David Harbage Blog

Against a backdrop of a fearful or lethargic market overshadowed by an apparent deepening of economic woes, surrounding the Euro zone in particular, we are pressing on in our promise to provide a view on the different business sectors within the UK equity market.

In the past week we have seen trading updates from a number of the leaders, in their respective industries, notably Royal Dutch Shell, Lloyds Banking Group, Centrica, GlaxoSmithKline, BT Group, British American Tobacco and Unilever. Pan-market and intra-sector, we expect investors to be increasingly discerning in their stock selection.

We have already covered natural resources, which incorporates oil & gas producers (plus the accompanying service companies) and mining. Previous blogs have also commented on banks, retail (both general and food), house builders and touched upon the support services sector. With the exception of food retailers (which includes Tesco, whose proposition encompasses much more these days), all of these business activities can be described as being cyclical – in the sense that these industries are sensitive to the economy. Each possesses the potential capability of offering growth in profits and asset worth, upon any meaningful pick-up in demand for their products or services.

By contrast, there is a range of less economically sensitive or dependent segments of industry – sometimes termed ‘defensive’ businesses – the largest of which are: pharmaceuticals (includes biotechnology, healthcare equipment & services), telecommunications (providers of fixed line or mobile), utilities (generating or distributing electricity, gas, water, other), tobacco, beverages and food producers. As these businesses provide essential staple products or services (with tobacco and alcoholic beverages coming into this category, due to their customers’ perceived product dependence), they tend to be less affected by an overall decline in consumers or companies’ ability to spend. Many – but certainly not all - of the underlying companies in these slower growth industries tend to pay out a greater proportion of their profits, in the form of dividends and repurchases of stock, primarily because they have limited growth opportunities.

Investors have, understandably, favoured non-cyclical sectors over the course of the past two years – with financial companies being particularly unloved, post the financial crisis – relative to the more economically sensitive businesses. The key question now is to assess the extent to which the equity market has already discounted the length and magnitude of the current economic downturn. Clearly, it is important to look at individual businesses to assess how different they may be (from an intuitive expectation) and perform but, from a broader industry sector basis, the following attributes and concerns merit further investigation:

Pharmaceuticals: the FTSE100 index features two global giants in GlaxoSmithKline and AstraZeneca. These companies used to enjoy a premium rating (by reference to earnings) ‘back in the day’, but since the 1990s the industry has struggled to produce new ‘blockbuster’ medicines, maintain or extend patent life of its products and its customers (governments and private health firms) have put pressure on prices and profit margins. The business model demands high margins on drugs that are approved, to overcome the very significant upstream expense – notably in research & development (R&D) facilities. However, such profitability is being increasingly squeezed by generic medicine manufacturers who challenge patents and governments seeking to implement austerity-driven price cuts. Unlike the biotechnology and junior pharmaceutical manufacturers, the big businesses feature robust balance sheets and strong cash generation.

With limited prospects of discovering and funding a new pipeline of business-changing products, both GlaxoSmithKline and AstraZeneca are committed to a high and progressive dividend payout accompanied by a substantial stock repurchase programme. Mergers of large pharmaceutical companies make sense (in theory, at least), as resultant synergies – notably a reduction in overlapping R&D laboratories, sales force (distribution channel can simply offer a wider product range) and other general administrative costs – can be substantial. Various obstacles, such as cultural differences, have inhibited these anticipated benefits but more recently there has been evidence of acquisitive corporate action – primarily to build up a depleted new drug portfolio. The prices paid for these junior companies have been high, and rarely earnings-enhancing, and investor disquiet about management effectiveness has become a perennial; resurfacing most recently earlier this year when AstraZeneca’s Chief Executive Officer stood down.

The telecommunications industry represents another provider of an essential service, which nowadays extends to providing the platform for multimedia services (such as TV on demand, via the Internet) and so much more than traditional voice telephony. BT and Vodafone are the two big FTSE100 index constituents that capture most of wider media headlines on an ongoing basis – principally driven by technological progress or problems. While the underlying assets and corporate personality of both has changed dramatically over the past ten years (by contrast with the aforementioned AstraZeneca and GlaxoSmithKline), each company possesses a bias towards relatively resilient revenue streams – rather than an abundance of growth in profits opportunity.

As the owner of much of the UK’s infrastructure, BT represents the more domestic operator with its growth potential residing in broadband (and an associated multimedia proposition – to compete with the likes of BSkyB and Virgin) and a recovery in its somewhat depressed global services proposition. BT is often viewed as a cash-cow, restrained by a tough industry regulator, a significant pension fund deficit and a highly geared balance sheet. Vodafone, by contrast, earns most of its income overseas following an explosive corporate growth spurt some fifteen years ago. Its international portfolio of businesses (which analysts often seek to value, by reference to a ‘sum of its parts’) can be divided between developed economies (where mobile usage or ‘penetration’ is high, such as in Europe) or markets, and emerging ones. The telecommunications industry is somewhat mature, as well as being strictly regulated, in the world’s leading countries which has meant that, although new platforms like smart phones and tablets have resulted in much higher data usage, prices and profit margins have come under pressure in response to intense competition. As such, incumbent fixed line operators have been perceived as quasi-utilities, but such a descriptor may be somewhat unfair insofar as Vodafone is concerned. Europe’s biggest mobile operator also operates in many far-flung countries which offer greater growth potential, which includes a significant stake in the United States-based Verizon Wireless business, whose value has yet to be unlocked or realised.

Utility companies have been making media headlines, as well as impacting financial markets, this week as the British Government announced new levels of subsidies to be paid in respect of environmentally-friendly fuels (typically reducing aid to the likes of onshore wind ‘farms’ and biomass consumers) and unveiled tax assistance to oil & gas explorers in the North Sea. One of the FTSE100’s largest utility businesses, Centrica, is a beneficiary of the latter as the company possesses both upstream (for example extracting gas from Morecambe Bay and the North Sea) and downstream (distributing to UK homes & businesses via British Gas) operations. By contrast Drax shares crumbled in response – notably as the company planned to reduce in dependence on coal in favour of biomass fuels. Although the water companies are more homogeneous, each of the larger listed utility businesses features different business models and levels of industry regulation. The greater the extent of regulation (as is prevalent for the water supply/services firms), so intuitively investors should expect a mathematically-driven and valued business, with limited revenue growth and upside surprise. As a consequence of having high confidence in revenues and earnings (and subject to levels of maintenance or other anticipated capital expenditure), these companies typically pay high dividends – as evidenced by Scottish & Southern Energy’s 5% fall on Wednesday to reflect the equity trading in its ex-dividend (meaning, without dividend) form. By contrast, those that have diversified into non-regulated territories or business activities, like Centrica, are likely incorporate greater opportunity for earnings growth and surprise.

The remaining defensive business activities, mentioned above, of tobacco, food and beverage manufacture have exhibited rather different attributes to the low-growth ‘cash cow’ businesses that electricity, water and telecommunication companies represent. The two big tobacco constituents of the FTSE100 index – British American Tobacco and Imperial Tobacco – are, post a series of acquisitions, multinational groups who have benefited from strong demand within emerging economies for their branded cigarettes. The same could also be said for the likes of the drinks giants Diageo and SAB Miller, whose globally-recognised spirits and beers (which command a premium price, relative to local alternatives) are often viewed as status symbols in Asia, South America and emerging countries featuring burgeoning middle classes. This is a very different landscape to the traditional perspective of domestic defensive businesses – which, focusing on the working classes, might have incorporated brewers, bookmakers and local tobacco consumption in the 1980s. The recognition of their growth potential has resulted in the equity of tobacco and drinks businesses being afforded premium valuations, by contrast with most listed utility companies.

While clearly more essential, food manufacturing businesses have not been able to command the same level of pricing power for upmarket or branded products and, with very different taste requirements (think chocolate) around the world, local favourites have rarely travelled well and been adopted in new geographies. Economies of scale have meant that larger companies, such as Unilever, have managed to maintain some semblance of growth – as well as diversify into non-food proposition, such as deodorants and detergents. Smaller companies (for example: Premier Foods) have often struggled, despite their ownership of well-known branded products, as their profit margins come under pressure from both ingredient suppliers (variable, harvest-dominated, commodity prices) and the food retailers. Brand names require significant regular investment (via advertising, marketing) in order to maintain their worth, pricing power and geographic reach. This applies to essential products such as food, drinks and tobacco – and includes cleaning products, too, such as owned by household business and FTSE100 constituent Reckitt Benckiser, or to mobile telecom networks (who many may now perceive as an undifferentiated service, not requiring such publicity) - as well as to luxury goods, subject to a discretionary purchase. 

Most high quality, industry leaders in the resilient business activities – especially those with a global business - have outperformed the wider UK equity market since the global financial crisis, when measured by reference to total (dividend inclusive) shareholder return. The extent to which they can continue to extend their premium valuations will depend upon the economic prognosis, the relative attractions of credit (corporate bonds), the shape of real yields (prospects for inflation and longer term interest rates) and the extent to which these businesses can deliver some semblance of growth (in bottom, if not top, line terms).                                                                                                                 

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.