Generating global alpha

Matthew McKelvey, head of equity product management for Insight Investment, says that a thematic approach helps narrow down the broad range of global equities.

Trying to predict the trajectory of the global economy and corporate profits has been challenging for equity investors over recent months.

The MSCI World index bounced off its mid-March low coinciding with the bail out of Bear Stearns as people started to believe that the worst point of the credit crunch could have been passed. Better than expected GDP growth, together with the arrival of tax rebates raised hopes that a US recession could be avoided. First quarter US corporate profits also proved better than expected - outside financials they grew by around 10pc year-over-year compared with pre-season expectations of around 8pc.

That optimism has started to wane. Oil prices have hit new highs and central banks around the world, including the US Federal Reserve, have made more hawkish comments on inflation. Hopes of further interest rate cuts may be disappointed and considerable uncertainty remains on the lagged impact of banks de-leveraging their balance sheets and charging more for credit. The outlook for the global economy, and companies with profits directly tied to it, remains cloudy.

In this environment it is even more important to identify companies whose growth is less reliant on the economy. Fund manager can use structural change themes to help them navigate through the world's equity market to find industries, segments of value-chains, and ultimately companies that will benefit from secular growth or elongated demand cycles.

There are four structural change themes currently of interest: demographics (ageing population in the developed world and growing wealth in the developing world), stronger for longer commodity prices, climate change, and the digital age.

These issues have the potential to drive growth for companies across a range of industries and geographies for some time to come. The challenge, however, is to look beyond the obvious. This means anticipating how cash flows will move through value chains and identifying the bottlenecks which will allow some companies to deliver profitable growth beyond the expectations reflected in their share prices.

One strand of the demographics theme is agriculture. Crop prices have risen dramatically over the past few years, which has caused civil unrest in some areas and prompted a mixture of policy responses from governments around the world. While low inventories, supply disruptions, bio-fuel demand and investor speculation played their part in the recent spike in some grain prices, underlying structural factors look set to persist. The world's population is growing and rising incomes in developing countries world will lead to increased protein consumption, which will require more grain to produce (1kg of beef requires around 8kg of grain). Food prices are also adding to global inflationary pressure. These issues will drive a supply response, which will involve more land being used for agriculture and improving crop yields.

Mechanised irrigation is an attractive part of the value chain. Only around 17pc of the world's agricultural land is currently irrigated, yet this land produces some 40pc of the world's food supply. While traditional flood irrigation is currently used on over 80pc of all irrigated land, mechanised irrigation is about 50pc more efficient - it can be used on uneven land allowing previously unsuitable land to be brought into production, requires less labour and monitoring, and can be used to apply fertilisers and chemicals. There are a small number of suppliers that should benefit from strong demand growth and pricing power.

Another angle on raising agricultural efficiency is a company providing specialised satellite navigation equipment which helps farmers prepare, seed, fertilize and harvest their land more efficiently. With the higher costs of diesel and crop treatments, farmers do not want to cover the same piece of land twice!

The structural themes are not necessarily mutually exclusive. For example, power generation is attractive where the demographics, stronger for longer commodity prices and climate change themes intersect.

Global population growth, together with industrial development is expected to lead to a doubling of electricity consumption by 2030. At the same time, concerns over carbon emissions are encouraging the development of alternative and renewable forms of power generation. Security of energy supply has also become an important issue for some nations.

These factors will drive a renaissance in nuclear power generation. According to the World Nuclear Association, 30 new reactors are being built around the world today, another 35 are planned to come online during the next 10 years, and over 200 are further back in the pipeline.

Exposure can focus on uranium mining, or move through the value-chain to companies which provide a range of services from radioactive waste disposal to de-commissioning and decontamination.

While there is a need for sustained infrastructure investment across many developing countries, the developed world has its issues too. The electric transmission and distribution grids of many developed countries, including the US, have suffered through under-investment and black-outs have focused attention on the issue. In the US, legislation was passed in 2005 to address the problem, and we are now close to a sustained period of investment. This theme can be backed in a number of ways, including investing in a company that installs, maintains and repairs electric power transmission lines. Its growth should be underpinned by the renewal of old infrastructure, as well as connecting new power generation to the grid.

Other strands of the power generation theme include specific segments of the solar and wind power industries. For example, there is a company that provides specialised bearings which are 'designed-in' to wind turbines by some of the leading manufacturers. Analysis suggests that bearings are in short supply, representing a bottleneck in the wind power value-chain.

With prospects for the global economy uncertain, structural change themes help investors find companies with durable growth potential - finding those at reasonable valuations often means investing in less obvious parts of global value-chains.