Last week’s inflation figures provide more evidence that the low-inflationary environment of the past decades has ended. How long-lived this shift proves to be is a moot point, but there seem to be two clear consequences of recent data: inflation is likely to stay high for longer than anyone expected; and interest rate rises are coming. This places equities in a new environment, and the impact on stock performance has already been significant.
Towards the end of 2021 markets exhibited parallels with the end of the dot-com boom. Valuations of loss-making companies were justified by reference to any metric that eschewed the need for profit, and SPACs were raising money without giving investors any indication of how their capital would be allocated.
This trend seems to have significantly deflated but we expect there will be more pain to come for many unprofitable companies that were previously in high demand.
Electric vehicles (EVs) are a great example – I don’t think anyone is in any doubt that electric vehicles going to be increasingly prevalent in the coming years, but for the entire sector’s equities to perform in the way they did seems unsustainable.
There will most likely be some winners that take market share and become very successful companies, but we do not feel the need to try to identify which of the many will make the grade.
We are much more comfortable investing in the companies that are plugged into this growth story but that don’t rely on one or two brands succeeding.
For example we hold Shenzhen Kedali in the Somerset Asia Income fund, which is a leading supplier of battery casings to the major EV battery manufacturers, including the largest, CATL.
It is deeply embedded in the battery system design and development process which protects it from competition and it is a direct beneficiary of the broader secular growth environment for electric vehicles.
The risk-reward for a company like this is much more appealing – it pays a modest dividend, has positive net income (unlike many EV manufacturers), and is much less richly valued. This company should succeed regardless of which EV manufacturers win-out.
The expectation of rising rates has been a catalyst for the de-rating in many of these high growth names, which relied on investors insatiable demands for earnings growth so far into the future.
At the same time, slowly but surely investors are beginning to remember the merits of dividend growth investing. Well-run companies that are growing sustainably, generating free cash flow and investing for future growth while paying dividends have been largely side-lined in recent years.
These companies might not be growing as quickly as some of the racier growth stocks out there, but they are solid, dependable and will compound a healthy return over the long-term. This should bode well for equity income funds – not only those that focus on Asia, but globally too.
Throughout my career I have seen dividend-focused funds come in and out of fashion, sometimes lauded for their dependability and other times written off as boring and pedestrian.
This has perhaps been one the biggest bear markets that I can remember for this method of investing, which makes me even more optimistic about the outlook on a three-to-five-year view.
This is not to say that growth is not important. Indeed, we target companies with growth above the Asia Pacific region but also reasonable dividends, in part as an indication of the quality of the management.
We don’t seek the highest growth at loftiest valuations, but we also don’t want high-yielding companies that are ex-growth or distressed. These bond proxy stocks can perform very well in short-term bursts as we have seen in the past six months or so, but again these returns are not sustainable.
Growth is extremely important and we can find plenty of it in Asia whilst generating an attractive yield. There are more “quality” stocks in Asia that are yielding more than 2% than the US, UK and Europe combined.
From a macro perspective, rising inflation and interest rates will put pressure on all equity markets, but Asia looks in a much stronger position than other developed and emerging markets as real interest rates are less negative and in some cases are actually positive (e.g. China and Indonesia).
As such, it is easier for these countries to keep rising inflation under control without harming their economy. Indeed, we may actually see some Asian countries ease policy while the rest of the world is tightening.
Mark Williams is co-manager of the Somerset Asia Income fund. The views expressed above are his own and should not be taken as investment advice.