution – so that non-core business activities are either off-shored and/or outsourced to create economies of scale across industries and sectors, rather than just at the company level.
Such frequent interchanges of trade flows, intellectual capital, and business processes allow for best practices to be replicated more quickly across sectors and countries. The same strategic framework used by a mature industry based in one country may also be applied across borders. The technology, energy, and pharmaceutical sectors have all experienced significant structural change; the design, manufacturing processes, and distribution and sales networks within these various industries are often located across borders.
However, global sector influences are increasingly influential even in those industries traditionally regarded as domestic- only. Local newspapers, for example, provide content that is relevant to the local marketplace. A newspaper based in Toronto does not compete with ones based in London or Paris and yet they all face the same competitive issue – the digital migration of data services, including classified advertisements, to on-line portals. Dynamic change is pervasive, irrespective as to whether the end-market is globally or domestically focused. But in a global environment of constant change, how do active managers successfully pick stocks?
Company life cycle analysis is instrumental to successful stock selection in global equity markets. Alpha opportunities can be found across all styles and marketcapitalization ranges. Where necessary, active managers may tactically adapt their buy and sell decisions to the maturation of the company life cycle, broader shifts in industry structure, and changing regional influences.
At the early stage of a companyʼs life cycle, the potential for a company to innovate and develop products can provide a significant growth opportunity. Emerging market wireless companies, for example, have years of sustainable growth ahead due to low market penetration rates and attractive GDP and population growth. Market penetration rates in India and Egypt are less than 15 per cent, providing a fertile environment for companies such as Bharti and Hutchison (India) and MobiNil (Egypt).
In maturing businesses, latestage investing is dependent on a companyʼs ability to create economies of scale through re-structuring and industry consolidation. Taking the example of the wireless industry again, the market penetration rate in the U.S. has climbed from about 50 per cent in 2001 to close to 70 per cent in 2005, leaving limited upside potential. Nonetheless, industry consolidation and efficiency gains through improving technology can provide further benefit to established players.
More broadly, profits growth for German stocks was more than 20 per cent in 2005 due to significant cost savings, despite a below trend real GDP rate of 1.6 per cent for the German economy. Even against the backdrop of a moderate economic growth environment, there are opportunities to exploit patterns of dynamic change.
Indeed, a mature company in one region could be an innovator in another, as different industries have various penetration rates in different regions. In Russia, the supermarket industry accounts for less than 16 per cent of all foods sold, providing significant growth opportunities for established players. Commercial banking is a mature industry in North America, but is less advanced in several emerging economies where investors have the opportunity to potentially achieve higher rates of revenue growth. Turkey is growing its consumer lending business from a very low base. Falling domestic interest rates are helping Brazil and Mexico increase loan demand.
It is, therefore, possible to use the more mature market to model how an industry may evolve in a less developed market. However, wider country considerations are essential to the overall stock analyses, including a countryʼs political, economic, and fiscal stability. In deciding where to invest, regional factors are strongly influential due to regulatory, historical, and cultural considerations. The industry structure may vary from region to region and different attributes need to be assessed such as the number of competitors and number of suppliers.
And it is not just in emerging countries where regional factors are more influential. Japanese financials, for example, have benefited from an improving economy and yield curve. In addition, they have completed a needed restructuring – writing off non-performing loans – and have improved and expanded their lending practices, particularly in consumer lending.
Neither should regional exposure be considered solely in terms of a companyʼs country of domicile. There are numerous examples of companies generating the majority of their revenue growth from outside their headquartered market, a relevant factor when summating the portfolioʼs risk, particularly to emerging markets.
Much of General Electricʼs growth is derived from China, providing opportunities to gain exposure to that market without actually being invested in it. Schlumberger is a U.S.-based oil services company with substantial international presence. Of its revenues, 78 per cent are drawn from outside the U.S. With producer spending on energy equipment and services accelerating worldwide, Schlumberger stands in a strong position to benefit. Conversely, to take an emerging market example, Infosys is an Indian-based IT outsourcing company that generates 90 per cent of its revenues in the U.S. and Europe.
The source of revenue generation will be an increasingly important metric for stock analysis as globalization trends progress. With more companies deriving their revenue growth from external markets or, in the case of emerging market companies, potentially taking increased domestic market share, a global equity portfolio provides investors with the opportunity to efficiently gain exposure to the best companies around the world. This approach also avoids duplication which may occur when investing in a group of regional mandates that each hold similar types of companies.
Energy companies BP and Exxon, for example, display strongly similar performance characteristics despite being domiciled in the UK and U.S. respectively. Approximately three-quarters of their revenue streams are generated from outside of their domiciled markets, while their stock price performances have trended closely (with a correlation of R2 0.471 between 31/12/00 and 31/12/05). To optimize returns, however, it might be more efficient to hold exposure to just one of the two stocks – whichever exhibits better relative fundamental or valuation attributes.
Historically, high cross border transaction and information costs and regulatory barriers prevented active managers from implementing a global portfolio of ʻbest in classʼ ideas. While these hurdles have been reduced over time, it is surprising to observe that most investors still prefer to invest in their home country despite the greater choice and diversity offered by the global equity universe.
As shown in Table 1, the top 20 holdings in the regional and country indices comprise a much larger composition of the total market capitalization – in some cases two-thirds or more of the index – relative to the global indices. History and geography also make some individual markets more concentrated in particular industries or sectors and more exposed to local economic and policy risks. In Canada, the top 10 holdings of the MSCI Canada account for 42 per cent of the market with the largest stock representing six per cent of the whole market. The financials and energy sectors dominate this market, while other sectors are even more concentrated.
By contrast, in the global market a portfolio would need to be invested in 150 stocks to gain coverage of 50 per cent of the market – the largest stock being less than two per cent of the market. The larger and more diverse universe of stocks to pick from enables a more efficient portfolio to be constructed – that is, a portfolio obtains a similar expected return for lower risk. Alternatively, for the same level of risk, a portfolio can achieve a higher expected return. Because of the large number of included countries, global indices provide natural diversification against sector and country exposure.
The global opportunity set offers more choice, more efficiency, and more diversity. As the global economy integrates further, active managers need the relevant skills and expertise to effectively exploit market inefficiencies arising from the patterns of structural dynamic change. A global mindset and the ability to act locally are prerequisites to achieving success.
Flemming Madsen is head of Canadian institutional business development and Fiona Leonard is an investment writer at T. Rowe Price Global Investment Services.
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