Productivity, innovation and pricing power have never been more important
Head of Equity Strategy
Summary: Before Russia’s invasion of Ukraine equities were already under pressure from rising commodity prices and a worsening interest rate outlook.
Equity valuations are under siege
Before Russia’s invasion of Ukraine equities were already under pressure from rising commodity prices and a worsening interest rate outlook. The war and subsequent severe sanctions against Russia have catapulted the world into an unpredictable and maximum uncertainty environment. When the future becomes more uncertain the precautionary principle dictates that the equity risk premium should go up, with equity valuations going down as a consequence.
Equity valuations are primarily driven by four factors: revenue growth, EBITA margin, incremental investment needs, and the discount rate on future cash flows. While the ongoing inflationary pressures might push up nominal revenue growth, the three other factors are all moving in the wrong direction.
Rising input costs for companies across raw materials, energy and wages are not only making operating margins more volatile; they will also compress margins—we have already observed this in the Q3 and Q4 earnings. As there has been underinvestment in our physical world for over a decade (the capital expenditures in the global energy and mining sector are historically low) and global supply chains will be reconfigured amid rising geopolitical tensions, incremental investments will likely move higher. Central banks have severely underestimated inflationary pressures as the world economy has exhausted the low-hanging benefits from globalisation and prior investments. The world economy has clearly hit physical limits and this is causing inflationary pressures. Central banks will have to reduce demand through tightening financial conditions which include higher interest rates and a higher discount rate on future cash flows. All of the above will lead to lower equity valuations.
Despite the vector of all the most important factors for equity valuation pointing in a negative direction, as of February 2022 the MSCI World Index is still valued 0.9 standard deviations (equivalent to the 86th percentile on valuation) above its historical average since 1995. Given the outlook and opportunity set we believe equities should be valued closer to their historical average, reflecting the increased uncertainty and difficulties modelling growth and margins. This means an additional 10-15 percent downside in the MSCI World Index.
It’s all about productivity and innovation
With a large-scale war back in Europe and commodity markets in upheaval, this has aggravated inflationary pressures and equities have entered an environment not seen since the 1970s. High inflation is essentially a tax on capital and raises the bar for return on capital, and thus inflation will filter out weaker and non-productive companies in a ruthless fashion. The days of low interest rates and excess capital keeping zombie companies alive longer than necessary are over.
Reading Warren Buffett’s shareholder letters from the 1970s the key to survival is productivity, innovation or pricing power. The latter is often a function of productivity and innovation, and coincides with high market share—or just size in general—providing economics of scale. Over the past year we have frequently mentioned mega caps as a theme during inflation. The largest companies in the world are the last to get hit from tighter financial conditions, and they also have the pricing power to pass on inflation to their customers for a longer time than smaller companies.
Besides raw size as way to survive inflation and higher interest rates, companies that are productive will have a higher chance of survival. Productivity can be measured in many ways, but in order to have a uniform measure that can be used across all industries we have looked at adjusted net income to employees. This measure can be plotted against the number of employees and will show a negative relationship. This means that the larger a company gets the lower its profits per employee get. In order words, there are diminishing returns to size, which should not be a surprise. If a company is trying to maximise profits then that will often naturally lead to sacrificing productivity; but what is lost in productivity is gained through economies of scale in its operations, and this allows for higher levels of aggregated profits. Companies that lie way above the regression line (see plot) are those that have significantly higher profit per employee (productivity) relative to what their size would suggest. The most productive company in the world relative to what its size would dictate is Apple (orange dot). The companies that are way above the regression line are doing something right. In our productivity and innovation table below, we show the two best companies in each industry group that have the largest spread above the regression line.
Saxo's productivity and innovation list
There’s a vast amount of academic literature linking research and development (R&D) intensity to future equity returns; many studies have found a positive relationship regardless of the intensity measure used. In our analysis we have chosen to use R&D in percentage of revenue as a measure of R&D intensity and as with our productivity ranking, we have selected the two companies from each industry group with the highest R&D intensity; certain industry groups with no R&D such as banks and insurance have been excluded. The productivity and innovation list should not be viewed as an investment recommendation but as an objective list highlighting companies that score the highest on our chosen metrics for productivity and innovation. These measures are not guaranteed to lead to outperformance in the future.
Europe’s seismic shift in security policy
For decades to come February 24, 2022 will mark the pivotal moment when Europe’s post-WWII security policy changed as Russia launched a full-scale invasion of Ukraine. In each decade following WWII, European countries inside NATO had lowered their military spending as a percentage of GDP to the point that it reached only 1.2 percent in 2019, compared to the US at 3.7 percent in 2020. This significant discrepancy—despite the NATO agreement in 2006 to commit to a minimum 2 percent of GDP—was the culprit behind the attacks by former US President Trump on NATO and European countries for doing too little. Europe had long argued that they spent money in non-direct military areas that had a security purpose inside NATO, but there is nothing like a black swan event to reveal that the emperor has no clothes.
Following Russia’s invasion of Ukraine all countries in Europe have said that the continent has changed, and it is clear that they must step out from under the US military umbrella. Germany has declared that it will indefinitely increase military spending to above 2 percent of GDP, signalling a major security policy shift. The 27 countries in the European Union spent €168bn in 2019, and if military spending is increased to 2 percent of GDP by 2030—and assuming GDP trend growth—then spending will increase to €346bn in 2030, translating into 8.4 percent annualised growth. In the event that military spending is accelerated, which is quite likely, the growth rate will be double-digit in the coming years. As stated in Moretti et al 2021, expenditures for defence-related R&D represents by far the most important form of public subsidies for innovation and it causes spillover effects in privately funded R&D, resulting in overall productivity gains. While increased military spending is happening in Europe due to the horrific invasion in Ukraine, it could cause long-term economic growth and innovation in all of Europe.
As a result, we are positive on the defence industry as a theme and our defence theme basket represents 25 defence contractors in the US and Europe. These companies provide exposure to military spending and should be viewed as an inspirational list and not investment recommendation.
|Diff to PT (%)||5yr return|
|Raytheon Technologies Corp||145,733||13.8||7.7||9.6||66.3|
|Lockheed Martin Corp||117,801||2.5||13.6||0.6||88.2|
|Northrop Grumman Corp||68,914||-3.1||15.8||-1.1||99.2|
|General Dynamics Corp||65,056||1.4||10.8||8.9||37.6|
|L3Harris Technologies Inc||48,265||-2.1||11.8||5.9||144.3|
|TransDigm Group Inc||34,728||2.9||37.5||18.1||220.4|
|BAE Systems PLC||29,523||1.3||11.5||-0.6||37.4|
|Howmet Aerospace Inc||14,205||-5.5||15.0||17.7||52.8|
|Dassault Aviation SA||12,130||32.0||7.4||8.7||21.3|
|Rolls-Royce Holdings PLC||10,188||-3.9||4.2||33.1||-63.5|
|Elbit Systems Ltd||9,342||12.1||8.1||-19.4||86.8|
|Kongsberg Gruppen ASA||6,537||7.2||10.4||0.0||235.3|
|Ultra Electronics Holdings PLC||2,976||0.0||13.9||-5.9||67.1|
|QinetiQ Group PLC||2,319||7.2||7.3||11.3||22.6|
|Babcock International Group PLC||2,236||0.2||-38.3||11.8||-57.8|
|Chemring Group PLC||1,236||-2.3||12.6||8.5||84.9|
|Avon Protection PLC||515||0.7||-11.7||12.4||44.6|
|Aggregate / median values||811,892||2.4||8.1||9.6||52.8|
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