Turning long-term trends into sustainable profits

Investing in global themes is increasingly seen as a convincing alternative to the traditional asset allocation approach by regions and sectors and well suited to a highly interconnected world economy.

Thematic investing is about seizing opportunities in long-term secular trends in economies and societies, such as climate change, energy or healthcare. The idea is to pick stocks across a variety of sectors falling within that theme. This approach is often not constrained by regional or country boundaries, and is expected to offer growth and above average return potential.

“The success of thematic investing ultimately depends on three factors,” explains Scilla Huang Sun, head of equities at Swiss & Global Asset Management.

Firstly, she says, the theme must be properly defined; secondly, profitable themes rather than hot topics should be preferred; and finally, a defined investment strategy must be implemented in a professional way.

For instance, it is wrong to assume that all growth trends will automatically lead to superior investment returns, warns Ms Sun. The internet bubble is a good example of a secular theme that has nevertheless failed to be profitable for most of the companies playing it. “The potential of an investment theme to generate profits for the companies involved is more important than the growth prospects.”

One major theme that offers both growth and profitability is the luxury industry, explains Ms Sun, who also manages the JB Luxury Brands fund. “Investing in luxury stocks exposes investors to the fast and secular growth of consumer wealth in emerging markets, and in particular China.”

As wealth creation in emerging markets is expected to continue to outpace that in the developed world, these countries represent an increasing share of the global luxury market. Asian consumers, in particular the Chinese, love Western luxury brands and are making a decisive contribution to the industry’s growth (see chart).

EXPENSIVE TASTES

Today, many luxury companies achieve more than two thirds of their growth in emerging markets. Luxury goods, which range from accessories, shoes, jewellery, cosmetics, leisure, premium food or spirits are emotional products and are often seen as status symbols. Many luxury brands, which often have long tradition and heritage, enjoy double digit margins due to their pricing power and unique franchise, and consumers are more than willing to pay premium prices for products and brands they like. This explains why prices of luxury goods are rising much faster than inflation, says Ms Sun.

Although recent events in the Middle East and Japan are expected to reduce sales growth of luxury goods by 2 per cent, sales are still estimated to rise between 7 and 9 per cent in 2011, driven by emerging markets but also by renewed strength in developed market consumption, according to Swiss & Global.

Demographic trends are at the core of many thematic funds. The ageing of the population, which has been driven by over 50 years of falling global birth rates and major increases in life expectancy, has opened up new opportunities for those firms that are in a position to offer products and services to this expanding demographic, explains Matthias Gäumann, product specialist at Lombard Odier Investment Managers.

Thanks to advancements in medicine and technology, senior citizens have become an increasingly important consumer group and the Lombard Odier Golden Age fund aims specifically at identifying those companies that meet their needs and aspirations. Investments range from companies that manufacture hearing aids, hip implants or pacemakers or offer services such as nursing homes, to firms that sell recreational vehicles or provide retirement planning services.

The timing of this theme is of particularly relevance in the developed countries, where the post-second world war baby-boomer generation starting to reach retirement is leading to an acceleration of the ageing trend. However, with the exception of Africa, populations are ageing across the globe, and particularly in bigger emerging countries like Brazil, Russia, India and China. It is estimated that by 2050 at least one fifth of the global population will be over 60 years old, says Mr Gäumann.

POPULATION BOOM

The population boom, mainly limited to emerging markets, is another major demographic trend. Lombard Odier estimates that, on average, 200,000 new people are being added to the global population every day. Combined with higher income levels, which are driving changing dietary habits, this trend calls for innovative and efficient ways to feed the world, explains Mr Gäumann.

Thematic funds such as the LO Nutrition Fund focus on investment opportunities across the value chain aimed at providing increasing amounts of food, of better quality, in the agri-business, the food and beverage industry, and logistics and supply.

A related theme is explored by the Vontobel Futures fund. This invests in companies providing innovation and technologies to develop replacement materials or in firms offering solutions to enhance productivity and yield management in natural resources, which are increasingly under pressure.

Booming population and increasing urbanisation levels – for the first time in history, more than 50 per cent of people live in urban areas – have also opened up new investment opportunities in areas related to energy efficiency, renewable sources of energies or cleaner transportation.

The themes around energy efficiency and alternative energies have today gained even more weight following the nuclear disaster in Japan, states Christophe Gruenig, head of wealth management at Vontobel. “The Fukushima disaster added a new twist to the discussion. People are much more aware of the risks related to nuclear energy, and the need for finding alternative sources of energy. The Middle East conflict too has been another incentive to look for alternatives to oil.”

The growing imbalance between energy supply and demand can be addressed by investing in companies which provide alternative sources of energy, or clean and innovative technologies and services. These have the overall aim of mitigating the impact of climate change and creating a more sustainable environment. The second investment area relates to energy efficiency, including companies ranging from energy efficient car manufacturers to producers of insulation material or infrastructure to reduce water leakage.

Although the percentage of assets invested in firms based in emerging countries is growing, most Vontobel thematic funds allocate to companies based in Europe or in the US, which often derive an increasingly bigger share of their revenues from emerging markets. “We are living in a global world. Themes such as the natural resources or infrastructure, driven by the development and industrialisation of big countries like China, India and Brazil, benefit Western companies. The country allocation is just a result of our bottom up analysis.”

Many investors allocate to a core, diversified portfolio, and then around that, they play tactical, satellite themes, explains Willem Sels, UK head of investment strategy at HSBC Private Bank. “We consider thematic ideas all those ideas that fall outside investors’ long-term core portfolios. These are more for investors who are happy to take a conviction call or to take a view and, in general, for those who like to be more actively involved in the management of their portfolio,” he says.

Themes, which can be both long and short-term, represent around 20 per cent of the total investors’ portfolio. Most often they are in equities, but they can also be played through commodities, currencies, structured products or bonds.

INFLATION FEARS

“The number one thematic idea, at this point in time, is probably for investors to hedge themselves against inflation,” says Mr Sels. “Risk appetite is still quite good, there is good economic growth and the core portfolio still has a bullish tilt to it. However, investors fear that inflation will erode their portfolio in the next one to two years.”

The inflation theme can be best played through structured products such as floating rate notes, which, having a coupon linked to libor, will generate higher returns on the basis that central banks hike interest rates to fight inflation. Floating rate notes would also partially compensate investors for losses in their bond portfolio. Investing in commodities, preferably in commodity stocks, is another valid hedge against inflation, as is investing directly on the currencies in those countries where central banks are raising interest rates.

Other themes in the currency space revolve around riding interest rate differentials or differences in monetary policies. “The world is not homogeneous, which leads to very different monetary and interest rate policies around the world,” says Mr Sels. “This is currently driving currencies.”

For example, a good theme is the weakness of the US dollar and the strength of emerging market currencies, which most people would play through structured products. These are in the form of a bond, where the return is a function of the difference in performance of the emerging market currencies and the US dollar, says Mr Sels.

Christophe Gruenig, Vontobel