We are at an important junction where the global economic recovery has largely been priced into markets. Investors are already anticipating inflation going up and Treasury yields rising further. So, the shift to value and to the more cyclical parts of the market – resources, energy and banks – has arguably played out to some degree.
Mid-January is an interesting inflection point, as in many ways this period represents the peak of good news – the uncertainty of the US election was removed; Biden was inaugurated; there were more positive developments on the vaccination front; and there was widespread optimism about economies re-opening. So, market movements already reflect the anticipated recovery to a large extent.
We believe there is a lot of value in quality stocks. Conversely, there is not much quality, and less value now, in value stocks. Interestingly, the global quality stocks in our portfolios are now the cheapest they’ve been in the last 10 years – whether you consider free cash-flow yields or even PE multiples.
Value investment strategies typically do very well in a short space of time when expectations of an economic recovery gain a foothold. We clearly saw that happening late last year. Going into value now, could mean moving once the horse has bolted.
Over the last few months, markets have been pricing in a more inflationary environment. The conventional wisdom is to own commodity stocks and energy stocks as these will do better in an inflationary environment. But what is not well understood is that quality stocks are pretty well placed in an inflationary environment. This can be attributed to their:
- Pricing power. Because of quality companies’ enduring competitive advantages, for example, strong brands, licencing agreements, copyright and intellectual property, they have pricing power. This benefits them in an inflationary environment as they’re able to pass on price increases to customers/clients.
- Capital-light nature. Quality companies also benefit from capital-light business models. The nominal value of their intangible assets should rise with inflation, and they should be less impacted by inflation’s effects on required capital expenditure, given their low capital intensity. In an inflationary environment, low-quality businesses that are capital intensive, are forced to increase their capital expenditure, which negatively impacts their cash flows and their businesses.
- Strong balance sheets. Rising yields should see mortgage and debt-financing costs increase, which will put pressure on households and low-quality companies. Because quality companies tend to be cash-flush and have strong balance sheets, they typically don’t have to finance debt at higher rates. Therefore, they are more resilient in a rising yield environment.
We are not in the business of timing markets. The Ninety One Global Franchise Fund is -diversified by sector and geography, and well balanced to include exposure to select quality cyclical companies as well as more defensive businesses and structural-growth compounders (such as high-quality capital-light financials like savings platforms and wealth managers). In addition to valuation discipline (quality at a reasonable price), this helps to mitigate the impact of any style rotation in the short term. We still expect quality to outperform over the longer term. Importantly, we think the market has already priced in a lot in terms of reflation and rotation towards value/cyclical stocks.
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This article was written by Clyde Rossouw, Head of Quality, Ninety One