Use "pricing power" to find growth stocks

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In his Budget speech on 20 March, Chancellor George Osborne announced the UK's real gross domestic product (GDP) would grow by 0.6%, half the rate forecast by the Office for Budget Responsibility (OBR) only three months ago.

Given the current lack of strong growth and a structural demand for yield in an environment where bond returns are very low, analysts tell Interactive Investor how to determine "good growth" stocks, using what they describe as "pricing power".

Pricing power to rate stocks

Graham Secker, head of pan-European equity strategy at Morgan Stanley, explains the reason for using pricing power in the first place is because "the most important characteristic of a 'quality growth' stock is that it has a relatively high degree of pricing power compared to its peers".

He adds: "Investing in companies with strong pricing power is always likely to be a good long-term investment strategy, in our opinion."

However, he says it is "even more important against the macro backdrop of modest economic growth and financial repression that we foresee in this cycle given three big-picture themes." He pinpoints these as follows:

  • Financial repression is "better at driving asset prices than real growth".
  • With low wage growth inflation acts as a drag on consumption.
  • Quantitative easing (QE) "is likely to reinforce existing trends in terms of winners versus losers; not reverse them. "While aggressive unconventional monetary policy such as QE can be successful in reducing tail risks and increasing asset prices, it is less successful at raising real GDP growth rates.

"For equity investors, the importance of this gap [between real GDP growth and inflation] is that it tends to be a good indicator for corporate margins and suggests a weak outlook for profits," says Secker, who expects real GDP to be comparable to consumer price index (CPI) inflation at around 3.2% for 2013, with the former rising to 3.9% in 2014 while CPI remains at 3.2% at a global level.

However, he adds "while there are some signs of optimism globally, the outlook domestically within Europe is much more downbeat and will likely act as a drag on corporate earnings going forward."

Indeed, economists forecast euro area GDP growth of -0.7% this year and 0.9% in 2014, coupled with CPI inflation at 1.5% and 1.6% respectively.

Baskets for rising stocks

Analysts at Morgan Stanley believe consensus margin expectations will rise over the next six months in airlines, luxury goods, software, telecommunications equipment and construction/cement sectors.

Airlines

Penny Butcher, transport industry equity research analyst, explains higher input costs are added in the airline sector, but they are "successful in passing these on to end customers".

She explains airline companies "believe they have pricing power, although certain geographies are better than others". Butcher quotes the US and intra-EU as "driving the power at the moment", as well as having good year-to-date corporate travel volumes.

"Input costs are rising, or expected to rise soon" she says, "but airlines companies under coverage have pricing power and can pass costs on to protect/grow margins."

She adds airlines such as low-cost carriers easyJet (EZJ) and Ryanair (RYA) are stocks with relatively high pricing power; while International Consolidated Airlines Group (IAG), Lufthansa, and the two low-cost carriers are considered the stocks most likely to see margin expansion in the next six months.

Butcher advises investors to go overweight on easyJet.

Luxury goods

Louise Singlehurst, analyst specialised in European markets, explains luxury goods stocks have higher input costs, yet are successful in passing these on to end customers. "There has been some easing of raw material prices but typically, cost is going up."

Singlehurst says it is "rare" that companies in the sector are unable to pass on the higher input costs to end customers, but adds sporting brands have and could experience "some pressure", mainly due to labour costs in Asia, "not so much raw materials".

Consensus margin trends are on the rise, she says, as most companies have a high proportion of fixed costs: Singlehurst forecasts between 5% and 10% top-line growth for most, such as Richemont, LVMH and Swatch and to a lesser extent PPR, Prada, Burberry Group (BRBY) and Tod's.

Yet, she explains, the biggest challenge to margins is foreign exchange, followed by the investment in retail and store openings for Puma, Folli Follie and Pandora, which have relatively low pricing power.

Singlehurst rated puma and Pandora "underweight", before concluding stocks in Swatch are most likely to see margin expansion in 2013.

Software

In the software sector, Adam Wood, European software analyst, says IT services companies are "seeing higher input costs but are not able to pass wage inflation on to customers as they see pricing flattening or on the down and so have to use other methods (pyramid) to protect margins.

"Software companies are probably seeing higher costs but are successful in passing these on to end customers," says Wood. "We're talking again about wage inflation as there are no other meaningful input costs to software companies. They do however have pricing power and so can pass this on and protect/increase margins."

With a decreasing pricing-power trend for IT services as low-cost competitors from India build more presence in Europe, Wood highly rates SAP (SAP), Dassault Systemes and Aveva stocks (AVV).

Aveva is among other stocks (SAP, Dassault, Temenos) that are most likely to see margin expansion in 2013, while Wood advises investors to go "overweight" on SAP and Aveva.

Wood highlights companies such as Indra, Capgemini, Atos, Tieto and Steria are those with a relatively low pricing power, while Indra is expected to see the largest margin contraction during the period and is considered "underweight" - as is Tieto.

Telecoms

Nick Delfas, European telecoms analyst, commented for most telecoms companies - with the exception of Kabel Deutschland, Ziggo, Telenet and Iliad - input costs are not rising but the companies have to cut prices "due to poor end demand" or other factors, thus their margins are "at risk".

Stocks with relatively high pricing power include Kabel Deutschland and BT (BT.A), while Vodafone Group (VOD) has low pricing power. Delfas rates BT and Kabel Deutschland "overweight".

Iliad, Ziggo and Kabel Deutschland are expected to see margin expansion in the next nine months, contrary to Vodafone, Tele2 and KPN, who will experience contracting margin.

Construction

Building and construction analysts Yuri Serov and Alejandra Pereda say they are not seeing "particular general increases in costs, barring some markets such as energy in Egypt and transport in India," in the sector.

The analysts agree construction companies have pricing power in markets with rising capacity usage, such as North America and South-east Asia, but pricing should be neutral in real terms in most other markets. In Europe, most companies are trying to push through price increases in the face of continually falling demand.

"A concerted effort may lead to some positive results, but this is yet to be proven and we remain sceptical as well," they add.

Four cement companies (Buzzi Unicem, Heidelberg Cement Group, Holcim and Lafarge) have "strong pricing power in some markets, neutral in others and are likely to struggle in some," say Serov and Perada.

Their consolidated margins will expand due to volume growth in emerging markets, while there is "arguably more skew towards markets with weaker growth dynamics" and hence, poorer pricing power for companies such as "underweight" Irish CRH (CRH).

Geberit is considered an "underweight" stock with relatively high pricing power for its cement in a large number of markets, most notably in Europe and some Asian/African markets.

Stocks with relatively low pricing power include St. Gobain, CRH as well as cement firms in many emerging markets due to a large number of local competitors.St. Gobain is most likely to see margin contraction after falling in the first half of 2013, but starting to bounce back in the second half.

"Nearly all cement players are likely to see margin expansion in 2013," add the analysts.

Oil and mining

Although Martijn Rats, head of European oil research and Haythem Rashed, oil markets analyst, are not expecting the oil and mining sectors to see margin upgrades in the next six months, they concur both sectors are currently seeing the best pricing-power dynamics.

They recommend investors add BG Group (BG.) to their portfolios as the company has high pricing power, followed by ENI (E), while companies such as Total (TTA) are seen as having relatively high production costs.

"Overall," Rats and Rashed say, "we think consensus margin expectations will stay the same as a persistently higher crude price drives improved profitability in upstream business, but then it should be partially offset by increasing service costs and weaker margins in the downstream."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.