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Separating the thrivers from the strivers

T. Rowe Price’s Randal Jenneke discusses the four key disruptive forces that are reshaping equity markets globally and in Australia.


In the early 1940s, economist Joseph Schumpeter coined the phrase “creative destruction” to describe how innovation or “industrial mutation” revolutionises economic structures and destroys old ones, emphasising that capitalism is an evolutionary process. 

This economic progress, which he described as not gradual and often disjointed and unpleasant, requires us, as investors, to focus on where and why disruptive forces are creating or destroying company value, and which business models are positioned to thrive, survive or dive.

We attribute much of today’s disruptive changes to four key sources:

Central banks have masked failure

Central bank policy and quantitative easing have effectively impeded the market’s capacity to reset, creating a distorted environment for competition.

With the cost of debt reaching such lows, many companies have been unduly afforded survival, as we saw in the global energy sector, particularly US shale, where businesses 18 months ago were able to roll over debt, resulting in an oversupply of capacity.

With the price of oil improving from sub-US$30 per barrel levels, all that preserved supply is coming back, preventing the oil market from finding its true equilibrium and stymieing the efficient allocation of resources and capital that would otherwise occur.

Complacency attracts disruptors

Australia is still the land of the oligopoly, where for decades banks, supermarkets and telecoms have staved off threats of competition and mega disruption.

Yet the greatest risk for any oligopoly is not disruption per se, but complacency.

Take supermarkets, for instance. Twenty years ago there were the discount operators BI-LO and Franklins.

These companies have either been acquired or have gone broke trying to capture mainstream market share, leaving the opportunity to service lower socioeconomic market segments wide open and inviting lower cost operators such as Aldi to step in.

Aldi’s process engineer style model typifies how business models are disrupting the status quo.

Incentivising oligopoly disruption are the high margins on offer.

Telstra’s 40+ per cent mobile margins were not lost on low-cost provider TPG, which has just become Australia’s fourth largest telecom provider having outbid Optus for bandwidth auctioned by the Australian government earlier in 2017.

Like supermarkets, the telecommunications industry has been disrupted because there was a vacant market segment and no existing business model focused on capturing it, further incentivised by the lower levels of capital required to enter a marketplace today.

In the case of telecoms, new low-cost entrants can roll out a mobile network and broaden coverage for a fraction of the historical cost.

Just like Aldi, they are entering the market in different ways, avoiding excessive barrier-to-entry costs that have thwarted previous efforts.

Populism drives government spending

Populism is on the rise and here to stay in Australia, as in most developed parts of the world. With a one-seat majority, the Turnbull government is more susceptible to populist pressures.

For instance, to stem and reverse the surge in electricity prices, the government is potentially looking at building its own coal-fired power generation, which would place it in direct competition with electricity giants AGL and Origin.

It aims to lower power prices through greater base-load competition, with clear implications for the marketplace.

This kind of intrusive political dynamic will persist because populism means votes, and votes need spending promises.

Australia’s financials sector will also continue to be impacted by government control and regulation, as seen already with the proposed bank levy and extended powers granted to APRA.

Regional banks and smaller non-bank financial entities may benefit given they are subject to lesser, or different, regulations.

We believe that the greater regulation coming into Australia is anti-growth and not a positive development and we do not favour financials.

Our preference is for business banks over the more consumer-focused banks that have greater exposure to Australia’s cooling housing market.

Clicks outpacing REITs

No view on disruptive forces can be complete without a reference to US retail juggernaut Amazon, which continues to cause havoc for the retail and property sectors, among others.

In Australia, around 60 per cent of the real estate investment trusts (REITs) sector are retail or retail-related.

Globally, we have seen a record number of store closures, indicative of consumers’ preference for online retail trading.

A number of retail businesses will face ongoing pressure, particularly the specialty retailers who pay the highest rents but are still vulnerable to online retail trading.

We have already seen a number of specialty retailers close their doors over the past year, including Payless Shoes and Pumpkin Patch.

Most exposed, in our view, will be the larger shopping mall operators plus retail property trusts.

While the full effect of this disruption is in its infancy, it presents a major issue for many superannuation funds that have an average property allocation of 10 per cent to 15 per cent, with a sizeable chunk of that likely to be retail related and therefore highly exposed to the risk of falling asset values as rents and occupancy levels come under pressure.

Disruptive conditions continue to favour an active approach to stock selection.

Applying a local and global lens is needed to discern the quality thrivers from the propped-up survivors that may face their day of reckoning as the tides of liquidity retract.

Randal Jenneke is head of Australian equities at T. Rowe Price.

 

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