Identifying the winners from losers

As credit spreads begin to narrow and consolidation is rife, investors would benefit from owning selected insurance companies whose portfolios have large exposure to non-government bonds.

There is a thick fog of uncertainty on how the unfolding global policy response will interact with the deflationary pulse emitted by the financial crisis. Investors have extremely low visibility on the timing or shape of the eventual recovery in the global economy and corporate profits. However, structural changes taking place in the economy are clear.

The most significant structural change to the global economy has been moving from an environment where, in retrospect, credit was too easy to find, to one in which credit is much more constrained. While this has been negative for the global economy and stockmarkets in general, it is important to keep in mind that the impact of this change will be unevenly spread across industries and individual companies within industries.

The challenge for in­vestors is to think through the different dimensions of this theme, identify the
relative winners and avoid the losers.

In an environment where credit is harder to come by and unemployment is rising, consumers will trade down to get the maximum utility from every pound, dollar or euro they spend.

Companies whose business models are perfectly suited to this include Wal-Mart in America. Its focus on offering value through low pricing has driven positive same-store sales, while most other retailers have been witnessing sales declining at a frightening pace.

TJX, which owns the TK Maxx clothing chain in Britain, is another example of a business model suited to a value environment. It buys excess inventory from department stores and then sells it at a big discount in
its stores.

Given the speed and severity of the slowdown and the constrained credit environment, accelerated industry consolidation is likely.

Weaker players will be pressured out of the market, acquired by their stronger rivals, or fall behind as they
cannot maintain competitive levels of investment in their businesses.

Companies that have strong franchises will enjoy an
even stronger competitive position as we emerge from this downturn. An example is the semiconductor manufacturing industry, where profitability relies on facilities being run at high utilisation levels.

While all players will suffer in the downturn, the leading players will be able to sustain investment in their businesses, while weaker players will not, thereby increasing their technological advantage and gaining market share over time.

Other examples include ground-parcel delivery in America, where second-tier players are exiting the market, further consolidating the industry around the leading players. This will help support prices, allowing market share gains in the near-term and lead to improved competitive positioning
further out.

Dislocations in the credit markets have substantially reduced the ability of companies to refinance and raise capital. Tightening lending criteria and risk aversion have fed through to higher borrowing costs.

Importantly, the impact of this change has been unevenly spread between different types of business. Larger companies, for example, have felt the effects of limited credit far less than others, as larger organisations often have more diversified businesses, longer track records and more resilient cash flows than smaller firms.

Fear around financing risk has also provided opportunity.
When Anheuser-Busch, the largest brewer in America, was acquired by its Belgian competitor InBev in 2008, the share price of the resulting company fell heavily in the immediate aftermath, as investors worried about whether the company could refinance certain debt obligations.

However, InBev’s share price then rose significantly – its management’s track record of success, together with the relative stability of cash flows in the brewing industry, allowed the company to raise the funding it needed.

One of the highest priorities for authorities around the world is to improve the functioning of credit markets, and a considerable amount of policy will be directed towards achieving that aim.

One way investors can back this view is by owning selected insurance companies whose investment portfolios include large exposure to non-government bonds. As credit spreads begin to narrow from very wide levels, the stock prices of these companies will benefit.

Furthermore, there is a better chance that these companies’ business models will be sustainable and their future returns will be more predictable than in other parts of the financial sector, especially banks.

Performance of Wal-Mart

The Ted spread