A post-financial crisis trend for deleveraging means equities are in far better shape to cope with this period of high inflation than they were in the 1970s, according to Gerrit Smit, manager of the Stonehage Fleming Global Best Ideas Equity fund.
CPI in the US reached 8.5% in March, the highest figure since 1981. This has hit growth funds such as the one managed by Smit, as the valuations of the companies they own are partly based upon future earnings, which are worth less the higher inflation rises.
Many value managers have claimed the worst is far from over for growth stocks, pointing to the high-inflation bear market of the 1970s for a hint of what is to come.
Yet Smit said growth stocks are in far better shape to cope with this period of high inflation than they were back then, as are equities in general, with net corporate debt at less than half the level it was at the start of the 1970s.
“I’m careful to talk of there being a benefit from the financial crisis, but people cleaned up their balance sheets in a private capacity and in a business sense afterwards,” he explained.
“Gearing was actually higher in the 1970s than what we are currently suffering from. I wasn't invested at the time, but we've all read up on this and how companies struggled to pass on costs.
“Obviously, their margins suffered from being burdened with debt and interest charges. I remember the phrase ‘the companies were working for the banks, not the shareholders.”
Debt as a percentage of market value of non-financial equities
Source: Federal Reserve Bank of St. Louis
However, value proponents pointed out that growth equities were more vulnerable to high inflation in terms of real returns than absolute ones.
Barry Norris, manager of the VT Argonaut Absolute Return fund, warned the lesson from the 1970s was that investors don’t pay high prices for long-duration assets in an environment like the current one.
“During the 1970s, only gold (+32%), oil (+32%), farmland (+13%) and housing (+10%) beat the US annual average inflation rate (CPI +8%) over the decade, while government bonds and previously high-flying growth stocks – the buy-and-hold Nifty Fifty of the 1960s bull market, thought to be impervious to downturns – performed disastrously,” he said.
Smit accepted this view was not without some merit, but he took issue with lumping all growth stocks in together – even those in the same sector. For example, while he expected “blue sky” or “moon shot” tech stocks to continue struggling, he pointed out household names such as Alphabet and Microsoft have all the traits of staples businesses and should continue to deliver the goods regardless of the macroeconomic backdrop.
“They grow at double digits on a sustainable level, not only in the top line, but also in the bottom line and cashflows,” he continued.
“Compare the free cashflow in a growing business to the yield on a bond. As an example, the 10-year bond yield is now about 2.8%, but let’s say it goes up to 5% in two years or so. If you start with an Alphabet or Google, you get a 4.5% free cashflow yield today that grows at double digits, so it stays ahead of the 10-year bond yield. And obviously that will give you the capital growth.”
He added: “Then if circumstances normalise in terms of inflation and economic growth, those company ratings will further improve and the market will continue to invest in them.”
Some value proponents remain unconvinced that even the highest quality growth stocks will be able to protect against inflation. Richard de Lisle, manager of the VT De Lisle America fund, noted that even after recent falls, a stock like Adobe is on a trailing P/E of 40x.
While it may well continue to increase earnings at an average rate of 19% per annum, if high inflation means every stock is doing the same in absolute terms – even ones currently on single-digit multiples – the software provider could tread water in the medium term as its multiple falls back to the market average.
Yet Smit said the problem with this theory was that there was nothing to suggest inflation would remain at its current heights for more than a matter of months.
“What is interesting is the issues that triggered inflation – the supply chain constraints from Covid – are softening. That is a fact. Container prices have dropped by more than a fifth [from their peak] and delivery times have improved by 15%,” he said.
“Obviously, the question then becomes how long the war will carry on for, because that obviously has an impact on energy which is a big input into inflation. But the oil price has already dropped from $120 to $103 – that’s a proverbial swallow not to ignore.”
Data from FE Analytics shows Stonehage Fleming Global Best Ideas Equity has made 202.7% since launch in August 2013 – a top-decile figure in its IA Global sector – compared with gains of 162.6% from its MSCI AC World index benchmark and 134.5% from its average peer.
Performance of fund vs sector and index since launch
Source: FE Analytics
The $2.2bn fund has ongoing charges of 0.83%.