Widespread stock market falls on the back of rising inflation and bond yields are the biggest worry for UK growth investor Margaret Lawson heading into 2022.
After a swift recovery from the coronavirus pandemic, many companies have reported better-than-expected earnings – boosting their valuations and outlook.
But as companies face rising inflation and investors brace for rising bond yields, Lawson said the greatest worry for her portfolio is multiple compression.
When inflation or bond yields rise, the discount factor that investors place on equities is also higher. This makes future returns less attractive, especially compared to the previous discount rate of less than half a percentage point (the current central bank interest rate).
Most growth companies are often on high multiples but if they fail to meet market expectations share prices can fall sharply.
“That's the danger with highly rated things,” Lawson said. “I realised in recent times the market is very unforgiving.
“You may say the market has always been unforgiving, but it's more unforgiving than ever. You will see things fall 25% in a day because they're already on perhaps peak multiples.”
A few weeks ago, shares in UK online electricals retailer AO World plummeted 14% in a single day after it warned of a weaker Christmas trading period due to supply chain issues and the global lorry driver shortage.
AO World performance over 2yrs
Source: FE Analytics
The company was one of the best-performing UK-listed stocks last year during the coronavirus pandemic, surging more than 500%, but it is now down 72% over the past year.
SVM UK Growth did have the company in its portfolio but sold it in the third quarter of 2021 before the profit warning.
Lawson said in a market where expectations and valuations are high, it is important to be able to move on and recycle capital if the outlook changes.
“I don't think about trying to reinvent a reason for why we should be holding this now in new circumstances,” she said. “It's a case of opportunity costs.”
Although she believes the business model of AO World will eventually dominate, there were better opportunities elsewhere, she said
“AO World did very well through the pandemic because we were all sitting at home and we all decided to improve our home,” Lawson noted. “But It wasn't going to get any better. That was really it.”
However, the manager hasn’t written them off completely and is engaging with the company to potentially re-enter the stock.
Even though multiples may well come down, the Lawson said there are some businesses that are worth sticking around in – even if the multiple may seem high.
She pointed to Keystone Law, which provides back-office services and IT support for lawyers who pay a portion of their billings to the platform when they bring in revenue. Over the past two years, shares in Keystone Law are up 65%.
Keystone Law performance over 2yrs
Source: FE Analytics
“Keystone Law’s only spend is probably on the platform,” Lawson explained. “So the cost is probably fixed. So therefore if more lawyers join it – because the costs are relatively fixed – it means that incremental revenue falls quite quickly to the bottom line.”
“My philosophy is all about trying to find good management teams that can continually deploy capital well. Am I going to ditch all that to buy some banks and oil companies? Highly unlikely.”
In her 40-year career in investment management, she admitted it is always a tough time to be a growth investor when there is inflation but, if the economy is strong, then growing companies are still well placed.
“If you've got strong businesses within the portfolio already, they've usually got a first mover advantage because they’re well invested so they pull away from the pack quicker,” she explained.
In her view, investors should expect higher levels of inflation in the UK, particularly in the labour market, but she noted that the economy next year will continue to be strong.
“We’re at full employment and we've got rising wages. These are the things that underpin the health of the economy,” she said. “Inflation is a worry, but I think it will probably peak at 4%, then it will settle down at three-and-a-bit.”
“If we’re on a strong growth trajectory, then strong growth companies will do better,” she added. “But there is always this point of view where growth is compressed and then you've got all the rubbish rising.”
Many of the industries that typically hold value stocks, are structurally challenged, however, she said, pointing to energy being disrupted by the shift to renewables and to digital banking disrupting traditional lenders.