2022 was marked by a rapid shift in inflation expectations and the fastest interest rate hike cycle in the last 40 years, which led to a steep downturn for long duration assets, particularly among disruptive change companies and growth stocks.
As interest rates rose, stock prices plummeted, prompting many people to question the rationale behind investing in fast growing companies that underearn in the present while investing for future growth, should higher interest rates become the new normal. We don’t know whether inflation will persist or what the terminal interest rate will be, but we do believe high-quality companies benefiting from disruptive change and with the opportunity to become significantly larger in the future will do well over the long term regardless of the macroeconomic climate.
The concept of disruptive change – an instance of radical change within an industry or market, often driven by technological innovation – is an important one within today’s financial world and, indeed, wider society. Without it, we would lack many of the things we now take for granted.
Critically for investors, there is clear evidence that the rate of disruptive change and innovation is accelerating. For example, it took just five years for 25% of the US population to adopt the internet, compared to seven years for mobile phones, 16 years for PCs, 25 years for television, 35 years for the telephone and 46 years for electricity (source: PEW Research Center).
This trend continues, as evidenced by the rapid adoption of artificial intelligence (AI). While it took Twitter two years to reach 1 million users globally and Instagram 2.5 months to do the same, the AI chatbot ChatGPT reached 1 million users in just five days!
This rate of change, innovation, and disruption creates highly attractive opportunities for investors. Of course, it also presents potential pitfalls. In such a dynamic environment, how can you identify those businesses most likely to be the long-term winners?
When starting to look at making a potential investment in a company, it is important to ask at the outset what the competitive advantage(s) of that company is (are). Almost inevitably, this question is followed by another – ‘why is it sustainable?’.
After all, the inherent nature of disruptive change means that the benefits of exposure to these areas, sectors and companies can only truly be felt over the long term. This means thinking beyond whether consensus expectations are too high or too low for the next quarter or two, and indeed answering an entirely different set of questions – How big can that company be at maturity? How durable are its competitive advantages? How critical are the problems they solve for customers, and could they solve more problems over time? How much value does every dollar reinvested back into the business generate? Is management building the right culture?
It is no coincidence, for example, that history shows that well-managed companies with strong competitive advantages often retain positive long-term prospects and come out of bear markets with a better competitive positioning. This is a trend we have seen on numerous occasions – from the bursting of the dot-com bubble in the early 2000s to the recovery from the 2008-2009 global financial crisis to the market rally following the onset of the Covid-19 pandemic. We expect this to continue and as the macro environment improves, growth in earnings and cash flows will likely be reinvigorated, allowing profitability to grow and healthy returns on invested capital to be generated.
Interestingly, the questions about a ‘competitive edge’ are increasingly being asked of fund managers themselves. What advantages can managers bring to the table in such a competitive market?
There are ultimately five sources of competitive advantage when investing – having information other participants do not; being able to analyse widely available information differently; ensuring better decision-making without behavioural biases; employing a longer-term perspective when investing; and having a sufficiently strong and flexible platform to benefit from the full opportunity set available.
The nature of the stock market – a complex, adaptive system that is constantly learning and becoming smarter from collective inputs over time – means that any informational or analytical ‘edge’ is likely to be at best slight and erode away over time. It is therefore the ways in which decisions are taken, the timeframes they considered within, and the platforms that can be employed to access the best opportunities where managers will ultimately have a competitive advantage.
What does this mean, then, for companies and equity markets? The economist John Kenneth Galbraith said: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” The sheer volume of predictions investors can access regarding a potential recession, inflation, interest rates, earnings revisions, asset prices, etc., underscore how true this statement can be.
We live in an uncertain world, and even well-known conditions and widely anticipated events can be shrugged off by financial markets one day and drive them up or down the next. This lack of predictability, which was fully on display last year, makes it difficult, if not impossible, to successfully predict short-term market moves with any consistency. Focusing on the fundamentals of individual companies therefore offers the best means of accessing the best opportunities.
The current period of uncertainty and volatility has widened the margin of safety between share prices and fundamentals. While uncertainty and the resulting market volatility may persist for some time, one thing is for certain: these conditions will drive increased differentiation between stocks, making skilled active management, patience and a long-term investment time horizon crucial to realising future excess returns.
Alex Umansky is a portfolio manager at Baron Capital. The views expressed above should not be taken as investment advice.