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July 23, 2021

Quality in a Brave New World

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July 23, 2021

Quality in a Brave New World


Global Equity Observer

Quality in a Brave New World

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July 23, 2021

 
 

The last quarter century since the inception of our team’s longest-standing global strategy has proved fertile ground for high quality compounders. Their combination of pricing power and recurring revenues has allowed them to comfortably out-earn the market as a whole, helped by the disasters that befell the technology, media and telecommunications (TMT) sector in the 2001-03 crash and the financials sector in the 2008-09 Global Financial Crisis. The other positive has been that, despite this superior record, they have generally only traded at a mild premium to the market, particularly when looking at free cash flow yields.

 
 

There is speculation that quality and compounders will struggle in the “Brave New World” of reflation and inflation. Our view is that the companies should continue to prosper, even if there is a shift to a more inflationary regime.

It is true that the last year has been less favourable for quality in relative terms. The first issue was that 2020 saw a growth boom, as investors got excited about a lot of the technological winners from the pandemic. Our view is that elements of this turned into a bubble, with some extreme valuations and speculative excesses around special purpose acquisition companies (SPACs). Our valuation discipline meant that we did not participate in this exuberance. On top of that, the fourth quarter of 2020 and first quarter of 2021 saw significant good news around the speed of vaccine development and rollout, which sharply accelerated the likely path of recovery. As a result, the value sectors and cyclical recovery plays in sectors such as financials, materials and industrials naturally came into favour, as their earnings expectations improved sharply in the “reflation trade”, comfortably outpacing the defensive sectors – notably consumer staples and health care – that make up much of our global portfolios.

Last year’s growth bubble has deflated somewhat in 2021, with information technology’s most expensive quintile only returning 3% year-to-date, against an average of 12% for the other four quintiles.1 The median valuation in the top quintile has dropped from around 130x 24-month forward earnings to a mere 110x or so.1 (This is provided you are kind enough to exclude stock-based compensation from their costs – otherwise the median stock in the quintile is loss-making.) As a result, in the near term much of the discussion is around how much legs the cyclical, or reflation, trade still has left.

It is unclear whether there are further positive growth surprises to come, how much upside still remains in cyclical earnings, and the extent to which any good news is already in stock prices, with materials up 82% and financials up 74% since March 2020, compared with only 32% for consumer staples and 42% for health care.1 The experience of the second quarter of 2021, with the cyclical sectors generally lagging slightly behind the overall index, suggests that the momentum behind the value trade may be fading.

Inflation watch

The fear is that the current economic boom will drive inflation, and prices have indeed already risen sharply for many commodities and products. What is not yet clear is how much of this is transitory – the result of spikes in demand and supply still constrained by the pandemic – and how much may prove to be permanent. The consensus seems to be that much of the inflationary pressure will indeed fade away as demand normalises and supply recovers, meaning that governments will not have to slam on the brakes.

We would agree that some commodities, for instance iron ore, are above likely long-term prices (which incidentally means that their producers may be over-earning at present). The key inflation variable to watch is wage growth: in service-orientated economies, people costs are more important than the costs of “stuff”, be it semiconductors or lumber. In the meantime, the market obsesses over tiny micro-signals about central bank intentions, reminiscent of the Cold War sport of Kremlinology, described by one eminent historian of the time as the attempt to work out who was winning the power struggles within the Politburo by the width of the black armbands worn at public state funerals in Red Square.

Looking through the timing and strength of the current economic recovery, there are longer-term concerns in the market about the fate of quality equities in a higher-inflation world, if that does indeed come to pass. While we do not have a strong view as to the likely path of inflation, given that there are decent arguments for both the transitory and the more permanent cases, we do believe that quality companies can still thrive in a more inflationary environment.

One key point to make is that inflation is fundamentally a nominal rather than a real phenomenon. It will accelerate headline revenue growth rates, but any benefits are illusionary as they are cancelled out by the rise in the price level. That said, there are arguments that inflation can particularly help lower quality companies. “Money illusion” can fool people into crediting companies that are not growing in real terms with growth status – not something that happens in today’s low-inflation world. In addition, inflation may help asset-heavy companies’ accounting profits, as sales rise relative to the book value of their assets and the associated depreciation. The final argument in favour of lower quality stocks in an inflationary regime is that they are less vulnerable to an inflation-driven rise in discount rates as nominal rates rise, given their lower multiple and shorter duration compared with more expensive stocks. This makes sense mathematically … providing you ignore the fact that the long-run nominal growth rate is likely to rise in parallel with the inflation and discount rates, cancelling out any effect on the multiple.

Compounders remain attractive

Overall, our view is that these inflation gains for lower quality companies are not “real” or “economic” and are thus unlikely to have a long-lasting impact, with the exception of some financials, which may see net interest gains from higher interest rates. We would also argue that there are two significant relative pluses for higher quality companies in a higher inflation world:

  • The first is that inflation will mean that companies have to deal with rising input costs. This is likely to put a premium on those companies who can pass those costs on to customers through their pricing power, one of the key characteristics that we look for in compounders.
  • The other is that this regime will probably require more frequent government intervention to keep inflation under control, prompting shorter economic cycles. The last few decades have seen unprecedentedly long economic cycles as governments have not had to slow economies down to dampen price rises, and this is unlikely to be sustained if inflation became an issue. In a world of frequent recessions, compounders’ recurring revenues would be an even more valuable source of earnings stability.
     

Ultimately, the case for compounders remains largely unchanged in a more inflationary world. Companies that can grow their earnings steadily in real terms across cycles are likely to continue out-earning the market, just as they have done over the last few decades. Pricing power and recurring revenues are arguably even more important in a world of rising input costs and higher economic volatility. In a world of expensive markets, with the MSCI World Index still at a 20x forward multiple for the first time since the TMT bubble at the start of the century - even after a 40% rise in earnings over the last year - compounders remain attractive.1 After all, given that markets currently involve significant valuation risk, why take earnings risk as well?

 
 

1 Source: FactSet. Data as of June 2021.


 
 

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.

 
bruno.paulson
Managing Director
International Equity Team
 
 
Featured Funds
 
 
 
 
 

DEFINITIONS

Free cash flow (FCF) is a measure of financial performance calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able generate after laying out the money required to maintain or expand its asset base. Return On Operating Capital Employed (ROOCE) is a ratio indicating the efficiency and profitability of a company’s trade working capital. Calculated as: earnings before interest and taxes/property, plant and equipment plus trade working capital (ex-financials and excluding goodwill).

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