Capitalizing on Global Future Themes

Strategic Frontier Management's updated Global Future Themes is available at: www.StrategicCAPM.com/topical.

We define a Future Theme is a thesis or proposition that could have such substantial global impact that when recognized will shift consumption, disrupt competition, or impact our lifestyle for a significant portion of the population. The pursuit of Future Themes seeks to identify differentiation of relative global competitiveness, but the fun in this exercise is that we get to think about “what if” unconstrained by shorter-term time horizons. Individually, these themes impact our lives everyday. Businesses are leveraging cost benefits to realize higher profit margins, disintermediating labor and reducing unnecessary tasks. Yet, simply identifying a trend or theme may not be sufficient to realize excess return. Given the extraordinary return potential of secular themes, it is not surprising thematic investing has become popular, but it is hard to maintain discipline with a time horizon exceeding twice the tenure of most portfolio managers.

Simply identifying beneficiaries of tailwinds can indeed bee meaningful to investors, but earnings potential, profit margin, and valuation also affect future realized returns. Creative destruction was first proposed by Joseph Schumpeter in 1942 to describe the "process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one." It can be difficult to differentiate transitory fads or correcting imbalances from true secular trends, however. Innovation continues to drive improving living standards, but also had a tremendous impact on labor. Yet, it is clear technological progress has driven significant global creative destruction affecting (lower) inflation and labor (participation) growth since 2002 (starting date of Industrial Revolution 4.0, we believe), which can have offsetting affects in productivity measures---a key driver of a country's potential growth. We have framed the Industrial Revolution around a pivotal collision of a Manufacturing Renaissance and Communication Revolution---it is hard to have an industrial revolution without the later providing a means to enhancing collaboration, it is the underappreciated Manufacturing Renaissance that has been compounding exponentially to accelerate this Industrial Revolution. A Financial Crisis in the middle of this period deferred, but did not derail the eventual total realized gain in productivity we expect.

The issue most overlooked by investors is profit margin, as we often highlight, and has a secular horizon over an investment cycle of 7-10 years, as well as cyclical (12-18 month). You see the effects of this missing element in hopeful expectations of investors, in particular why hasn't strong economic growth yielded better earnings growth to drive equity market outperformance. The most obvious example is lagging equity performance of Emerging Markets (6.5% forward margin), Japan (6.5% forward margin), and even US small cap stocks (5.2% forward margin) versus U.S. Large-cap Stocks (notable 12.0% forward profit margin). One's economy might grow twice as fast (i.e., China, in real terms), but if its equity profit margins are half as much, then there may be little difference in sustainable earnings growth, and thus long-term equity performance. This assumes beginning from similar valuation levels, of course. We also observe that in the case of small-cap, the trend has been very choppy since 2013 versus typical long trending behavior of margins generally, but also overlaps with a period of investors infatuation with top-line growth vs. company profitability. 

Many still private venture or private equity funded so-called unicorns --- the "disruptors" -- struggle for earnings yield with low or even negative earnings, yet exceptionally low interest rates have allowed them to tap debt markets at reasonable cost, for now, but the share of BBB to junk bonds or unrated debt has soared in recent years, not including the exceptional amount of unconventional private debt outstanding. With a greater number of companies seeing public listing (Lyft, Uber, Pinterest, Slack, Bumble, WeWork, Robinhood, Zoom, Airbnb, etc.), we will observe with interest how a company's stock responds to public market insight. Many have defined new markets or witnessed brands that became a verb, but do they have a long-term sustainable competitive advantage that won't go unchallenged. The risk is many will struggle with business models that struggle to earn a meaningful profit margin, as Uber recently disclosed in its filing, yielding profit growth in excess of the market. It also begs the question, why now? The rise in short-term interest rates last year has increased the cost of capital across the yield curve, even if it did flatten, so the difference between short and long-term rates are nearly 0%. We've discussed the handful of reasons for this, despite thinking we shouldn't encounter a U.S. recession for the foreseeable future, but maybe Europe and Japan will---and thus a key driving force for the US yield curve to reckon with, of course.

Future Themes interact with secular themes, which can be important in deriving long-term strategic policy. Our readers are familiar with our relatively unusual hockey-stick efficient frontier, recognizing the severe overvaluation of manipulated long-term Treasuries that we believe must limit total returns to less than inflation (negative real), if not outright negative over the next 5-10 years. The ability to adapt our long-term asset class return and volatility expectations with Bayesian adjustments is a unique strength of Strategic Frontier's strategic policy construction rooted in our proprietary Optimal Empirical Resampling. We are able to incorporate valuation dislocations, as well as abnormal influences that can affect long-term earnings growth that must influence returns.

We find value in the exercise and experience of identifying and discussing how such themes can affect our investment thesis on so many levels. We seek to uncover just a few opportunities that have potential to generate compelling excess returns over a long investment horizon.This is a process I have led in collaboration with my investment teams since 2003 or participated in beginning more than 22 years ago. I had the opportunity to present this last week at the West Coast RIA Summit in Los Angeles. 

Strategic Frontier Management, LLC is a California Registered Investment Advisor (RIA) providing Global Tactical and Strategic Asset Allocation solutions, as well as investment strategy consulting for asset owners and their investment advisors.

Disclaimer: This publication is for general information only and is not intended to provide specific advice to any individual. Some information provided herein was obtained from third party sources deemed to be reliable. We make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication, and bear no liability for any loss arising from its use. All forward looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of this author, and future market movements may differ from expectations. Index performance or any index related data is provided for illustrative purposes only and is not indicative of the performance of any portfolio. Any performance shown herein is no guarantee of future results. Investment returns will fluctuate, and the value of holdings may be worth more or less than cost. ? Strategic Frontier Management (www.StrategicCAPM.com) 2019. All rights reserved.