This month we have asked AnBro Capital for their perspective on stock picking in the current market environment. We are truly grateful to enjoy a very close working relationship with our various Asset Managers and the Chief Investment Officer at AnBro (Craig Antonie) has prepared a special note for Heritage Wealth Partners clients.
The shift from a low inflation, ultra-low interest rate environment to practically anything else has had a significant impact on equity valuations. The pandemic accelerated many things, like growth in cloud computing and streaming. It also managed to squeeze an entire equity cycle into the space of two years, resulting in extraordinary volatility and gaps between peaks and troughs.
Talk of a recession has now become commonplace. Whilst many are naturally hoping for a soft landing, there’s a chance that we land in a bed of prickly thorns instead.
If thorns are the base case, then what investments do we tend to look for?
In a recession, the key elements to look for are strong balance sheets and significant pricing power with customers. Consumer staples tend to be the go-to investments. Utilities, basic consumer goods and defence stocks are popular in these environments.
In a period of high inflation, investors gravitate towards commodities, consumer staples, healthcare, financial services and real estate. These businesses typically have high operating leverage, which means inflationary increases in revenue “drop to the bottom line” as the operational infrastructure is already in place. It’s never quite that simple of course, as inflation doesn’t affect every product or service equally.
When interest rates are rising, investors primarily jump into financial services stocks like banks. Higher interest rates drive improved margins, with some offset from impairments. Investors also look at real estate (provided balance sheets are adequately hedged), short-term bonds and good ol’ fashioned cash. These become “places to hide” rather than aggressive plays.
In 2022, we are dealing with a perfect storm that has all three of these scenarios. How are the different sectors performing in this environment?
Energy has clearly been the standout performer here, with the conflict in Ukraine driving a substantial increase in the oil price and certain other commodities. Oil was trading at around $75 at the end of December and is trading over 45% higher just six months later. This causes major problems for consumers and most companies.
We don’t know for sure where oil would be trading without the conflict, but we would wager that it wouldn’t be as high as it is now.
Growth has been the clear laggard in this environment. The year-to-date performance is made even worse by the stretched valuations coming into this year, the result of a period of great excess in the markets driven by unprecedented levels of stimulus.
The surge in inflation driven by oil and food prices has caused interest rate expectations to move far beyond the market’s predictions coming into this year. The impact on growth stocks is clear to see, with a vicious and broad sell-off of this sector.
For some context to this, let’s travel back in time to the Global Financial Crisis (GFC) that marked the top of the 2000s bull market. It lasted from December 2007 to June 2009 and sent shockwaves through the banking system worldwide.
The chart below shows the impact on various sectors for a period that includes six months on either side of the recession. This is because markets are forward-looking and tend to drop before recessionary data actually comes through:
We must be careful of course, as no two recessions are the same. Contributing factors are different and so are the macroeconomic factors like inflation, interest rates, and geopolitics.
A tale of two crises – what can we learn?
The S&P 500 sell-off was far more brutal in the GFC than it has been in 2022. Your immediate answer may be “2022 so far” which is a fair response, as the market is still in a downtrend. Still, the drop in the GFC was twice the level we’ve seen this year.
Another interesting observation is that every sector fell during the GFC, admittedly by different percentages. Only Consumer Staples put through a decent performance, with every other sector losing approximately 12% or more. Sectors like Real Estate fell over because they had too much leverage. Financials took the hardest knock because they were the source of the crisis.
In 2022, Energy has skyrocketed with the significant assistance of the conflict in Ukraine. Utilities, Aerospace and Defence, Materials, Value, and Consumer Staples have posted small moves. A key learning from this is that Consumer Staples have done ok in both difficult times.
Growth stocks performed in a similar fashion to energy stocks during the GFC, yet they represent the full spectrum of winners and losers in this sell-off.
Why? Are growth stocks sitting with too much debt? Do they require bailouts, as the banks did in the GFC? Are their earnings deep in the red?
None of this applies. Earnings are generally still growing, albeit at a lower rate in many cases. The only fault coming into this year was that valuations had simply run too hard in the pandemic.
Have markets finished falling yet? If we compare the two crises, there is a case to be made that they haven’t. Although Financials and Real Estate aren’t dealing with nearly the same issues as in the GFC, it does feel as though Energy, Defence, Materials, Utilities, and Value could fall. One can interpret this as having more downside risk if issues carry on and lower upside potential if things do turn.
We strongly advocate a diversified portfolio built to last for decades. As custodians of your portfolio, it is our business to grow your capital as much as possible over time. There is no such thing as a short-term investment strategy, investing takes time in order to manage the risk/reward pay-off. Risk/reward analysis suggests that allocations to growth will continue to prove profitable over time but what about now, is this strategy still sound?
It certainly makes sense at the moment vs. other sectors, don’t just take our word for it let the data do the talking as highlighted by this analysis:
A closer look at Unicorn:
These were the top 10 holdings on 8th June 2022, along with their year-to-date performance and drop since the all-time high:
Now let’s consider the earnings growth in these companies:
Despite delivering average growth of 42% in the last quarter, the share prices have fallen by 29% this year and 40% since the highs. This has compressed the multiples of these stocks considerably.
Sentiment towards the sector has been negative and everyone in the market seems to be singing from the same hymn sheet, arguing that growth stocks are expensive and that inflation eats away at future returns. Higher interest rates curb consumer spending and slow down the world’s most important economies.
When it comes to these macroeconomic cycles, one thing we know for sure is that this too shall pass. We don’t exactly know when, but we know from every previous recession that conditions eventually improve.
As mentioned, we are long-term investors. On a five- to ten-year view, we feel that above-average returns will likely come from capital-light companies operating in growing markets. They should preferably have low debt and above-average margins. To be honest, this sounds like a sensible thesis in any sector.
The Unicorn portfolio is filled to the brim with companies that have these characteristics. We certainly cannot control or influence the day-to-day movements in the market. All we can do is prepare for a “normalised” world and invest in the companies that look set to grow through any cycle.
Just as multiples have compressed, so too can they expand on the other side of this cycle. We focus on companies that should have far higher earnings when that expansion comes, leading to a turbocharged result for those who were brave enough to invest or stay invested “at the bottom”. Nobody can time it perfectly, so using a sensible risk/reward approach is often the way to get close enough to the bottom.