In recent times, investing in risk assets has been a rather miserable experience for everyone involved. The benign economic environment, and central bank largesse, prevalent for more than a decade inflated valuations for equities and indeed most financial assets. But that era now appears behind us.
Whereas the post-financial crisis era was less about investing capital and more about the ‘great inflation’ of financial assets, investors now face a new and ongoing challenge. Policymakers no longer ‘have our back’, and inflation (rather than the price of risk assets) is now the number one priority of central banks.
Regime change means the road ahead is not going to be so easy for investors, and the penalty for investing at inflated prices and a lack of future cashflows is quite burdensome, but there are several ways that one can prepare.
This starts with recognising, that the road ahead will be rougher and more uncertain, and that entering a new era means being open minded about where the best future opportunities may exist.
The perils of recency bias
We are all familiar with the outsized gains made by the technology sector in recent years, but after the 20% drawdown in markets in early 2022, what are the chances that a former market leader can repeat its outperformance in the next market advance?
There’s just a 27% chance of tech being in the top two sectors for forward returns from here – in other words, there is a greater than 70% chance that history doesn’t repeat itself.
The leaders over the last cycle were the information technology, consumer discretionary and energy sectors. Assuming they will automatically return as market leaders is a brave call. New leadership is likely to emerge this time, given the scale of surplus capital that has just been allocated to those winners. It may be prudent to challenge oneself to keep an open mind as to where market leadership will emerge, and to be cognisant of recency bias.
Where to find the future winners?
The next key question is where to invest capital within global equities. Given the environment of higher interest rates, and continued pressures on household consumption, caution is warranted for the growth outlook for many consumer-facing companies. It won’t be surprising if the falling propensity to consume (due to greater spending on mortgage and utility costs) and prior Covid-led pulling forward of demand will be difficult and enduring problems to overcome.
Therefore, sustainable growth that is less impacted by consumer cyclicality is preferable. For example, healthcare companies typically have less cyclicality in demand and, in many cases, have been indiscriminately de-rated in the reappraisal of higher growth companies.
Demand for better and more cost-effective solutions across ageing societies is a long-term positive for the correctly positioned companies. There are more opportunities here, where one can have confidence in higher growth compared to other sectors.
The accelerating energy transition
The energy transition investment theme is a secular one, and an enduring cycle of rising investment into renewable energy is upon us. Societies must address the challenge of sustaining the still-needed fossil fuel production, increasing supply from more trusted regimes, improving energy efficiencies, reducing emissions and developing alternative energy sources further.
The latter is key from a climate perspective, but also energy-intensive in its own right, creating a circular requirement for the other drivers. In short, the addressable market will grow and surprise investors, and profitability for many suppliers of the ‘picks and shovels’ of the energy transition is on an improving trend. This is an increasing rarity in the current environment.
ESG is more than an investment trend
Being constructively critical is essential in today’s turbulent world, and it is becoming increasingly obvious that companies cannot achieve high, long-term returns with unsustainable business practises.
Environmental, social and governance (ESG) factors can help identify change and the potential for accelerating returns. Long-term, active investors have the opportunity to add value by integrating ESG factors into their analysis, especially as we enter this new era where growth is harder to come by.
ESG is an essential lens through which to implement investment decisions. However, while good ESG disclosure, appropriate long-term incentive schemes and a governance structure that protects shareholders’ interests are all positive signals, they are not in themselves substitutes for the value created from engaging with management. Engagement also must be used to determine where issues exist, and to help ensure companies address specific areas of weaknesses.
Give priority to ‘future quality’ companies
If one wants to better future proof their investment portfolio then looking carefully at the future profitability of companies is mission critical. Fortunately, active investors are not beholden to the market weighting of past winners, burdened with potentially bloated levels of profitability.
Instead, focus on companies more likely to experience positive surprises in revenue and profitability in the coming years. We call these ‘future quality’ companies – businesses available at attractive valuations that can generate sustained cash flow growth and high and improving returns on invested capital.
Future quality companies should have long competitive advantage periods through which they can sustain high and/or improving cash returns. When identifying these companies, look to management quality, franchise quality and balance sheet quality and endeavour to always maintain a disciplined valuation approach.
Prepare oneself for the road ahead
It may be easy to become gloomy amid the turbulence of today, but there are plenty of reasons to be optimistic about the prospects for compounding future capital from today’s levels.
Firstly, valuations are now at healthier levels and the good, albeit challenging, news for investors is that when there is a regime change, there is also a high probability of new leaders emerging.
Secondly there are always companies to be found that are on a unique journey of improvement that can attain and sustain high returns on invested capital over the next five years or more and offer returns less dependent on the overall market cycle.
William Low is a global equity portfolio manager at Nikko Asset Management. The views expressed above should not be taken as investment advice.