Quality Growth Boutique
Global equities specialists since 1984. We provide a boutique investment experience for institutional and intermediary clients around the world.
The latest plot twist of the pandemic may have spooked markets in recent days, but the underlying sentiment is still one of worrying exuberance and investors are overlooking businesses in the consumer staples, health care and discretionary sectors that are still in the process of normalizing. Over the past months, the market has been incurring considerable risk by favoring hyper-growth, low-quality stocks while inflation has embarked on an unknowable trajectory. However, these stocks are unlikely to deliver on the high future return expectations investors have for them.
Even though people like drawing analogies between today and past crisis moments like 2000/2001 or 2008/2009, the truth is that we have never seen anything like this before. As a result, the inflation question has divided the market into binary camps of transitory vs. non-transitory as investors grasp for clarity. The bottom line is that we cannot know for sure and that we might be faced with a new phenomenon all together. In times like these, investors would be best advised to wait for some resolution. But the market doesn’t have time; it just wants to move up every day.
Today’s inflationary pressures highlight how unusual current times are. Despite many critical voices, the Fed has done a reasonable job in managing the situation as they are carefully waiting and balancing the risks – contrary to the broader market. Even if there is a strong possibility that the inflationary picture is going to stabilize in the medium term, it might take another year to work out all the kinks. Overall, the larger backdrop is still deflationary as indebtedness has reached new record highs and long-term growth is unlikely to surpass pre-pandemic levels.
However, should inflation dig in its heels, it is important to think through the business models of the companies you own. While labor-intensive businesses should be avoided since they are prone to wage growth, companies with pricing power can handle inflationary headwinds much better. Normally, consumer staples companies are the ones who see and disclose cost pressures first, which tends to worry investors once these pressures become known. However, consumer staples are also the ones who can pass these pressures on to the consumer more easily than other businesses. Therefore, they tend to come out better on the other side and much earlier than other companies. However, investors should make sure pricing power is sustainable and not a fleeting result of special circumstance. For example, automakers are an anomaly in this regard as the unusual environment of a heavily constrained supply side and massive demand have given them unique pricing power. The fierce competition among incumbents in the sector is bound to resume, however, which will ultimately erode their ability to pass through rising input prices.
Currently the market seems enthralled by high-momentum, low-quality names that have been posting high double-digit returns over the past years. These are businesses with high top-line growth but weak underlying figures, such as low return on invested capital, low profitability and high leverage. The market is extrapolating these businesses’ ability to generate double-digit revenue growth of the last five years forward, based on the risky assumption that high revenues will translate into high profitability. This is typical of late-stage cycle market euphoria, which has pushed a broad swath of names significantly above their long-term price averages. However, such companies can rarely maintain double-digit earnings growth for five years and then repeat that for another five years. Therefore, multiple compression is the biggest risk to the general market right now.
Thanks to the current market dislocation, there are a couple of attractive buckets in the market with companies whose balance sheets are healthy but whose earnings are still in the process of normalizing. As a result, their performance has been either flat or only slightly up until now. This has been unattractive to the general mass of investors that doesn’t have patience for earnings normalization.
In the consumer staples space, for example, Coca Cola, Pepsi and Heineken haven’t gone anywhere yet since the market is waiting for Covid reopening. The medtech space has underperformed because some of these businesses have been shut down during Covid. They should normalise as standard procedures like implanting pacemakers or stents come back after having been put off by the pandemic. But even in the technology sector, which has been booming, you find names like Visa and Mastercard, which have not done anything because the crossborder travel business is just about to come back.
Even within consumer discretionary, opportunities can be found since some of the retailing space in the US is still yet to recover. For example, Ross Stores has been an underperformer despite all this euphoria around consumer spending coming back thanks to the flush of savings. The stock should be a direct beneficiary of wage growth as increased consumer spending power and pent-up demand is likely to outweigh higher wages of their own workforce over time. Therefore, this is clearly a recovery play with people moving back to the stores. Inventory issues because of supply chain disruptions are expected to normalize as well.
These businesses had severe shutdowns during Covid and severe contraction in revenues, but they had no issue with balance sheet strength. As business normalizes for them, they can generate healthy cashflows that should carry them through the cycle. These names are growing earnings at high single to low double digits and offer a couple of percent of dividend yield. Those are good returns. Everybody is so used to the type of returns we have right now that they forget a normalised long-term equity return is in the middle single-digit space. If portfolios are able to deliver such returns over the next couple of years, I think investors would be pleased. I think the general market is going to be quite shocked that it can’t when the low-quality, high-momentum names run out of steam.
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