Back in January, we discussed our views on the year ahead. With the second quarter well underway, it seems like a timely moment to take stock. We asked Kilian Niemarkt, Client Portfolio Manager, how his team stays focused on long-term value creation in the face of macro uncertainty.
There have been some tumultuous events impacting markets so far this year. As an equity investor, how are you maintaining an optimistic outlook?
We still see a lot of attractive upside potential in the asset class. It’s true that interest rates are higher than they were in the previous decade. However, when thinking about value in equities, investors need to consider two aspects; firstly, what you pay and secondly, what you get.
What you pay is very much influenced by a company’s discount rate. This obviously goes hand-in-hand with rising rates, and it determines the terminal rate we use in our models to determine the value of a stock. It’s been a headwind for equity investors, but we think that the interest rate peak is imminent and this could turn into a tailwind.
Recent turmoil in the US banking sector has led the regulator to signal tougher regulations. Estimating the impact of this is difficult and uncertain, but U.S. Federal Reserve (Fed) Chairman, Jerome Powell, acknowledged that it may equate to an interest rate hike of 25 or 50bps, making it easy to understand that a lower terminal rate on Fed Funds should be priced. In light of this, the Fed’s increase of 25bps was seen from a dovish perspective, and that the end of the rate hike cycle may now be close to peaking, with interest rates eventually starting to fall.
In terms of what you get, this is determined by the profits of individual companies, and great businesses which harness the opportunity of change. Such businesses, for instance, use pricing power relative to peers to defend margins.
In sum, we see a significant amount of upside potential. Value is relative, and a headwind can turn into a tailwind.
You invest in great companies at attractive valuations. How do you find these businesses that perform well even in difficult times?
We have a tried-and-tested process which we’ve applied for over 16 years. It focuses on the four forces of competitive dynamics. We want to see 1) a winning business model, 2) the opportunity to gain market share, 3) a growing end market, and 4) a strong management team and a track record in execution. We want to see companies that tick all four of these boxes.
In order to find these companies, we need to look beyond the financial statements. To find a winning business we look at the intangibles, the factors that are not obvious from the profit and loss statement (P&L), balance sheet or cashflow statement. This varies by sector, for example in healthcare, it’s about research and development (R&D) capabilities, and attracting and recruiting the best scientists, the human capital. To find great businesses you have to go beyond traditional financial analysis.
Similarly, we seek to avoid companies that are focused purely on their financial statements. There is an excess of borrowing in the current environment, for example, 1) borrowing from customers by offering a weak returns policy, inefficient customer service or cutting R&D budgets and delaying investments, 2) borrowing from suppliers by not paying them on time, and 3) borrowing from employees by not paying them fairly or by providing unsafe working conditions.
Borrowing in this way can make financial capital look better in the short term, but it doesn’t necessarily result in a great business. Borrowing from the future can create a contingent liability, and once it is realised, it has an adverse effect on shareholders. Therefore, we look at great companies that create contingent assets and invest in the future.
What role are dividends playing right now, for equity investors?
Firstly, there is an opportunity cost when deploying capital. Dividends, to some extent, compensate investors for the opportunity cost of capital.
Secondly, dividends are a way of shorting the investment duration. High interest penalises long-term relative valuation compared to the short term, so the return on capital for shareholders is a way in which management teams can shorten the equity duration consistent with investors’ expectations.
There are two supplementary arguments to this: it can add to the capital allocation discipline for the management team of the company, and it can broaden the appeal to investors looking for income.
In the current environment, where do you see opportunities in companies?
We look for companies with a strong competitive advantage. Regardless of the economic outlook, it’s hard to imagine that strong companies with competitive advantages will not survive in the long term. We have seen previously that in a recession, great businesses can become stronger. They have the ability to increase market share relative to poorly-managed businesses.
In our view, the market is too focused on rising interest rates and the associated headwinds, and this provides opportunities for fundamental bottom-up stock pickers, such as ourselves.
And to narrow that down further, what are your areas of investment focus?
It is clear that inflationary pressures are impacting the disposable income and discretionary spending power of households. Those towards the bottom two quartiles of income distribution are particularly impacted as food, energy and shelter consume disproportionally high amounts of their earnings. Inflationary pressure in these three areas is particularly strong.
We’re focusing on stable companies with strong customer loyalty and robust brands. These companies will be able to use their contingent assets to demonstrate pricing power and defend margins, while at the same time growing top line revenues.
In addition, we are focusing on domestic business models with simple supply chains. These businesses have demonstrated a great level of resistance and have been able to gain market share relative to peers, who in recent years have suffered from global supply chain disruptions and labour shortages.