In a complex investment environment, investors should get back to basics and focus on corporate cash flows, scarcity value and the impact of inflationary pressure on profits. Simplicity will serve investors well in the coming years.
When things get complicated it often helps to try and simplify them. Looking out on today’s complex investment landscape investors should focus on the key fundamentals that drive corporate cash flows, profitability and ultimately asset prices over the long term. It requires sight of a company’s revenues versus costs, ascertaining if it is producing something other corporates can’t and identifying the key profitability drivers in its wider industry.
“At the end of the day, it really comes down to the fact that asset prices are a function of future profit” says Robert Almeida, global investment strategist and portfolio manager at MFS Investment Management in an interview with Top1000funds.com from the firm’s Boston headquarters.
“The simpler we can make it, the better off we will be.”
Keeping it simple means playing down the importance of trends and avoiding grand predictions. Political insight, a view on GDP or where the next spike in the virus will hit isn’t going to help either.
And he warns that the past won’t throw any light on the future in a view shared by other strategists like Alliance Bernstein’s head of institutional solutions, Inigo Fraser Jenkins, who argues investors are entering new terrain. After decades of low inflation, the characteristics that have underpinned the investment dynamic of the last 30 years are set to change.
“We think that the pandemic has changed the investment environment and the policy framework within which investment decisions are made,” says Fraser Jenkins. “Investors are likely to have to get used to a higher level of inflation, and governments may need a higher level of inflation to deal with debt levels. The pendulum will swing away from favouring owners of capital to labour.”
In truth, says Almeida, nobody knows what is going to happen and unlike science, finance is not rooted in immutable rules like gravity. Ignore the hubris and concentrate on making as few mistakes as possible.
Deciding what is and isn’t material has become more complex. Central banks have intentionally crowded out the purpose of financial markets via extensive asset purchases, leading to significant asset price inflation. Now the pandemic and subsequent recovery make it even more difficult to gage corporate profitability. Strong GDP levels coming out of COVID resulted in double digit corporate revenues and surging stock prices, fuelled by companies ripping out costs.
“Government stimulus, followed by the vaccine, has led to an explosion in economic growth boosting corporate revenues,” he says.
Now the picture changed again.
“GDP growth is fading as the stimulus wears off, while old costs are coming back into companies’ bottom line,” he says, just back from his first business trip since the pandemic – an industry conference in Salt Lake City. Elsewhere, new corporate costs are appearing like the spike in energy prices and secular costs like integrating sustainability.
“If you mix all these things together, plus expectations around cash flows and profits, my worry is things will decelerate faster than what markets expect,” says Almeida.
Add in the fact supply chain disruption is proving less transitory, impacting companies in two ways. On one hand it is triggering a negative supply shock, reducing the number of goods companies can put on their shelves and hitting revenues. On the other, bottlenecks are increasing costs like labour and raw material inputs, especially electricity.
“Companies are burning the candle at both ends. Profits are a function of revenues versus costs and in my view, revenue growth is vulnerable while costs are likely to rise,” says Almeida.
Solutions in scarcity
Making sense of these myriad cross currents requires investors focus on identifying the factors that will drive corporate profitability going forward. They should pick companies that are offering products and services which people are prepared to pay more for and stocks that can offer different profit streams.
“Scarcity has value,” says Almeida, who believes a scarcity value or premium will result in fierce competition for high performing stocks and bonds down the line, surprising investors.
As well as creating winners, the dispersion in risk markets will create losers. Avoid companies that don’t have something unique or have derived income from, say, not paying employees properly and now can’t raise prices. These companies will underperform in the next cycle, he predicts.
A scarcity value or premium will result in fierce competition for high performing stocks and bonds
It’s a sentiment echoed by Jimmy Chang, chief investment officer of Rockefeller’s global family office, part of Rockefeller Capital Management which includes both the family office, private wealth management plus Rockefeller Asset Management and Rockefeller Strategic Advisory, responsible for a combined $85 billion of assets.
Chang counsels a similarly cautious approach focused on finding the best quality and most consistent names with the strongest balance sheets as the market’s macro backdrop becomes less supportive.
“Our stimulus-driven economy is transitioning to mid-cycle,” he says. “While November and December are historically stronger periods of the year for equities, waning fiscal and monetary stimuli coupled with still elevated inflation portend higher volatility after the turning of the calendar to 2022. Such an environment warrants some conservatism, and we believe investors should focus on higher quality stocks with a history of earnings consistency.”
Both Chang and Fraser Jenkins think investors should position for higher inflation. While Chang has suggested investors play this with exposure to inflation beneficiaries like financial services and commodities, Fraser Jenkins suggests higher equity exposure, a strategic exposure to the value factor and a reduction in the duration of portfolios. “We also think that investors need to consider using factors alongside traditional asset classes in asset allocation,” he suggests.
Sustainability
Sustainability, as well as scarcity, will be the other performance differentiator in the years ahead. Investors will increasingly reduce allocations to companies in their portfolios that don’t integrate sustainability. And many companies haven’t factored in the cost of the transition, says Almeida.
“Given the level of corporate indebtedness today, ESG strikes me as an underappreciated material risk, particularly by corporate bond investors.”
When it comes to making investment decisions, Almeida warns technology holds challenges and opportunities. Sure, investors have more information than ever before. But it requires carefully sifting through and does not equate to knowledge.
“To be clear, reaction time to a data point is not a differentiator. The differentiator is the ability to disregard what isn’t material and incorporate what is,” he says. “As you take in more data you must decipher what information does, and doesn’t, change the investment thesis.”
Don’t build portfolios based on past trends or try and predict what might happen in the future; views on central bank tapering and interest rate policy are important but shouldn’t be central. Rather, bond and equity investors should focus on corporate cash flows, scarcity premiums and the impact of inflationary pressure on profits.
“Profits are a function of revenues versus costs and in my view, revenue growth is vulnerable while costs are likely to rise,” he concludes.
