November 2022
 

Portfolio manager John Bailer outlines some of the sectors he’s considering for his US equity income strategy, which he thinks are less prone to the whims of the ever-changing global economy.

The higher interest rate and inflationary environment could lead some businesses that have been popular among investors over the past decade to cut earnings estimates, says Newton US equity income manager John Bailer. This, he adds, could shine a light on other sectors not as beholden to the vagaries of the economy.

According to Bailer, the US equity market’s overt focus on growth over the past 10 years or so has resulted in an excess supply of digital services in the market, leading to overcapacity in many areas of the technology sector.

One of these is digital marketing where Bailer thinks companies are not expected to perform as well as they did in the past decade. This, he adds, could be due to the tough macro environment resulting in companies spending less on advertising.

Bailer notes tech companies such as Google parent Alphabet and Facebook owner Meta face customers that will slow spending. In July, Alphabet announced quarterly revenue growth had fallen to its slowest pace in two years¹. Similarly, Meta’s Q2 2022 results, published in July, showed a higher-than-expected drop in revenue and it announced plans to reduce headcount growth over the next year².

“In some areas private equity is telling companies they need to generate cash and cut costs and one way to do that is to spend less on digital advertising,” says Bailer. “So, these [digital advertising] companies are going to be more subject to the vagaries of the economy and at risk in terms of their growth projections.”

Oil and infrastructure
On the other hand, Bailer thinks there are areas of the ‘old economy’ due a funding boost because they have been underinvested in over the past decade. Capital expenditure (capex) on physical assets such as oil extraction, for example, has been falling and he says lower investment in capex means supply/demand is good for oil.

“We think oil prices should stay higher for longer,” he adds. “Even in a recession, we think demand should remain stable.”

Meanwhile, the average age of private fixed assets in the US has been on the up, Bailer says. He thinks America’s US $1 trillion infrastructure bill³ should address some of the underspending on the country’s ageing infrastructure and could throw up some interesting opportunities. “Globalization is reversing, and we want to own companies that will benefit from this resurgence in infrastructure demand,” he adds.

One area of infrastructure Bailer thinks could hold opportunities is the electrical grid which he says could benefit from the ongoing move to renewable energy. There could be an opportunity in companies that sell into utilities because the latter are not economically sensitive, Bailer says.

“If you are a regulated utility, you are going to spend irrespective of what the global economy is doing because you know you must get to a renewable future. As more cars start to plug into the grid, as well as the development of wind and solar power, these industrial companies that sell into utilities that people perceive to be cyclical may not be cyclical because there is such a demand for spending.”

Defense
Defense is another area Bailer sees as presenting opportunities, noting Russia’s invasion of Ukraine has led several countries to increase their spending on military defense. Shortly after Russia launched its offensive in February, Germany committed to lift military spending above 2% of GDP⁴ while Poland has increased its spending in this area from 2% to 3% of GDP⁵. “Customers will be spending on defense despite what the economy does,” he adds.

Bailer says before the conflict in Ukraine, defense stocks’ multiples weren’t very high and there has not been a significant revaluation since.

He also notes a lack of semiconductors as part of ongoing global supply chain issues has affected defense companies, but a slowing of global growth could free up capacity as it would mean less demand for these chips from other sectors. “As global growth slows there will be plenty of semiconductors that will be able to go to defense companies and at the same time, their revenues are unlikely to decline,” he says.

Elsewhere, Bailer is looking for companies that have pricing power as a buffer against higher inflation. He notes certain insurance companies, namely those dealing in worker compensation policies, could benefit as wages increase.