Monday, November 19, 2012

Stop Relying on Emerging Markets for Growth

Nike (NYSE: NKE) is the last company to report results and disappoint the market with its outlook and commentary on emerging markets and China in particular. I think investors have three choices in this sort of situation. They can either react to the reality of the situation, pretend it doesn’t exist or try and take a long term view based on their prognosis for the Chinese economy.

Corporations Need to Rethink China

In a similar way corporations have to ask themselves these questions too and this will require a change in thinking. For the last few years earnings reports from international companies have been littered with a familiar refrain. It usually involves a variant of the ‘US doing ok, Europe weak, emerging markets going great and we are investing for growth there’. This sort of commentary plus associated earnings numbers usually results in a series of expectations for future growth that rely on a large contribution from markets like the BRICs. It’s time to rethink those earnings assumptions and the valuations put upon the companies that are expected to make them.

Moreover these considerations aren’t just linked to top line growth. If a company is investing heavily in a market that will disappoint in future then it will be saddled with unnecessary fixed costs, inventory and underutilized capacity. Margins would suffer. So don’t listen when someone tells you ‘Oh it’s ok that China’s growth will come in at 7% when 8.5% was expected, it’s still good growth’. If your company is geared for 8.5% then the marginal shift downwards will hurt you.

What Nike Said

A good example of the kind of considerations that investors and corporations need to be making can be illustrated with Nike in this report. Orders for China were weaker and order book growth of 6% was a lot weaker than revenue and inventory growth of 10%. Nike’s commentary on China was ‘involved’ and detailed. I will summarize.

  • Consumer is becoming more discerning
  • Economy is slowing
  • Market ‘evolving’ and maturing quicker than expected
  • Company strategy changing to reflect consumer tastes
  • Retail landscape changing

In other words, Nike is recognizing that the economy is slowing, but believes that it is also about a consumer that is evolving its preferences into more distinctive and expressive ways. You can’t just slap a logo on a pair of trainers and expect to sell them anymore.

It’s an interesting argument to which my only rebuttal is this.

Nike may well be able to innovate and generate sales growth but frankly I’d rather invest in companies with end markets that had the potential to outperform expectations rather than disappoint.

Where Next For China?

I’m not going to apologize for displaying tendencies that border on the early stages of obsessive compulsive disorder with this theme. There is nothing wrong in being cautious on investing hard earned money. I’ve discussed my doubts that China can effectively stimulate growth in an article linked here. Also here is a recent article which outlines some of the recent data on China and which stocks are particularly affected.

Of course it isn’t just about a slowing China, it is also about companies who have been baking in assumptions of the Chinese Government successfully stimulating the economy back to growth. This is particularly pronounced in the area of technology spending where Cree (NASDAQ: CREE) will be hoping that China can and will massively expand its roll out of LED street lighting. The issue has been around for over a year now and China’s plans are still not clear.

 Another industry hoping for second half growth from China is telecommunications. With North American carrier spending weakening and Europe’s ongoing problems the industry was jolted when Chinese company ZTE warned of weakening domestic spending. This is a problematic development because the likes of Cisco, Finisar, JDS Uniphase (NASDAQ: JDSU) and Ciena have all been expecting a better second half. JDS Uniphase is a good example. It’s management is generally cautious on the outlook but when discussing the geographic outlook in its last conference call it affirmed that Asia was a ‘pretty strong environment’ and it was expecting it to remain reasonable.

Caterpillar (NYSE: CAT) recently lowered its outlook based on slowing mining capital machinery spending and even McDonalds (NYSE: MCD) has reported very weak same store sales growth in China recently. It’s tough out there and from Big Macs to Big Mining, China’s demand growth is slowing and putting pressure on once coveted sales growth in the region.  I think Caterpillar’s growth will remain weak as long as fixed asset investment growth slows in China. As for McDonald’s it is dealing with an increasingly aggressive promotional and discounting market in China.

What is an Investor to do?

If you think that the Chinese Government will successfully stimulate the economy then go ahead and pick up some bargain looking stocks. The other option is to bury your head in the sand and pretend it is not happening. I need not discuss the wisdom (or lack of) in this approach.

The third approach is to downgrade your expectations for Asian growth in your stocks and reshape your portfolio towards stocks less exposed to China and emerging markets. I appreciate that this might involve avoiding large swathes of the market (something truly diversified investors will not be comfortable doing) but if you are taking a macro view you should be willing to do something about it. The good news is that there are plenty of stocks out there that are not overly dependent on cyclical growth from emerging markets and perhaps it’s time for them to come back into fashion?