So far, 2022 has been a bruising year for equities. The first quarter was dominated by rising bond yields, as the Federal Reserve backtracked on its prior assertion that inflation would be transitory, prompting a sharp decline in equity valuations. However, earnings expectations remained fairly robust.
This all changed in the second quarter – the worst sell off since the onset of the pandemic in early 2020 – as the fundamental impact of inflation began to filter through into earnings. Company outlooks became more downbeat – in some instances dire – and the downgrades started to come through. In a market full of uncertainty and volatility, what should investors do?
Back to basics
During periods of growth uncertainty, it is important to find companies that can deliver today. It’s often better to just go back to basics rather than seek the next big idea. At a time when share prices are under pressure as earnings and valuations retreat, dividends become an increasingly important driver of returns. Yet the type of dividend-paying stock that is purchased is crucial. Often, an investor’s instinct is to buy the highest yielding business at a point in time because that – in theory – will deliver the highest return, but for us, the high yield on offer often represents a red flag or ‘yield trap’.
In periods of stress – such as the one we’re in now – these high yielding traps often cut payouts because they either stem from temporary high earnings, high unsustainable payouts or falling share prices. That lead to disappointing total return profile. A much better strategy is to focus on companies that generate enough cash to not only reinvest for growth but also have the ability and confidence to distribute a growing dividend despite the challenging environment. Over the same time period, such dividends compound and deliver a much healthier growth profile with much less volatility.
Own the right type of tech
Having been the darling of the equity market for the past few years, technology has been very much out of favour so far in 2022. Yet it is still possible for a portfolio to deliver robust returns through holding technology; it just has to be the right type of technology. For us, this means those high-quality incumbents that have business models which are strong enough to deliver today.
Potential disruptors such as Klarna in the private market, Robinhood or Wish that experienced exorbitant valuations during COVID – have what we deem to be unsustainable business models. They are good examples of companies that are not profitable, and this led to them trading on speculative valuation multiples, with longer-duration cash flows potential that are vulnerable to higher interest rates. Now we are seeing the cost of capital increase, these shares have seen extremely sharp sell offs, which causes significant damage to portfolios.
In contrast, established companies such as Visa, Automatic Data Processing or Broadridge have strong enough balance sheets to contend with higher rates, and are therefore outperforming the more speculative tech that grabbed a lot of headlines and the market over the last two years. Competition from new entrants has also decreased, given that capital is now more expensive to access, which is a further benefit of being invested in the strongest incumbents.
Confidence for the future
Focusing on dominant companies exposed to very strong growth themes means they are better insulated from a downturn in the market; the growth theme will still be there. What’s more, the sell off in the market this year has made a number of these companies cheaper, and therefore growth is available to buy at a more attractive price.
An example of how attractive these businesses are can be found in the tobacco space, where Philip Morris recently offered to buy smokeless tobacco producer Swedish Match at a 40% premium compared to what the market was prepared to pay at the time. So, when quality companies are discounted excessively, they can become attractive acquisition targets.
Against a deeply challenging backdrop, we believe that the conditions are fertile for a quality approach to outperform the wider market. Robust performance can be generated due to companies trading at attractive valuations, having more durable earnings in terms of profitability and cash flow, with solid balance sheets able to cope with the cost of capital rising. This should enable such an approach to protect portfolios at a time when the average company in the market is beginning to deliver ever more grim earnings reports.
Abrie Pretorius is portfolio manager of the Ninety One Global Quality Equity Income fund. The views expressed above should not be taken as investment advice.