Quality Growth: The last man standing
Ramiz Chelat discusses sectors and regions that may recover quicker and how to understand company valuations.
Global equity markets rallied in the second quarter almost as quickly as they declined amid the shock of the pandemic. Share prices have responded to massive global monetary and fiscal stimulus and seem to be ignoring the risk of a second COVID-19 wave.
We are looking through this year’s recession and believe investors should focus on the sustainability of growth beyond 2021. We do not expect a market correction akin to what we saw in March. But in countries where infections are rising, consumer behaviors, like eating out and travel, will be impacted. This will alter recovery rates over the next 18 months. Recovery and economic growth will be relatively slow in many emerging markets as they have not received significant fiscal or economic stimulus.
Valuation multiples today can be misleading. A business valued at over 30 times earnings can still be attractive if earnings continue to surprise, while a business trading at 10 times can be expensive if the earnings outlook continues to deteriorate. It is important to look for sustainable growth over a five-year period and assume some multiple contraction. Consider growth factors like the strength of a company’s competitive advantage, predictability of its business model, and favorable shifts (such as consolidation) in the industry that it operates. On that view, valuations look quite reasonable in many cases.
Consumer desire to travel is clearly coming back after the lockdown. Domestic travel is recovering, while international will take longer. Demand for cruises has been robust, with Royal Caribbean indicating 2021 bookings in line with historic trends. Dominant online travel sites like Booking.com seem well-placed, as are companies like Safran, which has a high proportion of earnings from engine maintenance on narrowbody aircraft, which is more exposed to domestic travel.
Sub-sectors in information technology show long-term growth but it is important to be selective. The market is bullish on software-as-a-service (Saas) models with more predictable subscription-based revenues. Companies are also accelerating the move to cloud platforms, with the likes of Amazon and Microsoft benefitting, while people are spending more time on social media (which has driven social media ads for Tencent) and are making more e-commerce purchases.
Consumer staples have seen divergence in performance. Companies with on-premise exposure, like Coca-Cola or Anheuser-Busch InBev, will take some time to recover. They are less reliant on incremental stimulus than consumer discretionary businesses, but may have more predictability and the potential for downside protection. Over a three- to five-year period, these businesses can potentially be quality compounders. In contrast, there is some over-optimism in the consumer discretionary sector.
Financials are expected to recover more slowly in developed markets, due to pressures including low interest rates and non-performing loans. In emerging markets, there is opportunity for some faster growing financials, particularly in the private sector banks in India.