Insights
Superpowers to the Rescue?
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Global Equity Observer
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October 31, 2022
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Superpowers to the Rescue?
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October 31, 2022
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Superpowers to the Rescue?
Superpowers to the Rescue? |
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Nine months into 2022, and the MSCI World Index has fallen by more than a quarter, not helped in recent days by the Russian annexation of four provinces of Ukraine and the currency and bond crises in the U.K. Remarkably, the year’s fall has still been all down to derating, rather than any drop in forward earnings, which are actually up 3% this year, boosted by the boom in energy profits.
The market’s earnings have edged down a little in the last quarter (off 2%), but this is a U.S. dollar number,1 and thus easily explainable by the currency’s continuing strength, which reduces earnings earned in weaker currencies. Margins remain very close to the all-time record levels seen earlier in the year.
The market’s earnings numbers are clearly not anticipating a significant slowdown, let alone a serious recession, with forward earnings expected to rise over 5% over the next year, despite the dollar headwind, and only materials — affected by recent falls in metals prices — facing an earnings fall. The classic cyclical industrials sector’s earnings are expected to outperform the overall market over the next year, up 8%, while double-digit growth is anticipated for consumer discretionary stocks.2
The fall in the market multiple does suggest more wariness about future prospects than the earnings estimates do, with the MSCI World Index forward multiple dropping from 19x at the start of the year to sub-14x at the end of September. However, the new level is only 3% below the 2003-19 average, with the approximate 20x multiples of 2020-21 looking like the outlier. The defensive sectors have outperformed, as consumer staples, health care and utilities have “only” dropped 14-17% this year, but the worst-performing sectors — information technology, communication services and consumer discretionary, all off over 30% — were the most expensive at the start of the year, rather than the most cyclical, as growthier multiples have contracted most.3
In this environment, our global portfolios have not shown their historic relative lack of downside participation, falling roughly in line with the market. Indeed, the derating has been only marginally less severe than that of the market. The bias towards defensive sectors mitigated the derating, but the portfolios’ exposure to more expensive sub-sectors — i.e., software & services within information technology and life sciences & equipment within health care — largely cancelled that out. The strategies’ forward earnings have been roughly flat this year, as the dollar strength balanced the stocks’ steady compounding. This earnings performance has been slightly behind the market. A mechanical explanation of the gap is the lack of exposure to energy, which drove the bulk of the market’s earnings rise; but a more fundamental explanation is that the portfolios’ two “superpowers”, pricing power and recurring revenue, have not helped in a world of inflation and excess demand, with recurring revenue arguably being a handicap right now.
We value pricing power (the ability to pass on costs to consumers) and recurring revenue (the propensity towards repeat purchases, either due to long-term contracts or consumers’ force of habit), supported by brands. The combination of the two “superpowers” means that both margins and revenues are robust in a downturn, supporting profits. However, at the moment, pricing power seems fairly universal given all the supply shortages, not least in staff, which have fed into inflation, shrinkflation and the dreaded skimpflation (the deterioration in services we have all suffered), meaning that fundamental cross-cycle pricing power does not currently provide an edge. The situation is arguably worse for recurring revenue. Long-term contracts prevent providers from exploiting high spot prices and can also cause short-term problems in passing on inflationary cost rises, at least until the contracts expire, when pricing power allows the company to catch up.
We still regard pricing power and recurring revenues as superpowers, key for compounding, i.e., the ability to grow earnings in both good times and tough times. This is crucial as we worry that the current good times for corporates may well turn into tough times in the next few quarters, with any slowdown or recession threatening the record corporate margins as the current excess demand turns into a potential excess supply. We are less worried about the portfolio’s earnings vulnerability as the two superpowers should again provide downside mitigation, as seen by the resilience of earnings during the pandemic. History suggests that a fall in the market’s earnings has been accompanied by portfolio outperformance alongside resilient earnings.4
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Managing Director
International Equity Team
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