Lazard Insights Navigating Change with Economic Franchises Summary • As markets normalize and volatility increases from depressed levels, we believe investors who wish to successfully navigate change will need to adopt an absolute return mindset and be more selective about their holdings and portfolio construction. • Economic franchises have investment characteristics that help generate stable returns through different market environments, making them useful in times of uncertainty and change. • Companies with sought-after attributes, like economic franchises with dominant competitive advantages, often trade at relatively high market valuations. To maximize returns investors must not overpay for these opportunities. Today’s global landscape looks increasingly uncertain. Interest rates are rising after years of low or, in some cases, negative real rates. Inflation is starting to inch higher, and equities appear expensive after a strong decade-long run. ese factors have led many investors to question the market outlook. Although we still believe many high quality businesses exist, not all are attractively valued. As the investment environment normalizes, investors should adapt their portfolios to focus on valuation in order to achieve their return target. Today’s Investment Challenges Over the past decade, companies have benefited from a combina- tion of low interest rates, earnings growth, and low wages, which has contributed to lofty equity valuations and record corporate profits. Today, the S&P 500 Index trades at nearly two times its historical average of 16.8 (Exhibit 1). e only other times in the last 100 years when equities were this expensive were during the late 1920s and early 1990s, which preceded the Great Depression and the bursting of the tech bubble, respectively. High and rising profit margins (Exhibit 2) have led to higher earnings and higher equity valuations. We believe it is important to stress that these profit margins are likely unsustainable and, thus, question the extreme valuation multiples that exist today. Ultimately, we believe profit margins will decline over the long term, either through moderating sales growth or higher input costs (e.g., higher wages, interest rates, higher raw material prices). Lazard Insights is an ongoing series designed to share value- added insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. is paper is published in conjunction with a presentation featuring the author. e original recording can be accessed via www.lazardassetmanagement.com/insights.
Transcript
Lazard Insights
Navigating Change with Economic Franchises
Summary• As markets normalize and volatility increases from
depressed levels, we believe investors who wish to successfully navigate change will need to adopt an absolute return mindset and be more selective about their holdings and portfolio construction.
• Economic franchises have investment characteristics that help generate stable returns through different market environments, making them useful in times of uncertainty and change.
• Companies with sought-after attributes, like economic franchises with dominant competitive advantages, often trade at relatively high market valuations. To maximize returns investors must not overpay for these opportunities.
Today’s global landscape looks increasingly uncertain. Interest rates are rising after years of low or, in some cases, negative real rates. Inflation is starting to inch higher, and equities appear expensive after a strong decade-long run. These factors have led many investors to question the market outlook. Although we still believe many high quality businesses exist, not all are attractively valued. As the investment environment normalizes, investors should adapt their portfolios to focus on valuation in order to achieve their return target.
Today’s Investment ChallengesOver the past decade, companies have benefited from a combina-tion of low interest rates, earnings growth, and low wages, which has contributed to lofty equity valuations and record corporate profits. Today, the S&P 500 Index trades at nearly two times its historical average of 16.8 (Exhibit 1). The only other times in the last 100 years when equities were this expensive were during the late 1920s and early 1990s, which preceded the Great Depression and the bursting of the tech bubble, respectively.
High and rising profit margins (Exhibit 2) have led to higher earnings and higher equity valuations. We believe it is important to stress that these profit margins are likely unsustainable and, thus, question the extreme valuation multiples that exist today. Ultimately, we believe profit margins will decline over the long term, either through moderating sales growth or higher input costs (e.g., higher wages, interest rates, higher raw material prices).
Lazard Insights is an ongoing series designed to share value-added insights from Lazard’s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via www.lazardassetmanagement.com/insights.
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A Strategy for a Long-Term Future is Unlikely to Resemble the PastSince the global financial crisis, equity returns have exceeded investor expectations. Over the past eight years, investors have earned strong returns simply by tracking the market, that is by having beta exposure. Market returns have been healthy enough for alpha, or above-market returns to become a secondary concern.
As markets normalize and volatility increases from exceptionally low levels, we believe investors who wish to successfully navigate change will need to be more selective about their holdings and portfolio construction. Simply tracking the market will be insufficient:
• First, we believe investors need to focus on companies with the ability to consistently generate absolute returns—companies with highly forecastable earnings and proven business models that tend to perform well during challenging periods. We call these companies “economic franchises.”
• Second, investors need to have logical return targets with conservative assumptions and a long-term focus (we suggest a minimum of five years).
• Third, in challenging periods investors should not rely on benchmarks, but should identify attractively valued stocks and high quality businesses.
• Finally, investors need to adequately diversify their investments. Simply owning more stocks does not always significantly reduce risk, especially in an expensive equity market.
Economic Franchises: Focus on the Right CompaniesEconomic franchises have investment characteristics that help generate stable returns through different market environments, making them useful in times of uncertainty and change, such as now. Economic franchises often have market-leading positions, a long history of stable financial returns, relatively low levels of debt, and sustainable competitive advantages (Exhibit 3). Their competi-tive advantages are sourced from one or more of the following:
• Natural Monopoly: This refers to a business where very large up-front capital costs mean that it is most efficient for only one provider of the product or service to exist. For instance, infrastructure companies, which own assets that are critical to an economy and society like airports, toll roads, and regulated utilities, fall into this category. The up-front cost of building such assets and scale needed to operate them makes it most efficient to have only one provider exist. Examples include PG&E, an electric utility company in California, and Atlantia, a global motorway and airport holding company in Italy.
Exhibit 1US Equity Valuations Are Stretched
0
12
24
36
48
20182002198619701954193819221906
(P/E)
Average
US 10-Year Cyclically Adjusted
As of 31 December 2017
Source: Lazard, Minack Advisors, S&P
Exhibit 3Economic Franchises Have a Rare Combination of Desirable Investment Characteristics
Sources of an Economic Franchise Characteristic of an Economic Franchise
NaturalMonopoly
Cos
tLe
ader
ship
NetworkEffects
Brands &
Intellectual
Property
High
Switching
Costs
High return on assets / regulated returns
Market-leading positions in attractive industries
Large and sustainable barriers to entry (moats)
Stable return history
Low-to-moderate financial leverage
Sound corporate governance /stewardship
Source: Lazard
Exhibit 2US Profit Margins Have Risen
0
2
4
6
8
10
2017201320092005200119971993
(%)
Average
S&P 500 Trailing12-Month Profit Margin
As of 31 December 2017
Source: Bloomberg
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• Cost Leadership or Economies of Scale: Some businesses have cost advantages over their competitors because they can leverage their buying power to offer lower prices to customers and gain more market share. Examples include Cisco, a communications equipment manufacturer, and International Game Technology, a lottery operator.
• Network Effects: Network effects occur where the value of a network increases with the number of users and results often in monopolistic/duopolistic industry structures. A prime example is Visa’s electronic credit card payment network.
• Brands & Intellectual Property: These are businesses that possess intangible assets, which can represent a barrier to entry. Examples include dominant household products from Procter & Gamble, or the patent portfolio derived from billions of dollars spent annually on research & development (R&D) at Medtronic. Such brands and R&D spend make it very difficult for competitors to overcome.
• High Switching Costs: Certain products and services are critical to customers, often making it very risky or costly for customers to switch to another competitor. For instance, critical software and database providers, like Oracle, source their advantages from high switching costs.
In our view, less than 2% of the 14,000 constituents in the MSCI All Country All Cap Index are equity franchises. This amounts to about 250 companies throughout the world and does not include financials, pharmaceuticals, and energy companies because their earnings are not easily forecasted, an essential component of an economic franchise.
More Predictable and Sustainable EarningsEvery investment decision implies a view of the future. And, unfortunately, the view can be wrong. Revenue growth could be less than expected, a new competitor may cut prices, or a recession could impact earnings more than expected. We believe economic franchises can help address this forecasting risk because quite simply, their earnings have historically been easier to fore-cast and more resistant to economic shocks.
Market forecasters have had more success predicting franchise company earnings over time than predicting earnings for the MSCI World Index. From 1997–2017, the average broker forecast error for franchise companies was significantly lower than that for the MSCI World Index (Exhibit 4). More recently the franchise differential has been minimal, owing to low vola-tility and a bull market over the past decade. As volatility and uncertainty return to markets, we expect the forecasting spread
between franchises and the MSCI World Index to widen, just as it did during the recession in the early 2000s and during the global financial crisis.
A key driver of companies with forecastable earnings are high and stable profit margins. We believe some businesses with strong
Exhibit 4Franchises Have Historically Been Easier to Forecast
0
2
4
6
8
MSCI World Index
Franchise Universe
2017201420112008200520021999
Rolling Broker Consensus EPS Forecast Error (%)
As of 30 September 2017
The returns presented in this chart are based on an investable universe of 250 com-panies that represent our global equity franchise universe as of 1 September 2017. To create this universe we applied a set of qualitative criteria that reflects the desired characteristics of a global equity franchise stock. Performance for the GEF universe presumes that the constituents qualified as franchises at all times. The performance of the GEF universe does not represent actual trading or the impact of material eco-nomic factors on Lazard Asset Management’s decision-making process for an actual Lazard Asset Management client account. Past performance is not a reliable indicator of future results. It is shown for illustrative purposes only.
Source: Lazard, MSCI
Exhibit 5Franchises Have Historically Had Higher and More Stable Profit Margins
6
11
16
21
20172014201120082005200219991996
Franchise Universe
MSCI World Index
(%)
As of 30 September 2017
The returns presented in this chart are based on an investable universe of 250 com-panies that represent our global equity franchise universe as of 1 September 2017. To create this universe we applied a set of qualitative criteria that reflects the desired characteristics of a global equity franchise stock. Performance for the GEF universe presumes that the constituents qualified as franchises at all times. The performance of the GEF universe does not represent actual trading or the impact of material eco-nomic factors on Lazard Asset Management’s decision-making process for an actual Lazard Asset Management client account. Past performance is not a reliable indicator of future results. It is shown for illustrative purposes only.
Source: Lazard, MSCI
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competitive positions and barriers to entry can increase their margins over time. However, this is not true for the vast majority of businesses, particularly those that operate in competitive markets and have limited, if any, sustainable competitive advan-tages. As mentioned earlier, many of their profit margins may not be sustainable in the long run. Economic franchises, on the other hand, tend to have consistent and sustainable profit margins which have historically been higher than the broader global equity universe. During times of economic stress, like the recession in the early 2000s and the global financial crisis, the profit margins for franchise companies actually increased (Exhibit 5). If equity markets were to endure another stress test in the near or medium term, we believe economic franchise companies could sustain their profit margins.
Valuation Matters in an Expensive MarketCompanies with sought-after attributes, like economic franchises, often trade at relatively high market valuations, reflecting their stable cash flows, high returns on capital, and solid growth oppor-tunities. We believe one of the keys to equity franchise investing is to let the franchise company’s competitive advantages work for investors—most of these businesses have a wealth of growth oppor-tunities and available capital. But to maximize return prospects, we believe investors must not overpay for these opportunities. Investors should also have a valuation methodology to reduce the likelihood that they are overpaying for franchise companies. At Lazard, after identifying a franchise universe of about 250 compa-nies, we rank each company according to its potential upside, with reference to the difference between its intrinsic value, as deter-mined by our fundamental analysis, and the current market price.
Case StudyWhich Company is a Franchise: Medtronic or Amazon? Medtronic
Comparing the financial results of two well-known companies helps further highlight our definition of an economic franchise. Medtronic, the largest medical device manufacturer in the world, has strong brands and intellectual property, plus high switching costs. It holds dominant positions in many of its key business segments. It often has two to three times the market share of its nearest rivals, it spends billions annually on R&D, helping it shore up existing market positions and develop new products. Medtronic also owns the largest patent portfolio in the medical device manufacturing industry. The company’s earnings have grown substantially and consistently over the past 20 years, which includes two recessions (Exhibit 6, left). Driving Medtronic’s earnings stability has been its steady oper-ating margins that have ranged between 25% and nearly 40% annually. By contrast, we do not consider Amazon to be an economic franchise as it lacks a dominant market position across its business lines, operates in highly competitive markets, and its earnings and margin history have been less stable and harder to forecast.
The securities mentioned are not necessarily held by Lazard for all client portfolios, and their mention should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio.
Source: Lazard, Amazon Company Reports, Bloomberg, FactSet, Medtronic company reports, Morningstar
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Important InformationPublished on 29 May 2018.
Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness.
Mention of these securities should not be considered a recommendation or solicitation to purchase or sell the securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio.
Certain information included herein is derived by Lazard in part from an MSCI index or indices (the “Index Data”). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom.
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As the investment environment normalizes, investors should consider adapting their portfolios to focus more on valuation. Simply owning index funds that track popular benchmarks may lead to disappointing returns. Resetting macroeconomic and market dynamics are complicating the equity outlook as many of these indices are loaded with overpriced securities. We believe investing in a concentrated portfolio of companies with stable earnings and attractive valuations is a more reliable way to deliver strong results.
