• The global macroeconomic environment is highly uncertain heading into 2016. Our approach remains the same: a focus on bottom-up¹ drivers of return in our search for unanticipated earnings growth.
• Technology is evolving at an unprecedented rate and disrupting an array of industries, providing a wide range of investment opportunities, as well as serious challenges in legacy industries.
• We generally prefer service companies over those in the manufacturing sector, given more resilient pricing power and stronger growth.
• Those firms that are able to reduce costs and strengthen balance sheets, particularly in highly competitive industries faced with overcapacity, will be rewarded in 2016.

In aggregate, the backdrop for equities is challenging and the macroeconomic environment is highly uncertain.

Low interest rates reflect massive quantitative easing by central banks around the world, artificially boosting many asset prices and creating a potentially dangerous situation when rates start to rise.

Significant currency distortion, weak commodity prices, slowing growth in China and mixed economic data in Europe and the US have added to the uncertainty.

For equities, this has meant low absolute returns and increased volatility.

It is therefore particularly relevant to take a selective approach to investing, focusing on those companies that can deliver unanticipated earnings growth despite the uncertain environment.

We see a number of different dynamics at play that have the potential to surprise the market in 2016.

Disruptive technology driving rapid change

Technology is evolving at an unprecedented rate and new business models leveraging increased connectivity, particularly in the mobile space, are threatening to reshape industry dynamics in a number of different areas.

Firms such as Amazon, Google, Facebook, Alibaba and Tencent are already household names in their respective end markets.

The revenue and market capitalisation of these companies already rank amongst the largest in the world.

However, the number of industries facing disruption is increasing rapidly and now extends well beyond the immediate e-commerce, social media and handset space.

Disruptive technology is shaking up traditional industries such as:

• Autos (Tesla, Uber)
• Apparel and food retail (Yoox, Zalando, Just Eat, GrubHub)
• Hospitality (Priceline, Expedia, TripAdvisor, Airbnb)
• Recruitment (LinkedIn)

Other industries that are about to experience significant disruption include healthcare and banking.

We are focused on finding opportunities where the market has either overlooked or underestimated companies’ potential to disrupt.

Service firms preferred for their pricing power

The global economy is likely to be characterised by ongoing deflationary pressure in 2016.

A lack of pricing power is already evident in the traded goods sector where competitive pressures and overcapacity make for a challenging pricing environment.

By contrast, the services sector has been able to maintain pricing power, given a lack of tradability in many areas.

The divergence between manufacturing deflation and services inflation naturally informs a bias towards service companies in our portfolios heading into 2016.

We still find some attractive opportunities among those manufacturing firms with a substantial component of high margin recurring revenue, such as maintenance providers and parts suppliers.

These types of companies should prove more resilient to any decline in capital investment spending, particularly in industries that benefited from the capital spending boom in China over the last 10 years.

Saving profits with “self-help”

We are seeing evidence that companies in challenged sectors, such as industrials, energy and mining, are taking steps to support earnings and we expect this to be a key feature of 2016.

There is an increasing focus on “self-help”, as companies seek to restructure by reducing costs and strengthening balance sheets in order to weather the uncertain demand and pricing environment.

For example, firms like diversified miner BHP Billiton and oil and gas major Royal Dutch Shell have committed to substantial cost reductions and lower capital spending in the face of sharp declines in commodity prices and revenues.

In the industrials sector, earnings have been hurt by the combination of softer economic growth and excess inventories.

However, inventories are now at levels such that even a modest upturn in end demand should translate into better profitability.

Firms that have been able to reduce costs should show significant operating leverage even with a moderate uptick in revenue.

Companies behind the curve in terms of expense management are likely to see share prices suffer.

A focus on innovation

Regardless of industry, however, we continue to focus on innovation as a driver of returns in 2016.

Our emphasis is on companies that are committed to finding new, interesting and sustainable ways in which to grow their businesses, but whose efforts have not yet been fully recognised by the market.

For example, in the healthcare sector, firms continue to gain insight into disease processes and are continuing to develop a variety of new treatments to improve mortality.

Despite a more challenging regulatory backdrop, we expect the sector to continue to experience strong pricing power for therapeutic innovations.

Another example is the food and beverage sector where firms have to differentiate their products and services to command pricing power in a highly competitive industry.

Starbucks is a case in point where management is intent on finding innovative ways to improve the customer experience (such as the introduction of mobile payments) to sustain customer traffic and support average spend.

Looking for earnings surprise

As we have highlighted, the economic backdrop remains highly uncertain and we cannot predict with any accuracy what will happen in the global economy, markets, commodities or currencies in 2016.

The best approach in our view, is therefore to focus on developments at the company level, to identify individual companies that can deliver earnings surprise and outperform in an uncertain and challenging environment.

^{1. Investment based on analysis of individual companies, whereby that company's history, management, and potential are considered more important than general market or sector trends (as opposed to top down investing).↩}