Structural shifts have yet to be priced in

If you’re like me, you’re getting sick of hearing about ‘the new normal’. A life post COVID-19, either with the presence of a vaccine, or permanent social distancing. However, there are qualities about a post-COVID society that are drawing investors in. According to Matt Reynolds, Investment Director at Capital Group, the structural shifts of a post-COVID society still remain important and have yet to be priced into the market.

In this wire, Matt discusses the structural shifts that he is currently observing, including the move toward digital usage, the rollout of 5G and the importance of the healthcare sector. He also explains how he identifies long-term trends, and shares five stock ideas for the post-COVID economy. 

Edited Transcript 

With COVID-19 sparking a structural shift towards an increase in digital usage, what do you look for in a company?

We're looking for companies that have attractive business models or that are able to tap into secular growth opportunities and have the desirable characteristics of experienced management teams, robust balance sheets, high returns on capital and strong cash flows. We see these as what we call quality growth companies and they have strong relative resilience in the current volatile markets. Some of the digital companies display these characteristics and have benefited from the strengthening of a tailwind created by how people work and spend their leisure time as a result of COVID-19. And when we look longer-term, we think that many of these changes in activity will stick and that the growth trajectory for some of these companies has actually accelerated.

Looking forward, do you remain bullish or bearish on this trend long-term? 

We'd say we're pretty confident and we think that there is a potential for further growth going ahead in these companies.

What are some of the key risks to this stance?

The obvious risk is that this strengthening tailwind dissipates in some way, or it dissipates more than expected or evaporates for some businesses and for consumers as they come out of the pandemic. And so our analysis is really focused on understanding those trends that are sustainable and those activities that even if they retreat, they retreat to a higher level than they were before the crisis. As a stock-picking investor, the other key risk obviously is if a management team mis-executes their strategy in some way, and that damages our long-term thesis for the investment.

Specifically in the technology sector at the moment there are very expensive valuations. How would you justify that?

In our view, the growth will continue or growth companies will continue to command a higher premium relative to other investment opportunities. And this is for a couple of reasons. One, we think that true growth opportunities are fewer in a world of lower GDP growth rates, there'll be sought out more frequently. And secondly, in an era of ultra-low interest rates, this reduces the discount rates that we use to evaluate stocks. And so this allows investors to extend their timeframes to increase their focal length if you like, and this tends to favour growth opportunities.

We also see some businesses such as software as a service (SAAS) businesses having the potential to cater for very large and often global addressable markets. This enhances their potential to achieve a long-term compounding of their growth.

One key final point; as stock pickers, we only really invest in the companies where we see the potential for long-term adequate returns, and that's not the case for every tech stock. Indeed there are some tech stocks that should be avoided merely because they are expensive either with a long-term perspective.

We've spoken about the increase in digital usage as a consequence of COVID-19. Another structural shift that investors are starting to notice is the move towards 5G. Who would you pinpoint as the biggest winners of the rollout of 5G and why will they win?

One way to think about 5G is to talk about 5G in a very simple framework and that'll help answer the question. When you think of 5G as having three levels, the first level are the broad providers or telecoms companies. The second level are the enablers and the infrastructure providers that make 5G work, and the third level being users and the industries that will adopt 5G as part of their business models. At the moment, we see the most opportunities being in that second level, being in the enablers and also to some degree in the third level being the user industries, but that's for the longer-term.

The enablers are the owners of key infrastructure in the 5G ecosystem. These are things like cell tower operators, the high-end chip makers, component makers and data centres. That's where we see a terrific opportunity for growth going forward as 5G is deployed over the next several years. That third level, the users of 5G services, that will come over time and that's really seen through the prism of cost savings. Potential costs can be taken out of manufacturing and other industries as they avail themselves to some of the benefits of 5G such as its very low latency and its very high capacity. That's particularly the case, for example, when they deploy machine-type communications within those business models.

Another sector that's been in the limelight throughout COVID-19 is healthcare. What trends are you looking for specifically in the healthcare sector? And do you think that these trends will be maintained post-COVID-19?

We see a potentially very significant increase in the number of novel or new drug targets as a result of innovations that we're seeing in cell and gene therapy. We're seeing the use of big data, machine learning and artificial intelligence within the healthcare sector, particularly as these new treatments are designed to speed up the trials and testing of new therapies. So we see a lot of growth ahead in the healthcare sector. We see also more investment coming into public health infrastructure, and we're seeing really a brand new COVID vaccine-inspired in some ways, collaboration across companies as they seek out these new compounds. We think these are going to be very important trends over the next three to five years. We think these trends certainly outlast the current COVID-19 environment.

There are some sectors, like technology, that look attractive and have a runway for long-term growth. While Capital Group is a bottom up investor, are there some market sectors that you might be taking a relatively lower exposure to over the medium-term?

Yeah, it's a great question. We analyse and research all sectors on a global basis. But there are certainly some sectors where we have a comparatively low level of investment at the moment compared to say the broader market or the index weighting, for example. There are three sectors where we have very low levels of investment at the moment

1. Global banks, because we see net interest margins continuing to decline and traditional profit pools being picked off by new competitors.
   
2. We also have comparatively small investments in the energy sector and energy companies. Many of the competitive advantages that the energy companies enjoyed have been eroded and now they're nearly commodity price takers.
   
3. And finally, the telecom operators which I touched on earlier. I left that out of 5G comments because we're not heavy investors in the telecommunications companies and we're concerned at the heavy CapEx that is ahead of those telecommunications companies as they go about the 5G networks.

Can you provide an example of a company that you think will continue to perform following COVID-19?

There are several companies that we believe could continue to benefit from the shifts in behaviour that we're seeing in a number of sectors. Good examples would be PayPal and Mastercard, where we see electronic transactions continuing to grow and replace the use of cash. I'm sure all of us are tapping even for small items like coffees and small purchases now, whereas previously we used to use cash and that's not going to go away quickly. Amazon and Microsoft are good examples of companies that continue to benefit from the growth in cloud computing. And cloud computing’s addressable market, we think, is much larger than what the current size of the market is.

Netflix is another good example of a company that should continue to benefit from changing consumer habits. As some consumers permanently changed their viewing habits to do more online. Whilst there might've been a rush of subscribers into this initially, we think a number of those subscribers will stick and that habits will change over time to more viewing online. And again, the addressable market for viewing media online is very much larger than what the current market is at the moment.

What makes these companies different to many others is that their current market shares in their area are actually relatively small in comparison to the potential market that they can address over time. And a growing market share we think potentially prove a very strong tailwind for future results, and as results improve obviously that should be reflected in the valuation of the companies.

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