After such a long period of growth in the UK, companies exposed to the economic cycle should be enjo...
After such a long period of growth in the UK, companies exposed to the economic cycle should be enjoying their best environment for years. However, recent announcements from Invensys, Rolls Royce, Kingfisher and Corus reveal a very different picture. Volume growth is often low or non-existent, and margins are being squeezed.
Part of the reason lies in the changing makeup of growth, not just in the UK but across most developed countries. Globalisation of markets has created intensely competitive conditions for traded goods. Pricing power has been removed, leaving profit margins exposed to rising input costs and currency fluctuations. In the UK, export manufacturers are suffering a twin squeeze from fuel and labour costs, compounded by the strength of sterling. In the high street, retailers are experiencing some cyclical growth in volumes, but this has been more than offset by price deflation.
Despite the maturity of manufacturing and retailing activity, there has been growth in service related areas. The revolution in technology and telecommunications, the expansion of financial services, and the trend towards business outsourcing, have all contributed. New companies have emerged in these areas in recent years, exploiting the structural changes which are taking place. The promotion of Logica, Colt Telecom and Capita contrasts sharply with the relegation of older cyclical businesses such as Corus, Whitbread, Tomkins and others.
Small and medium sized companies are playing a major role in the growth sectors of the UK economy, and their stock market success in recent years reflects this. In mature areas, scale can offer some protection against competitors, and historically the UK's major companies have enjoyed better access to capital and managerial skills. This is no longer the case. In the current environment, where product and service lifecycles are becoming shorter, size does not necessarily confer significant advantage. Having a flexible organisation, with access to intellectual capital, will often be the determinant of success.
In a virtuous circle, emergent companies have been able to attract stock market support, which in turn has sustained their growth and ability to attract quality management. Many companies have been able to exploit this and progress directly from the lower to the upper end of the UK stock market. Turbo Genset, now capitalised at over £1bn just months after leaving Ofex, is just one example. There has rarely been such a level playing field, in stock market terms, for early stage companies.
Any further reliance on cyclical patterns seems dangerous. Price and margin pressures may well continue in manufacturing and retail areas, where there is maturity of supply and demand. Cars and clothes are likely to remain cheap, despite rising consumer wealth, in the face of overcapacity and changing spending patterns. A proper assessment of the market in which a company operates becomes the key to investment appraisal, almost regardless of the stage of the economic cycle or the size of the individual company. If the market dynamics are supportive, then even the earliest stage company can become dominant in its field within a relatively short timescale.
Investors should maintain an open-minded attitude to entirely new areas of activity. Autonomy, which dominates the fast developing field of knowledge management software, has been able to sustain gross margins of over 90% while it has grown, such is the strength of its intellectual property. Despite having only Nasdaq and Easdaq listings, its market capitalisation of over £5bn would place it well up the FTSE 100 rankings. Smaller company, RPS, which specialises in environmental consultancy, has grown its earnings at a sustained, compound rate of 20% for five years, and is the only quoted operator in its field. The stock market rates both companies at a premium, but their likely continued growth contrasts with the leap of faith involved in assuming that cyclical groups can overcome all their problems.
The last quarter of the calendar year should see an active new issue market for growth companies. The extremes of performance seen a year ago were due in part to a limited supply of investment opportunities, particularly in technology.
Even now, the technology sector only represents about 6% of the UK stock market. This understates its importance to economic activity. A steady stream of small to medium sized new issues looks likely.
The traditional economic cycle looks to be breaking down in the face of a structural change towards service-based growth. The pattern is of heightened competition in markets for traded goods, and the emergence of the new economy. This points to a more complex picture for growth prospects in the UK. Investment strategies will have to be flexible enough to cope with this new environment.
David Stevenson, Fund Manager, Scottish Value Management Ltd
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