Ten years on from the financial crisis, how have European companies changed?
This edition of EuroView takes a different tack to usual by looking at the past decade since the Global Financial Crisis (GFC). In particular, we are focusing on what we can learn from improvements in corporate behaviour to help us deliver strong stockpicking performance in the coming decade.
Despite the recent bout of volatility, European equity markets have delivered excellent returns since the depths of the crisis back in 2008/9. As at 31 March 2018, the MSCI Europe index had returned 75% since 15 September 2008, the day Lehman Brothers filed for bankruptcy protection, and 170% since the end of February 2009, the low point of the crisis for European equities (source: DataStream).
Although returns have been strong, Europe ex UK has nevertheless lagged the US in the ten years since the crisis, as chart 1 indicates. However, the “super-tanker” European economy has turned and is now enjoying positive momentum. Economic data from the eurozone has been strong and forward-looking indicators continue to be very positive. We continue to see scope for further stockmarket gains but we expect stock-specific factors to have a greater influence on performance.
Correlations between stocks are finally declining
Over the last decade we have experienced regular sustained periods of high correlations between stocks within the market. In 2017 those correlations declined significantly back towards pre-crisis levels before rising again more recently.
We believe we may be entering an era of lower stock correlations as the period of extremely loose monetary policy draws to a close and macro themes become less influential in determining individual share prices.
As correlations in the market unwind, it is high-quality bottom-up fundamental analysis that will identify the best companies for the next decade and, in our view, will provide the best chance of generating significant alpha.
Furthermore, our analysis suggests many industries and companies have transformed themselves during the post-crisis era with the intention of building their resilience should there be a repeat of the GFC in the years ahead.
We challenged our in-house sector analysts to explain how companies have changed their businesses in the years post the crisis. In addition we’ve explored how industries have redirected their business models following technological advancements and shifts in social awareness.
The conclusions from this exercise have broad repercussions:
- We believe companies in general are financially much more robust than they were a decade ago, although there are exceptions
- Companies have acknowledged that social awareness is not an economic cost, but rather an absolute necessity in running a successful company
- The market can be brutal with companies who fail to think outside their silo, i.e. identifying technological change early is fundamental to retaining your market rating
It has become very clear that the outstanding companies of tomorrow are those that have learned and adjusted their business models since the GFC.
Perhaps the most powerful theme to emerge over the last decade has been corporate responsibility. The need for change has been driven from the top by governments and ethical institutions and at the micro level by employees who increasingly want to work for companies who respect the environment, as well as a millennial generation who seem significantly more socially aware.
Governments provided backstop, and now want more influence
In the depths of the financial crisis, the cost/benefit analysis of accepting government equity or participating in a liquidity scheme was easy for a bank: acceptance or death. For policymakers the reality was equally stark: banks were too big to fail. Going to taxpayers and central banks for a bail-out shattered any illusions industry leaders, investors or policymakers might have held that business could operate ring-fenced from the rest of society.
Questions were asked if companies and the financial system had placed too much focus on short-term profits at the expense of longer-term value creation and calls for a more sustainable form of capitalism grew louder.
The cost of providing a backstop has been a seat at the table for all stakeholders alongside, and at times above, shareholders. The state of government finances and the toll on economies and public welfare, none of which have recovered from the shock of 2008 and 2009, has only provided more urgency. Ten years after the crisis companies are under more scrutiny and regulatory pressure than ever before. Those companies that embrace the breadth of claims on their business will be more resilient for future challenges and those that assume it is business as usual will flounder.
Consumer protection a growing priority
This can be seen most starkly in the banking sector. There has been a predictable focus on risk reduction. But beyond that, regulators’ views of the industry have fundamentally shifted to prioritise consumer protection and the industry’s social role. Banks have had to change their business practices, grow their compliance departments and demonstrate cultural integrity.
The challenges spread far wider than the banks. The OECD BEPS (base erosion and profit shifting) project has limited the ability of companies to exploit mismatches in tax rules. Living wages have been introduced from the UK to California. Corporate pressure to help make progress on the UN Sustainable Development Goals is accelerating.
Nor are these just one-off initiatives. The current consultation for the UK Corporate Governance Code, the grandfather of similar codes around the world, states that a company’s function is to “generate value for shareholders and contribute to wider society.” Profits can no longer be the sole purpose of a company. The same consultation urges all companies to take action on diversity and climate change, issues of undoubted importance to a large part of society but which corporates often considered as goodwill efforts rather than core strategy.
Further evidence of the erosion of trust between companies and other stakeholders can be seen in the increasing demands for non-financial disclosure. Today 50% of exchanges have some type of ESG reporting guidance, up from just one in 2006. Annual reports around the world have ballooned and there have never been more companies publishing corporate responsibility reports.
Capitalism has always relied on creative destruction and while banks certainly got creative with financial instruments their vital role as the plumbing of the economy prevented their destruction. Governments frequently step in where market forces fail, and the period post the financial crisis has been no exception. The net result has been the end of “laissez faire” capitalism and more intervention for all corporates.
Successful companies have always been aware of the need to maintain their licences to operate, and have engaged stakeholders accordingly. The difference now is that in an area of rising expectations and increasing transparency, unsustainable business models have nowhere to hide. We as investors need to ensure that our future valuations and forecasts explicitly take into account this very real backdrop.
Sector view – financials face stricter regulation
We have isolated a number of sectors that have experienced the most interesting changes over the past ten years in the hope that our readers can reference particular areas of interest. As we’ve seen from the previous section, probably the most appropriate place to start is the financials sector, given that the banks effectively caused the GFC in the first place.
It is no surprise that it is the banking sector which has been most transformed in terms of both losses and the political and regulatory response to the GFC.
Significant increase in regulation
Regulatory capital requirements have materially increased. Banks and their investors have had to get to grips with a whole new lexicon of capital buffers. Incredibly, back in 2007 Royal Bank of Scotland would not even disclose its Core Tier 1 capital ratio (subsequently revealed to be below 4% with the broader Pan-European banking sector averaging around 6.5%).
Today, Core Tier 1 capital is universally seen as the highest quality form of bank capital and is the starting point for all bank analysis. RBS now boasts a 15.5% Core Tier 1 ratio whilst the sector averages around 14%. The way in which this capital is calculated has also changed; for example, deferred tax assets which require future profits to be generated may no longer be included in capital. Like-for-like capital buffers have probably risen three-or-four fold over the past decade.
This is a positive in ensuring history does not repeat itself. However, it is an enormous challenge for those banks (and there are many) who have as yet been unable to adjust their business models fast enough to generate above cost of equity returns on this enlarged buffer.
Low interest rates = pressure on margins
With the conventional monetary transmission mechanism impaired, central bankers have developed “unconventional” tools in an attempt to restore a degree of inflationary impetus to the economy. For many banks, the resulting near-zero interest rate environment has served to crush margins as the downward repricing of assets cannot be offset by the repricing of liabilities.
With liquidity regulation also part of the regulatory toolkit (it wasn’t back in 2007) and credit demand still low, many banks need to restructure further to generate acceptable returns. This isn’t just important for shareholders, but also for society at large given that banks need to generate new capital to support growth and lending to the real economy.
Diverse opportunity set
So, is it all doom and gloom in the banking sector? Not at all. The Pan-European banking sector is more diverse today than ever before in terms of earnings security, capital generation, capital adequacy, dividend-paying capacity and asset quality risk. That should equate to stockpicking nirvana for the active manager.
While they call it a financial crisis, the culprits were the banks. Insurers made it through the crisis without a policyholder being harmed. Moreover, they have substantially outperformed the banks over the ten years since the crisis.
That’s not to say there weren’t challenges. Many insurers took losses on bank subordinated debt because they had focused on the investment grade rating rather than the extension option embedded in the bonds; others failed to properly examine officially “risk free” Greek government bonds.
But while regulators have required banks to hold ever increasing amounts of capital, insurance sector capital was seen as broadly adequate, although in need of a more consistent regulatory framework. To this end, European insurers spent much of the decade since the GFC preparing for the implementation of a new regulatory capital standard: Solvency II.
Robust capital position underpins attractive dividends
Most major insurers demonstrate strong capital positions under the new rules, and this fact underpins the attractive dividend paying capacity of the sector (insurance is the highest dividend yielding sector).
Insurers have also invested a lot of effort in improving the disclosure of the key drivers of their profitability. This process will take further steps forward when a new accounting standard, IFRS 17, is introduced in 2021. This helps to improve forecasting in what was a notoriously opaque sector. It also helps us discern more clearly the drivers of future profitability and identify mispriced opportunities.
Sector view – tech transforms consumer sector
Technology has become a major part of everyday life since the arrival of the smartphone just over ten years ago. The consumer sector has so far seen the greatest impact of this as we order everything from clothes to food to taxis online. The next wave of change could come in industrial businesses as these increasingly embed new technologies in their operations.
The post-GFC era in the technology sector has been marked by the increasingly important role technology plays in the lives of consumers and businesses alike. This has been particularly evident in the US, prompting the acronym du jour, “FANGs”, ascribed to the dominant internet tech giants of Facebook, Amazon, Netflix and Google (now Alphabet).
Europe too has tech companies set to benefit as we move beyond the consumer phase of the tech adoption curve towards industrial adoption. The likes of German company SAP provides software that facilitates the automation of industrial processes by providing real time data on a firm’s industrial output. For this next wave of technology adoption, Europe’s rich industrial heritage provides a fertile environment for tech firms in this continent to establish a lead.
Tech now touches every part of our lives
In the context of the 10-year anniversary of the GFC, the increasing role of the tech sector in the wider economy is worth pondering. Already, 76% of global transaction revenue touches an SAP system. As business workloads move to the cloud, datacentre companies like Amazon and Microsoft are providing ever more important infrastructure to corporates.
In the future, the failure of any of the tech companies behind this vital infrastructure could therefore have repercussions into the wider economy. The prosperity of the European tech sector is therefore not only important for investors, but also society at large.
Technology has been the main catalyst for change in the consumer sector, rather than lessons learned during the previous crisis. Since Apple launched the first iPhone in 2007, 67% of the Western European population now carries a smartphone (source: Statista). The growth has been exponential over the last ten years, as shown in chart 6, and this marks a step-change in online penetration.
The implication for companies in the consumer sector is twofold: they face a shift in the competitive landscape, as well as in consumer behaviour.
Barriers to entry have tumbled
With the rise of e-commerce, the need for physical stores has shrunk. Further, the rise of social media and user generated content means brands now can reach millions of consumers in an instant, for free. This evolution has caused a drastic reduction in the capital requirements and hence the barriers to entry of the industry. Today, new brands can be built entirely online, marketed for free through social media, with a pure online distribution model.
Consumer behaviour has changed
We now shop online as well as offline, receive deliveries at work and at home, collect in-store or at a pick-up point, reserve online and buy in store, return in store or at a drop-off point. The list goes on. We expect to be able to do this anywhere, at anytime, preferably for free and through a frictionless process.
Social media, instant gratification and shorter attention spans have also contributed to shorter fashion cycles and a general expectation of constant newness.
Traditional businesses need to adapt
Large store networks with long leases, and supply chains set up to minimise costs at the expense of lead times and production flexibility, are not the ideal starting point. However, those that have successfully redirected their business models are more resilient as a result.
For example, companies that have shifted to omni-channel distribution require a smaller store network; this means fewer fixed costs and lower operational gearing going into any future recession. Those that operate with shorter lead times and greater production flexibility are better placed to respond to rapid changes in consumer tastes and demand. This translates into lower markdowns, better full price sales and lower inventory risk.
The benefits for those that have embraced technological change are widespread, while the risk to those that haven’t will only continue to become more acute. We expect stock performance to differ accordingly.
Sector view – cheap credit benefited aerospace and autos
Just as we saw with banks, strengthening balance sheets was a top priority for automakers in the wake of the GFC. However, while ultra-low interest rates eventually dented banks’ profitability, the same loose credit conditions prompted booming demand for autos and aircraft.
The past decade has been a boom for the commercial aerospace industry with order books rising more than 200% over the period. It is hard not to point a finger at the availability of cheap credit since the GFC as both airlines and leasers can cheaply finance new planes. New planes are more efficient and customer experience is greatly improved, so the pressure not to be left behind adds fuel to the demand. The result is that Airbus now enjoys an order book of over €1 trillion, equivalent to the GDP of Mexico.
What if demand slows as credit conditions tighten?
Will it all end in tears? Global airline passenger growth has averaged 3–4% over the past 30 years. The airline industry, however, is hugely cyclical. It will take only a marginal slowdown in passenger growth to tip the market into excess capacity, knocking ticket prices and hurting profitability. If that occurs alongside a tightening of credit, then the aerospace industry will see order cancellations. That said, there were no production cuts during 2007–09, although the boom prior to that was far less extreme.
If global growth continues on its current trajectory then capacity supply and passenger demand should remain broadly in check, and both airlines and aerospace companies will be financially in a good place. However, that scenario is now incorporated into most companies’ own plans. As we know, over-confidence often leads to disappointment. Thus stock selection becomes even more important, because when the cycle turns only the fittest and most agile will outperform.
The autos sector has had a rollercoaster ride since the GFC. With some OEMs (original equipment manufacturers) and suppliers nearing bankruptcy at the trough of the crisis in early 2009, the turnaround has been quite remarkable. Almost every company now stands on a far firmer footing both operationally and financially, but nevertheless remains vulnerable to the next downturn.
Strengthening balance sheets was a priority
The first port of call for management teams in the crisis was to strengthen balance sheets. This was combined with a tightening up of capacity to improve breakeven points and, latterly, increasing consolidation through closer OEM partnerships (e.g. PSA/Opel).
Operations were increasingly supported by strong demand, led primarily by the US and China. Since the GFC China has not only developed into the third major profit pool but also helped to diversify geographic exposure from the US and Europe.
Major beneficiary of cheap credit
The icing on the auto sector’s cake has been the supply of cheap credit through loose monetary policy. This has helped support very low lease rates and therefore encouraged customers to pay higher average selling prices and demand more content. This is mostly clearly evidenced on the streets through the increasing popularity of SUVs.
Regulatory and structural threats ahead
Some things don’t change. The auto sector remains a hugely fixed cost industry and is highly sensitive to the economic cycles of each major region. Neither factor helps to diminish volatility. Meanwhile, emission rules have become ever more important – particularly post the VW “dieselgate” scandal – putting pressure on the levels of profitability these companies can achieve. The sector also faces the combined structural threats of the transition to electric powertrains and of the risks to car ownership from autonomous driving and ride-sharing.
Sector view – tough times for telcos and utilities
The defensive sectors of telecoms and utilities have had a difficult time since the GFC. New technology has required significant capital expenditure (capex) from telcos, while their profits have been a target for regulators. Utilities are still recovering from their pre-GFC M&A boom and now face similar regulatory risks.
With 25% underperformance versus the market, telecoms have been the worst performing sector over the last ten years. The only beneficiaries from this sector have been consumers and footballers, while shareholders have taken a lot of pain. Consumer prices have generally reduced on an absolute basis while quality of service has been edging steadily upwards.
Capex and regulation have eaten into profits
The large telecom companies were cash generating machines until 2012/13 when the first wave of huge investment was required (4G). Since then they haven’t stopped investing (4G+, fibre, 5G), roughly doubling capex while revenues and profits went into reverse.
Meanwhile, regulation has become more intrusive, eating away at large profit centres (e.g. ending charges for EU roaming). The exception was UK-based BT where annual price inflation was rampant. This has now unravelled as BT invests almost all the benefit in sports rights.
M&A and cost cuts offer hope
Does the future offer any hope? Merger & acquisition activity could be the key. Recently, there have been three small announcements and this may only be the beginning.
About 50% of telecom revenue is spent on labour to some degree. With the advent of artificial intelligence and e-commerce, the largest telecoms companies are hoping to cut their wage bills. Meanwhile, there are no longer any abnormally large profit centres to be regulated away, and industry revenues appear to be growing again.
Stock selection will be very important to avoid the laggards. We will focus on markets with encouraging pricing and volume dynamics, combined with company-specific cost-cutting opportunities.
Pre-GFC, European utilities bore few of the characteristics one typically associates with the sector: stable, regulated, visible cash flows and dividends. The 2000s had marked a capex and commodity-fuelled boom which culminated in a wave of M&A in 2007–09, after which the bust duly followed.
Prices have fallen and borrowing is high
By January 2016 German forward power prices were a third of where they peaked in the immediate aftermath of the 2011 Fukushima accident. As a result, commodity-driven earnings shrunk materially and the sector became more utility-like: approximately three-quarters of the sector’s enterprise value now stems from fully or semi-regulated businesses (networks and renewable power generation), up from less than half before the GFC.
Nevertheless, leverage (borrowing) remains high across the sector and dividends are barely covered by cash flows, leaving many utilities exposed to regulatory and political risk.
But this does not preclude alpha generation: since 1995, the three top-performing European utilities have on average outperformed the bottom three and the market by 60% and 40% p.a. respectively. Proof that these liquid, volatile stocks with divergent regulatory, political, and commodity drivers can be a source of idiosyncratic returns.
The investment environment has been transformed in the ten years since the financial crisis. Central bank stimulus was aimed at ensuring economic stability but had other consequences too. For equity markets, years of quantitative easing resulting in low bond yields saw investors pile into sectors offering stable dividend streams (“bond proxies”). As QE is withdrawn and interest rates start to normalise, we would expect stock-specific themes to become once more the main driver of share prices.
At a sector level, clearly the repercussions of the GFC have been mostly strongly felt in the banking sector, with a number of banks needing to be taken over by other institutions or bailed out by governments. Even for the strongest banks, the emphasis now is on capital strength and improved disclosure.
Government intervention has become a feature elsewhere too. Whether it be banning mobile roaming charges or forcing up emissions standards, governments are showing a greater willingness to impose regulations in order to protect consumers, rather than leaving industries to self-regulate.
The spread of technology into every area of life is perhaps the most obvious change of the past decade. Here too, we see the impact of the GFC and subsequent quantitative easing programmes. Ultra-low interest rates have encouraged risk-taking by insurgents. New, disruptive companies can obtain very low-cost finance that allows them to expand quickly and take on incumbents, who often have high fixed costs that make them less agile.
This pattern can be seen across technology and consumer sectors, with the public happy to embrace new entrants after the GFC tarnished some old-style market leaders. We are starting to see signs that regulators (especially in Europe) are targeting the new tech/consumer behemoths on a number of different fronts, such as investigating their tax structures or their treatment of start-ups and developers.
Low financing costs have had other consequences too, such as allowing “zombie” companies to stay in business when they might otherwise have folded. In some instances this has created overcapacity and contributed to keeping inflation low. However, rising credit costs will be a test for such companies.
Just as companies had to adapt in order to survive in the immediate post GFC era, so they will need to change again in order to succeed as monetary policies start to normalise. Those companies that have strengthened their balance sheets, reduced their costs, engaged all stakeholders, and embraced technological changes are likely to find themselves better-placed than those who have not.
This may be a challenge for corporates but it opens a clear opportunity for stockpickers like ourselves as we expect clear distance to emerge between the winners and losers in this new investment landscape.
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