Insights
Investing in a deeply uncertain world
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Global Equity Observer
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March 21, 2022
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Investing in a deeply uncertain world
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March 21, 2022
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Investing in a deeply uncertain world
Investing in a deeply uncertain world |
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The military conflict in Ukraine means the world is witnessing a televised humanitarian crisis and grappling with forces and scenarios not contemplated in Europe since the Second World War. Our team’s thoughts are with the victims and families of all those affected. While year-to-date the MSCI World is down 8% in U.S. dollars, it remains up more than 10% in the last 12 months. This fairly limited market drop has been down to a de-rating rather than any fall in market earnings expectations.
Forward earnings estimates, perhaps optimistically, have actually risen 3% over the last two months. Historically, it has been the robustness of earnings in tough times, be they the Global Financial Crisis or COVID, that has provided our global portfolios’ relatively low participation on the downside, not something that has applied so far in 2022 given that the market’s earnings have held up so far this year.
It is worth noting that the de-rating has been valuation driven, with the more expensive stocks falling more. Dividing the MSCI World into five quintiles by end 2021 multiples, the top quintile is off 15%, the second down 9%, while the other three have only fallen 1-4%. While we have been very focussed on valuation over the last few years, trimming the more expensive, growthier names as they have re-rated, on top of always avoiding the most expensive growth names, the portfolio’s high quality means that they are mildly more expensive than the market, with about half the portfolios’ weight in the second quintile. As such the market’s de-rating has been a headwind, though it has had the benefit of making some names, both inside and outside the current portfolios, more attractively valued. The final point to make is around the sector moves. Consumer staples, a key sector for our global portfolios, has held up relatively well this year, but looking at the other outperforming sectors in 2022, our philosophy means that we are not invested in energy (the standout performer this year), materials or utilities, while we are significantly underweight financials, not least because we avoid banks.
We remain focused on compounding over the long run, something the market struggles to do. What we look for in a stock is simple, but hard to find. First on the list is companies with dominant and sustainable intangible assets, for instance brands or networks. These intangible assets should drive pricing power, which we define as the ability to pass on input cost inflation to the end consumer. This is particularly important in today’s inflationary environment. The signal you have pricing power is a history of a high and stable gross margin in the face of input cost shocks. We also demand the ability to steadily grow revenues organically, rather than a volatile cyclical top-line, with a substantial recurring element. Such recurring revenue can come from repeat purchase of a favoured shampoo or face cream, or from long-term relationships and contracts. The combination of pricing power (protecting margins) and recurring revenues (protecting sales) should lead to robust profits. Given the reliance on intangible rather than tangible assets, these profits should be generated at high returns on capital, and as such robust earnings should turn into robust cash flows.
Sadly, compounding requires more than a strong and sustainable franchise that can be relied upon to grow steadily at high returns. It also requires the right management, who are not only going to continue to innovate and advertise to preserve and improve the intangible assets, but also allocate the remaining free cash flows well. Some companies are fine acquirors, but most are not and should therefore focus on returning the excess cash to shareholders. The final test is valuation. We are happy to own companies we believe are going to compound at fair value, relying on the compounding to deliver the returns, but paying too much for them risks the permanent destruction of capital.
This process for selecting stocks has been consistent for a quarter of a century. Both this history and basic economics suggest that our global portfolios’ earnings should be relatively resilient in a squeeze on the wider market’s profitability, be it due to inflation, governments’ reaction to inflation or a geopolitical crisis.
The market still looks vulnerable, especially if the current geopolitical crisis worsens, with the MSCI World Index over 17 times forward earnings, a multiple never reached between 2003 and 2019, and this on earnings estimates up 57% from June 2020 and 23% above the pre-COVID peak. In a deeply uncertain world, we would argue that limiting your uncertainty by owning a portfolio of relatively predictable compounders makes sense, particularly when they are available at a modest free cash flow premium to the market.
Risk Considerations
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market value of securities owned by the portfolio will decline. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. Changes in the worldwide economy, consumer spending, competition, demographics and consumer preferences, government regulation and economic conditions may adversely affect global franchise companies and may negatively impact the strategy to a greater extent than if the strategy’s assets were invested in a wider variety of companies. In general, equity securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. Stocks of small- and mid-capitalisation companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility. ESG strategies that incorporate impact investing and/or Environmental, Social and Governance (ESG) factors could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. As a result, there is no assurance ESG strategies could result in more favorable investment performance.
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Managing Director
International Equity Team
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