The Bull Market Isn't Over. It's Changing: Whitepaper


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Markets, especially in the developed world, have hit new highs. However, a rising economic tide will no longer lift all boats to the extent it once did. Winners are likely to be organic revenue generators, efficiency vendors and innovators.

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The Bull Market Isn't Over. It's Changing: Whitepaper

  1. 1. Not FDIC Insured May Lose Value Not Bank Guaranteed INSIGHTS THE BULL MARKET ISN’T OVER.THE BULL MARKET ISN’T OVER. IT’S CHANGING.IT’S CHANGING. THREE TYPES OF COMPANIES THAT MAY BENEFITTHREE TYPES OF COMPANIES THAT MAY BENEFIT DR. JERRY WEBMANDR. JERRY WEBMAN CHIEF ECONOMISTCHIEF ECONOMIST ELIOT WALSHELIOT WALSH SENIOR ANALYSTSENIOR ANALYST Since early 2009, when many of the world’s equity markets correctly began to anticipate the end of the Great Recession, investors have enjoyed a remarkably pleasant ride. Of course, there have been rough patches—debt crises in Europe, political impasse in the U.S., persistent deflation in Japan—but markets, especially in the developed world, have generally responded by reaching new highs. I’ve argued previously that these strong returns may well mark the early years of a secular bull market, reminiscent of the period that began in the early 1980s and persisted throughout the next decade. Nevertheless, we must acknowledge that growth is tepid, at best, in many parts of the world. Given how far markets have already come, it stands to reason that a rising economic tide will no longer lift all boats to the extent it once did. Investors would do well to remember that GDP growth is only an average, however. Many firms can and do prosper despite only modest economic tailwinds. But with the easiest gains already having been made, investors must now take a more active approach. Specifically, we must use what we know about the unique characteristics of today’s global macro backdrop to help identify companies poised to thrive in it. I believe the winners, given the conditions businesses face now, are likely to be: u Organic Revenue Generators—firms that don’t need to expand costs much to grow sales. u Efficiency Vendors—companies that sell efficiency or productivity to other firms. u Innovators—companies whose inventions take costs out of a process, or that have built a “better mousetrap.” The secular bull market isn’t over.Global valuations are still reasonable. PAGE 2 Investors must actively search for companies that can thrive. Focus on three types of firms that appear well suited for such conditions. PAGE 4 But it’s changing. Many companies could see profitability fall as they spend more on staff and equipment. PAGE 3
  2. 2. As I noted in my 2014 Outlook, inves- tors have treated markets’ appreciation with considerable skepticism, with retail investors remaining overweight cash and high quality bonds, even as major equity indices have accrued (in some cases) triple-digit returns since the end of the Great Recession.1 Valuations are now significantly richer than they were a few years ago, but they are generally far from excessive, especially outside the U.S. Bull markets generally don’t end when valuations reach their historical aver- ages, but rather when they become untenably high, other excesses— inventories, capital investment, debt—start building up, recessions loom or inflation picks up significantly. As of early 2014, I see little evidence of any of these conditions in most of the developed world or much of the emerging world. Furthermore, stocks generally appear attractively valued relative to bonds, based on global comparisons of earnings yields (the inverse of price-to- earnings ratios) and 10-year government bond yields.2 And while some measures of investor sentiment appear elevated (a potentially bearish sign), the fact is that only 54% of Americans reported having any money at all invested in stocks as of January 2014—down from 67% in 2000.3 As we’ll see, not all equities are created equal in today’s macro environment. And while the “easiest” equity market gains are likely behind us, even modest global growth can support firms that are positioned for the evolving economic environment. To figure out which firms these are likely to be, we’ll take a closer look at the global economy. What the Global Economy Is Telling Us About Stocks Source: Ned Davis Research, as of 3/14/14. *Historical median P/E is calculated by taking the historical averages based on availability of sufficiency of data—in the case of the United States this historical median is derived from 23.6 years of data. The Cyclically Adjusted Price to Earnings Ratio (CAPE) is a measure of the price of a country’s index divided by the 10-year rolling average of earnings, which provides a more stable measurement of current valuation. Each country is represented by the corresponding MSCI country index. The MSCI country indices are market-capitalization-weighted Indices designed to measure the performance of their respective country’s equity markets. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results. 1. Source: Jerry Webman, “Swimming Up the NILE,”, 12/9/13. 2. Source: Ned Davis Research, “Earnings Yields vs. 10-Year Government Bond Yields, All Country World,” as of 3/4/14. 3. Source: Gallup, 1/17/14. Stocks Appear Attractive Globally Cyclically adjusted price-to-earnings (CAPE) ratio as of 3/14/14 CHART 1 I Current P/E N Historical Median P/E* Europe ex.UK Brazil Spain Japan C hina M exico UK Korea G erm any Sw itzerland U.S. South Africa Italy 0 10 20 30 40 50x 17.5 9.5 10.7 9.3 15.3 13.4 14.2 18.919.4 19.0 12.8 20.5 23.2 17.9 22.4 16.5 16.5 19.9 16.9 20.2 20.2 22.8 22.2 14.7 23.9 38.8 Large Discount Modest Discount In-Line 2
  3. 3. the difference. If the continued moder- ate growth I expect pushes companies to expand to protect market share, however, penny pinching may cease to be an effective earnings strategy. To boost organic growth, many firms will eventually have to start spending money on machines and labor. When they do, it will probably be good for the economy and for sales, but profit margins will likely suffer. In the short to medium term, at least, potentially falling profit margins could disappoint financial markets. And the story follows a similar path in Europe5 and even Japan. The key for investors will be finding companies able to deliver earnings in this tougher environment. Currently, economic growth in the world’s four major economic geographies—the U.S., Europe, China and Japan—may be positive (even improving in some cases), but it’s hardly robust anywhere. My 2014 Outlook called for non-inflationary but lackluster expansion, or NILE, for short, in the U.S.; sporadic recoveries in Europe and Japan; and a policy- driven slowdown in China (albeit still to a relatively high growth rate). That fore- cast still stands as we move through the second quarter of 2014. Naturally, in a slow-growth environ- ment, companies that depend on rapid economic expansion to increase earnings are likely to disappoint them- selves and their investors. Our job is to identify companies that can expand at a much faster pace than simple aver- ages for the economy itself. In 2014, however, the challenge inves- tors face goes beyond simply finding growth in a low growth world. Firms in general have been growing profits by restraining capital expenditures and hiring, and squeezing their expense lines, rather than following strategies to expand sales. In fact, from 2008 through 2013, S&P 500 Index earnings per share rose 118%, while revenues per share only grew 7%.4 Cost-cutting and share buybacks made up most of 4. Source: Strategas Research Partners, “Why Do Companies Spend Their Money?” 2/19/14. 5. Source: Duke/CFO Magazine Global Business Outlook Survey, as of 12/13; OECD, “Main Economic Indicators—complete database,” Main Economic Indicators (database), (Accessed on 2/24/14). 6. Source: Art Steinmetz, “Active Investing: The Case for a High Conviction Approach,” OppenheimerFunds, Inc., 2/28/14. Lackluster Global Growth Year-over-Year GDP growth (%) CHART 2 Source: IMF WEO, January 2014 (last update). Estimates may not be achieved. I 2013 I 2014e I 2015e 0 2 4 6 8 10% World Developed Markets Emerging Markets U.S. Japan Euro Area China –0.4 3.0 3.7 3.9 1.3 2.2 2.3 4.7 5.1 5.4 1.9 2.8 3.0 1.7 1.7 1.0 1.0 1.4 7.7 7.5 7.3 AN ARGUMENT FOR ACTIVE INVESTINGAN ARGUMENT FOR ACTIVE INVESTING With lackluster but non-inflationary growth unlikely to buoy equities whole- sale, and with increasing numbers of companies running out of ways to bolster earnings-per-share growth through cost cutting and share buy- backs, I believe markets will draw an increasingly sharp distinction between winners and losers. Rest assured, though: I believe there will be winners. We’ll simply have to look harder to find them, and that means taking an active approach to investing. Active investing allows for greater selectivity, which is likely to be desir- able in the current environment. Interestingly, a recent paper by OppenheimerFunds’ President, Art Steinmetz, found that since 1993, the passive S&P 500 Index has underper- formed the Lipper Large-Cap Core category of actively managed mutual funds over rolling three-year periods when profit margins were declining, as they appear poised to do now.6 INSIGHTS 3
  4. 4. What investors need to look for today are companies that (a) don’t require scorching economic growth to pros- per, and (b) can sidestep, or even capitalize on, the increasingly com- mon need to spend more on hiring and capital equipment to boost sales (cost-cutting having nearly reached its limit). The companies most likely to thrive in such circumstances fall into three broad categories: 1.Organic Revenue Generators Firms that don’t need to expand costs much to grow sales. 2.Efficiency Vendors Companies that sell efficiency or productivity to other firms. 3.Innovators Companies whose inventions take costs out of a process, or that have built a “better mousetrap.” Let’s examine each category in turn. 1. ORGANIC REVENUE GENERATORS While some companies will struggle to grow revenues without hurting profit- ability, Organic Revenue Generators’ business models and/or competitive positions allow them to increase sales without spending a lot on hiring or capi- tal expenditures. Leading global media companies are prime examples. A small handful of media companies—roughly a dozen— control the overwhelming majority of content distributed worldwide. Thanks to rising global affluence and the widespread adoption of smartphones and tablets, global media consump- tion is growing rapidly, and major media companies are meeting this demand in part by finding inter- national growth opportunities at a very modest marginal cost of produc- tion as they simply send out a few more electrons. Notably, many such companies need only about a third of their cash flow to operate their busi- nesses; the rest can go toward share buybacks, dividend growth or other shareholder-friendly uses. e-Commerce leaders can increase sales organically in a similar way. Some have already sunk enormous sums into the infrastructure they need to process and ship merchandise on a massive scale. With such assets now in place, they may continue to take share away from traditional brick-and- mortar retailers globally, probably for decades to come. Source: Citi Research, Euromonitor, April 2013. Estimates may not be achieved. Past performance does not guarantee future results. e-Commerce Leaders Continue to Take Share from Brick-and-Mortar Retailers Online Retail Sales as a % of Total Retail Sales CHART 3 Finding Potential Winners in Today’s Environment I 2012 I 2013e I 2014e I 2015e I 2016e I 2017e 0 2 4 6 8 10 12 14% U.S. JapanChina UK India FranceGermany 4
  5. 5. data by 20167 —the equivalent of 250 billion DVDs worth of data. The associated investment opportunities are many, but in the current macro- economic environment, certain types of firms with exposure to the phenom- enon would appear better placed than others. These companies sell efficiency or productivity improvements to other data-dependent companies—server farm cooling solutions, energy efficient microchips, and the like. As the data deluge continues to gather strength, opportunities for such companies should multiply. Another class of companies, which we call “justified middlemen,” also sells effi- ciency to other firms. Frequently, they source and distribute high volume, low margin necessities to a large but frag- mented base of business customers that would find doing so themselves too costly or cumbersome. Take, for example, Bunzl, a UK-based global firm that supplies common items to grocery stores, restaurants and healthcare- related businesses, among others. Its food service channel is instructive: Bunzl buys paper bags, coffee cups, napkins, to-go containers, and so on in bulk and sells relatively small quanti- ties to thousands of dispersed eateries. These businesses couldn’t function without such supplies, but they’d find sourcing all of them individually both costly and time-consuming. Bunzl’s massive purchasing power and supply- chain efficiency allow it to provide these goods profitably, but at a low cost. A broader set of Internet companies enjoy comparable advantages. A range of next generation Internet platforms are poised to take advantage of a global transformation in advertising, but they don’t need to spend much on person- nel or capital equipment to do so. 2. EFFICIENCY VENDORS There’s more than one way for firms to become more efficient. If they can’t do it on their own, they can take advantage of the products and services Efficiency Vendors offer. Let’s consider two very different examples of this category. The world’s dependence on data pro- cessing, analysis and storage continues to skyrocket. We are living in the “data deluge” era, with global Internet traffic alone slated to surpass a zettabyte of 7. Cisco Visual Networking Index: Global Mobile Data Traffic Forecast Update 2012–2017, February 6, 2013. Estimates may not be achieved. Internet Traffic Continues to Expand Rapidly Global Annual Network Traffic 2012–2017e (in zettabytes) CHART 4 Source: Cisco Visual Networking Index, 2/27/14. Estimates may not be achieved. Past performance does not guarantee future results. 2012 2013 2014e 2015e 2016e 2017e 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 Zettabytes INSIGHTS 5
  6. 6. 3. INNOVATORS Innovating to grab market share and preserve pricing power is another way some companies can overcome the hurdle of slow growth. This is particu- larly true of firms whose inventions take costs out of a process or those building a better proverbial mousetrap. New technologies like robotics stand to introduce significant cost savings into manufacturing processes. Lastly, remember that innovation doesn’t have to look like something out of the Jetsons to help drive efficiency gains. Just look at the hydrofractur- ing and horizontal drilling techniques that have enabled the ongoing North American energy revolution. Some of the makers of related equipment— pumps, perforation guns, nonmagnetic steel casings—may prove to be among the greatest beneficiaries. Thanks to the paradigm shift in the energy indus- try, many of these companies may see strong enough revenue growth to maintain or expand profitability even if they do need to increase hiring and capital spending. The U.S. Has Increasingly Become a Net Exporter of Petroleum Products Weekly U.S. Net Exports of Total Petroleum Products (Thousand Barrels per Day) 12/31/04–3/28/14 CHART 5 –5,000 –4,000 –3,000 –2,000 –1,000 0 1,000 2,000 3,000 3/28/14 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Source: U.S. Energy Information Administration, as of 4/2/14. 6
  7. 7. Summing UpSumming Up The secular bull market we’ve enjoyed for the past few years isn’t over, but it is changing. Investors today confront a world of relatively modest economic growth in which equity valuations have risen and profit margins may be peaking, as companies increasingly must deploy capital to drive future expansion. In such an environment, it’s unrealistic to expect a rising tide to lift all boats, and investors consequently must become more selective. This change means taking a more active approach to investing, and focusing on types of companies whose characteristics make them particularly well-suited to thrive. I believe that as we move through 2014 and beyond, the advantages of Organic Revenue Generators, Efficiency Vendors and Innovators will serve investors well. INSIGHTS 7
  8. 8. The Lipper Large-Cap Core Index is an unmanaged index representing large-cap core funds tracked by Lipper. The S&P 500 Index is a broad-based measure of U.S. equity performance. The index is unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any investment. Past performance does not guarantee future results. These views represent the opinions of OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the open of business on April 21, 2014, and subject to change based on subsequent developments. The mention of specific companies does not constitute a recommendation by any Oppenheimer fund or by OppenheimerFunds. Certain Oppenheimer funds may hold the securities of those companies mentioned. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and geopolitical risks. Emerging and developing market investments may be especially volatile. Due to the recent global economic crisis that caused financial difficulties for many European Union countries, Eurozone investments may be subject to volatility and liquidity issues. Investments in securities of growth companies may be volatile. Small and mid-sized company stock is typically more volatile than that of larger, more established businesses, as these stocks tend to be more sensitive to changes in earnings expectations. It may take a substantial period of time to realize a gain on an investment in a small or mid-sized company, if any gain is realized at all. There is no guarantee that the issuers of stocks held by mutual funds will declare dividends in the future, or that dividends will remain at their current levels or increase over time. Diversification does not guarantee profit or protect against loss. Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. Before investing in any of the Oppenheimer funds, investors should carefully consider a fund’s investment objectives, risks, charges and expenses. Fund prospectuses and summary prospectuses contain this and other information about the funds, and may be obtained by asking your financial advisor, visiting or calling 1.800.CALL OPP (225.5677). Read prospectuses and summary prospectuses carefully before investing. Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc. 225 Liberty Street, New York, NY 10281-1008 © 2014 OppenheimerFunds Distributor, Inc. All rights reserved. DS0001.409.0314 April 21, 2014 CONTACTCONTACTUSUS Visit Call 800.225.5677 FollowFollow us:us: VisitVisit Search Google CurrentsSearch Google Currents for OppFunds to access ourfor OppFunds to access our timely thought leadershiptimely thought leadership Visit | Call 800.225.5677 Scan this codeScan this code to learn moreto learn more about us:about us: DR. JERRY WEBMANDR. JERRY WEBMAN CHIEF ECONOMISTCHIEF ECONOMIST Jerry Webman providesJerry Webman provides strategic viewpoints on thestrategic viewpoints on the financial markets and thefinancial markets and the economy. In his career,economy. In his career, Jerry has had roles as aJerry has had roles as a researcher, a financial advisorresearcher, a financial advisor and a portfolio manager. He hasand a portfolio manager. He has been in the industry since 1983.been in the industry since 1983. ELIOT WALSHELIOT WALSH SENIOR ANALYSTSENIOR ANALYST Eliot Walsh is a seniorEliot Walsh is a senior analyst in the capitalanalyst in the capital markets research research group. Eliot has been in the indusEliot has been in the indus- try since 1998.