Quality Growth Boutique
Global equities specialists since 1984. We provide a boutique investment experience for institutional and intermediary clients around the world.
The strength and magnitude of the market’s rebound from the effects of COVID-19 has surprised many investors. Earnings estimates have returned to levels before the start of the pandemic, yet equity markets are hitting all-time highs. Negative real interest rates, high savings levels and banks flush with deposits have been major drivers of equity pricing.
Investor sentiment reflects growth that will continue at past levels, effectively ignoring risks hiding in plain sight. Economies and businesses globally are facing stiff headwinds, including high government debt, increasing wages, supply chain bottlenecks and rising inflation. Reconciling these contradictory drivers could lead to increased volatility and a divergence in company performance.
If inflation persists, central banks may be forced to accelerate tapering, which will have consequences for economies operating at high levels of leverage and stocks trading at historically high multiples.
Finding opportunity in today’s underappreciated business models
In buoyant markets, the attractions of business models that perform through volatile times can be underappreciated. One example is UK-based Rentokil, which we believe has seen resilient organic growth historically and should continue to see growth persist in the highly recurring, ”can’t be neglected” business of pest control. In our view, Rentokil is well-positioned to consolidate the industry and reap the benefits of the operating leverage that comes with scale and density. Investors can view this as a high-quality name given it serves a critical need that affords it pricing power, and low capital needs that should result in high returns.
Another example is payments company Mastercard which has low capital intensity, high margins and operates in consolidated markets. We feel it naturally provides inflation protection by taking a percentage of the value transacted and is positioned to benefit from changes in consumer spending, such as those caused by the pandemic. Purchases of hard goods are now running above trend, and with ongoing normalization post-COVID, demand for services should increase.
Capital intensive business models of automobiles are a stark contrast to payments, yet consumer clamor for big-ticket items, shortages and reduced manufacturing through the pandemic bolstered their stock prices. However, as companies increase production levels to run at full capacity, they will face challenges from input cost inflation, particularly if demand softens as pressures on consumer pocketbooks increase.
Shortages of gas, plus rising power and commodity prices in Europe have their roots in policy decisions. Some influential political groups are demanding the immediate end of fossil fuel use, even though renewables are not yet able to fully meet energy needs. Manufacturing and utilities will bear the brunt of rising costs and time will tell if European consumers are prepared to pay more for energy and goods.
The speed and rate of regulatory action in China took markets by surprise. Some measures reflect Beijing’s concerns about social issues, such as the price of education and minors playing online games. We approach China with caution and are avoiding sectors that may be under a longer-term cloud. Regulation on e-commerce, however, shows China catching up with developed markets, and intervention could level the playing field for some companies like JD.com, China’s second largest B2C online platform after Alibaba. The consumer staples space is less affected. For example, companies such as snacks group ChaCha Food are able to pursue volume growth and expansion opportunities with strong pricing coming through and stationary maker Shanghai M&G has room for consolidation.
We are also cautious around Beijing’s localization drive. Retail investors in China can push valuations strongly, although there are select quality names that are trading at reasonable valuations and picking up business from international rivals. As fundamental long-term investors, we can take advantage of this volatility by focusing on companies with leading market positions and good volume growth that are taking market share.
While EMs have struggled this year after a strong start, select EMs are poised for a rebound. In general, emerging markets central banks have not stimulated as much as developed markets. Some EM central banks have raised interest rates quickly to combat sharp increases in inflation. Brazil has been among the most aggressive in this regard, which could negatively impact its GDP growth in 2022.
Inflation is picking up in India and Indonesia, but monetary policy has been more supportive, particularly in India, and interest rate rises are likely to be gradual. Both countries are coming off periods of weak credit growth and relatively slow economic growth, even before Covid-19. We see a lot of pent-up demand on the credit side and potential for a strong economic recovery next year.
EM currencies, excluding China’s renminbi, are the cheapest they have been since 2014, while current account deficits are in a better place than when we last saw tapering in key markets like India and Indonesia. EM stocks are trading at attractive valuations and generating solid income (12x 2022 forecast earnings and a roughly 3% dividend) relative to developed market stocks, underscoring the long-term opportunity of the emerging market asset class.
Investors and regulators are applying more pressure to companies on social and environmental issues. The costs could significantly impact business performance, with weaker companies seeing a disproportionate impact. As a result, poor social or environmental practices are an acute concern. The value of risk from climate change is top of mind as governments tighten up on emissions. We are carefully assessing how companies will meet new climate standards, i.e., investing in technologies or buying different types of energy.
While it’s industry standard to use ESG scores to assess risk, we have found the greatest risks are found as narrow red flags on specific issues that can damage shareholder value. Even screaming messages can be hidden inside broad headline ESG ratings, where the overall figures are diluted by no-news variables. We constantly weigh the magnitude of potential damage vs probability i.e., timing. Headlines can make timing seem more likely and magnify the magnitude of potential damage – so we need to dig-in and identify which risks to react to.
Dealing with the near-term risks of regulation or further out risks from physical change to the climate is an area where granularity is important given the severity of the risks. Nestle, for example is a well-run company, in our view, with a large agricultural footprint, with an associated biodiversity and greenhouse gas emissions (e.g., methane from dairy cattle) footprint. The company though is well-staffed with researchers, scientists and agronomists as well as investing around one billion dollars a year on ESG challenges, such as packaging and reducing greenhouse gas emissions. Importantly, Nestle is funding this work by reinvesting savings made throughout the business. As a result, its forecast costs, and resulting profits have not changed materially due to this significant investment. Companies with less robust operations may face the risks of previously not forecasted costs and stakeholder pressure for change.
One way to think of the major risks to avoid are blow-up risks and the simmering long-term risks that could turn into a crisis at some future date. Either could impact investment flows, new regulation, or reflect poorly on a brand. It is important to address both sets of issues, even if some big ones are still non-chronic. Our goal is to find the companies that can address ESG considerations, and in doing so try to reduce risk and lift the valuable quality of predictability.