Dominant defensives can withstand stagflation shock

by | Oct 26, 2022

By Jacob Mitchell, chief investment officer at Antipodes Partners

The last twenty years have been characterised by falling interest rates and inflation, as well as low volatility around GDP. In addition, investors became accustomed to the Fed put at the first sign of asset price turbulence.

However, we are now in a fundamentally different regime, as the Fed and other central banks tighten policy in response to rising inflation. Our base case remains stagflation, and far greater volatility in nominal GDP growth outcomes to what we have become used to in recent years.

In the next slowdown, we anticipate a continued shift towards fiscal activism, rather than the passive outsourcing of economic policy to central banks via QE and asset price stimulus witnessed during recent decades. We expect this stimulus to focus on long term investment areas like decarbonisation, tech and infrastructure, as well as efforts to localise supply chains.

In a backdrop of stagflation, investors need to be selective, as growth and value will become more correlated, and bonds and equities will continue to be correlated. A weak economic environment is challenging for weak cyclicals, just as much as high inflation is challenging for weak growth stocks. Equity markets will likely become more stock specific rather than driven by style, and tightening credit conditions will see the market continue to favour resilient businesses with strong balance sheets.

Uncertainty brings opportunity

We see several such businesses in the enterprise software space, which has seen a widespread drawdown in valuations over the recent months. We believe larger market leaders in the space are well placed to outcompete many of the single-feature companies, where high-growth rates will deteriorate rapidly in a more testing economic environment.

Enterprise resource planning, or ERP, refers to software solutions for the finance department – such as general ledger, accounts receivables, and payables management, and procurement. These solutions exist to improve back-office and logistics productivity, while cloud versions further enhance expense savings and business agility.

SAP is a near pure-play in back-office software applications, and the largest global ERP provider – at almost 30% market share. SAP is expected to gain share as its customers migrate to the cloud. This is because SAP benefits from a ~2-3x revenue uplift as on-premise maintenance and support revenue transitions to cloud subscription revenue. Its €11.4bn of on-premise maintenance and support revenue in 2021 can transition to €22.8-34.2bn of cloud revenue. As more customers adopt the cloud, SAP should also benefit from economies of scale in cloud costs and margin.

Investors quickly dismiss SAP as a legacy on-premise solution ripe for disruption by new cloud-native start-ups. The reality is ERP is an R&D intensive sector, and there have been very few entrants into this space, particularly targeting the large enterprise segment. Our research suggests, outside of the top ERP vendors, the rest of market – roughly 45% of ERP market by revenue – has limited competitive ERP cloud offerings.

A quality defensive business, SAP is trading on a 20.5x forward P/E. This is cheaper than other defensive parts of the market, such as consumer staples. SAP is also expected to grow at a faster rate than the consumer staples sector, without facing the same inflationary pressures.

Resilience amid inflation

Away from the software space, leading pharmaceuticals company Merck is another quality defensive business that is not facing the same inflation pressures as other defensive parts of the market.

Almost a third of the company’s earnings come from vaccines and animal health, which have high barriers to entry, consolidated market structures and, as a result, higher profitability relative to traditional drug development. Merck manufactures the HPV vaccine Gardasil, which has been proven to prevent a variety of cancers and has a long runway for growth – while the animal health business has high brand equity, particularly among herd animals.

In terms of its pharma business, Merck’s Keytruda is the most successful immuno-oncology drug globally. While the patent cliff begins at the end of 2028, Merck is preparing itself via combination studies with next-generation immuno-oncology drugs that could extend Keytruda’s dominance, internal pipeline development via its own R&D engine, and ample balance sheet capacity for acquisition.

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