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After a roller coaster year in the UK equity market in 2020, investors and commentators are looking forward to better news in 2021 as several Covid-19 vaccines are rolled out and Brexit is seen as done and dusted. The pundits are predicting a period of reflation, talking up commodities and banks, which tend to benefit from rising interest rates, while anticipating a recovery in the hard-hit leisure, travel and retail sectors. This optimism seems to ignore many uncomfortable realities. We are currently in the eye of the storm as regards hospitalisations and deaths from Covid. There is a massive backlog of routine operations with hospital waiting lists now said to number over 4.5 million people. The huge government programmes to subsidise the wages of furloughed employees have saddled the UK government with debts at levels not seen since the second world war. Many businesses have disappeared and those that have barely survived thus far may find they are unable to finance an upturn. Long term unemployment and retraining will also be costly. Shopping habits and working practices have likely changed permanently, with implications for real estate usage and values. Of course we are all itching to go on that longed-for holiday, to eat out again and enjoy favourite leisure pursuits, but what then?
Many businesses have handled 2020 well and some have positively thrived. Pure online retailers, computer games publishers, and diagnostic test kit providers have been particular winners. More generally though, the strong have got stronger, leaner, fitter. The aftermath of the Global Financial Crisis in 2008 taught us that beyond a relief rally lasting only a few months, the secret of wealth creation over the next decade lay in investing in businesses with strong finances, expanding markets and secular growth opportunities, and the ability to withstand competition through the possession of sustainable barriers to entry.
The UK stockmarket offers many such attractive combinations of growth and sustainability. In the domestic arena, one example is the long term trend for individuals having to take greater responsibility for their own retirement savings following the phasing out of defined benefit pension schemes. This need is addressed by several listed branded investment platforms which possess network effects as they scale and which also benefit from customer inertia and satisfaction inhibiting switching to alternative providers. Another trend is the digitalisation of UK government services to citizens which understandably tends to favour suppliers with previous referenceable experience and trusted reputations for delivery. The growth in online and hybrid retailing is most profitably addressed by having a well-known brand and a national network of (preferably low cost) click & collect locations.
Looking more globally, there is an increasing demand for safe water and the capability for the purification of water supplies usually comes with regulatory approvals from government agencies. The same is true of the rising need for more effective and environmentally friendly sterilisation of hospitals and hospital equipment. The rising cost of healthcare requires better data and information systems to discover best practice, which can then be rolled out for greater efficiency and effectiveness. Here, incumbent hospital software providers have the competitive advantage of historic data sets and high switching costs. The rising need for cybersecurity advice in an increasingly digital age often demands the employment of highly technical talent under a substantial corporate umbrella which holds a record of previous success. The rising incidence of political instability even in democracies is likely to require greater individual protection for first responders such as the police, to the benefit of defence groups with patented protective clothing. Rising global awareness of Chinese ambitions to control the South China Sea generates investment in naval and unmanned aerial capabilities in the region to the benefit of established defence suppliers with patented products or government approvals.
Finally it is important to note that many of these combinations of secular growth and barriers to entry are often found lower down the size spectrum where a company has the opportunity to dominate a specific niche. The easiest way to identify such businesses is to analyse the returns on capital employed, or the ungeared returns on equity capital. The stock market focusses on earnings per share, and generally looks out only a couple of years. However, not all earnings are created equal. Earnings should not be looked at in isolation but in relation to the capital employed to achieve them. Superior returns on capital are a strong indicator of enduring competitive advantage, particularly if sustained over many years. If a high proportion of those returns can be reinvested in the business at similarly attractive returns, rather than distributed, so much the better. As Albert Einstein reportedly said: “Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t, pays it.”
Originally published in Investment Week 1 February 2021.
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