The outlook for 2023

Throughout 2022, the key concerns for investors have been how inflation and rising interest rates might impact their portfolios. At the start of 2023, those concerns persist. Alliance Trust has canvassed its nine stock pickers, to see how they are seeking to insulate their investments against inflation and the possibilities of recession.

Inflation proofing

Over the long term, investing in equities has proved a reasonable inflation hedge, given revenue, cash flows and earnings are able to adjust to the environment of higher input costs. But over shorter periods, this may not be the case, as rising inflation tends to be associated with declining stock prices, according to Bill Kanko, Founder and President of Black Creek Investment Management.

“High-growth stocks with little or no present earnings and cash flows are much more sensitive to the higher interest rate environment, as central banks raise rates to counteract inflation,” says Kanko. “Companies that are reasonably valued and have current cash flows and earnings should be less affected by rising interest rates.

“In an inflationary environment where real bond yields are higher, investor interest will broaden out beyond the winners of the past decade (ie high-growth companies) to other areas of the market, including ones that are more economically sensitive.” However, he points out that in the short term, stocks may fall in reaction to the impact of higher inflation and interest rates.

Jupiter’s Head of Strategy for Value Equities, Ben Whitmore, agrees that equities have proved a hedge against inflation over time. However, he adds that they initially react poorly to unanticipated inflation or a change from low to high levels of inflation.

“This can be clearly seen in the 1970s, and now to a degree,” says Whitmore. “Real assets have historically proven a good hedge (commodities, property) against inflation. Furthermore, companies that can raise their prices in line with inflation, have also proven a good hedge.”

Valuations are also key, says Whitmore. “The portfolio can also be protected by the starting valuation – high inflation leads to high interest rates, and this tends to favour companies, where the value of the business is more determined by near-term cash flows, rather than businesses that are valued off cash, flows a long way in the future. Low valuations tend to triumph as a result over high valuations.”

Andrew Wellington, Managing Director, Consultant Relations and Institutional Sales at Lyrical Partners, agrees, believing that owning businesses with attractive valuations as well as resilient business structures, is one way to protect against inflation.

“Inflation impacts companies in two ways,” he explains. “First, it raises their input costs. But second, it increases their revenues, as they raise their selling prices to pass through their higher costs. As a result, inflation often increases the revenue and earnings growth of businesses that can pass through rising costs.”

The catch, he says, is that inflation also tends to be accompanied by higher interest rates, which typically compress the valuation multiples of stocks. In past periods of inflation, faster earnings growth has been more than offset by falling valuation multiples, leading to disappointing returns.

“During the Great Inflation period from 1973 to 1982, nominal earnings growth for the S&P 500 was higher than average, but the overall index return of 7.2% per year fell below the inflation rate of 8.9%, as multiple compression resulted in negative real returns over a decade.”

Protection against inflation for Wellington comes first by owning value stocks: “Since 1960, there have been four periods of elevated inflation with CPI above 4% for one year. In each of those periods, the cheapest stocks outperformed the S&P 500.”¹

Pricing power is a common company feature that stock pickers highlight when selecting stocks to beat inflation, as well as valuations. Rajiv Jain, Chairman and Chief Investment Officer at GQG Partners, says, “From a sector perspective, we will look to increase our exposure to names that traditionally exhibit strong pricing power, as long as those stocks continue to be reasonably valued, in our opinion.”

In addition, he adds that certain business models such as Visa Inc. have revenue that is partially driven by the dollar amount of transaction volume, which may act as an inflation hedge.

Sunil Thakor, Research Analyst and Co-portfolio Manager at Sands Capital Management, would agree on the transaction element. “The best pricing power, in our view, is ad valorem, where businesses capture a transaction fee; this results in a higher fee – directly linked to revenue generation, so an inflationary environment and more revenue – as prices rise. Typically, these companies have costs that aren’t as actually margin-accretive.”

Thakor also looks for businesses that are asset-light, built on intangible rather than tangible assets, with limited sensitivity to global supply chain disruptions and fluctuating raw materials prices.

“We seek to own businesses with strong balance sheets and low debt, resulting in muted interest expenses, and also ones that have market-leading positions, delivering must-have products and services. This often results in pricing power.”

Recession proofing

It may seem obvious, but diversification and careful stock selection are essential to ensure your investments can weather a recession. The key characteristic is to ensure you are not overpaying in terms of current valuations for future growth of revenues, earnings and cash flows, according to Kanko. He says while diversification does not necessarily mean adding holdings, it does mean taking advantage of future opportunities, and considering the many risks that the current environment poses, including increased geopolitical concerns and uncertainty about the timing and shape of a future economic recovery.

“We feel there will likely be a recession in 2023, given the effects of rising rates (to fight inflation) and slowing growth across many developed and developing markets,” says Kanko. As a consequence, his team has adjusted its financial discounted cash flow models to incorporate an earnings downturn in 2023.

“For cyclical companies, the adjustment has been even greater,” he says. “However, out-of-favour, non-US companies, which tend to be more cyclical, look attractive, as many already have the worst-case scenario priced into their valuation. US stocks continue to look more expensive broadly, but we are finding opportunities.”

“We have increased our cost-of-debt assumptions in our analysis across all portfolio companies, and have ensured that companies with debt on their balance sheet have repayments that are further out. Share prices will be volatile, but strong underlying business fundamentals should ultimately prevail.”

Jain agrees that stock picking and selecting sectors carefully are important in preparing a portfolio for a potential economic recession. “We can rotate from names in certain pro-cyclical sectors, including consumer discretionary and technology, to companies operating in more defensive areas such as consumer staples, utilities and healthcare,” he says. “And we focus on high-quality businesses, regardless of their sector classification, which we believe are well positioned to thrive in recessionary environments. These companies are typically characterised by profitability, brand loyalty, and strong balance sheets. During recessions, their financial flexibility affords them the opportunity to maintain their research and development budgets, to innovate new products, and increase their advertising to gain market share.”

Needless to say, investing in businesses driven by secular forces that can persist regardless of the economic cycle, and that have leadership positions, competitive advantages, financial strength, and experienced management teams, which enable the businesses to “survive and thrive” amid times of crisis, is wise in the current economic environment.

Secular change can occur regardless of what’s happening in the real economy, says Sands’ Thakor. “For instance, a recession isn’t likely to derail the shift from paper to electronic payments, the enterprise transition from on-premises to cloud software, or the need for innovative therapeutics to address unmet medical demand.

“In times of stress, the biggest and best-run businesses tend to entrench their leadership positions. They’re often better positioned to handle a downturn, and can use their position of strength to take share from – or even acquire – struggling competitors.”

Thakor says he doesn’t expect the share prices of the businesses he invests in to be immune amid a protracted market drawdown, but he does expect them to continue to deliver fundamental growth in excess of the broader market, which he believes is essential for outperforming over the long run.

Rob Rohn says SGA’s investment approach has always been focused on investing in companies with the most attractive predictable and sustainable cash flow and earnings growth it can identify, using an investment horizon of three to five years.

“We do not invest in companies which are reliant upon a strong macroeconomic backdrop for their growth, and therefore consistently have less exposure to segments of the market which would be expected to be hurt most in an economic downturn such as industrials or commodities.”

Growth or value?

So where are our stock pickers looking for growth or value, or both, going forward in 2023?

Wellington says that while growth is important if you pay too much for it you will get disappointing returns. Consequently, a successful investment must have both growth and value. “Today, we are finding this combination of both deep value and growth across a range of sectors and industries,” he says. “There are no broad categories that offer this combination. Rather, value and growth can only be found in individual stocks that have slipped through the cracks and been ignored or misunderstood by the market. We find these rare opportunities by being purely bottom-up, sifting through the cheapest stocks in our universe, and finding the exceptions that offer quality growth.”

Encouragingly, Kanko says his team is finding opportunities in many areas of the market, including higher-growth stocks, where valuations have come down considerably and look attractive to long-term investors. In particular, he cites recent purchases PayPal Holdings, Inc. and Kuehne + Nagel International (K+N), the global transport and logistics company, based in Switzerland.

PayPal Holdings operates an account-based, two-sided platform that enables digital payments on behalf of merchants and consumers worldwide. It operates in 200 markets and over 100 currencies. “We had the opportunity to purchase PayPal Holdings at an attractive valuation, given that fintech share multiples contracted significantly,” says Kanko. “The company’s growth prospects remain strong, given the continued adoption of digital payments, fraud protection, e-wallets, and other services.”

“Kuehne + Nagel International is the global leader in sea freight and air freight forwarding worldwide. While sea freight has historically constituted a large part of its business, it has been transforming into a fully integrated freight forwarder, and continually improving its end-to-end supply chain solutions and distribution services offerings to its clients. K+N has a strong balance sheet, which will allow it to invest and gain market share. The company’s asset-light model provides high returns on its underlying assets.”

Jain says, in looking to achieve growth and managing downside risk, essential to compounding wealth, his team has found opportunities in the financials and healthcare sectors.

“Charles Schwab offers wealth management as well as securities brokerage services and is expected to increase its net interest income in a rising rate environment. And Humana is a health insurer where enrolment growth is expected to be driven by the ageing demographics in the US.”

Jupiter’s investment process looks for lowly valued shares with strong balance sheets and high conversion of profits to cash. Whitmore says, “Given the sharp fall in many areas, there are opportunities spread across many sectors. These include media, IT services, the PC/semi-conductor industry, and a wider range of consumer cyclicals (retail, for example). It is noticeable that there is a particularly high number of potential investments at the moment, due to the fear of rising rates, energy prices, and a global recession.”

Thakor says Sands Capital believes seeking businesses with long-term structural drivers of above-average earnings growth, is important in achieving strong long-term returns.

“Secular change is one of the most durable sources of long-duration growth if you can identify businesses well positioned to benefit from that change,” he says.

So, from a sector (and secular driver) point of view, he highlights: financial services digitalisation; evolving retail habits (ecommerce, formalisation and consolidation, omnichannel; demand for data access, storage, and processing; and the computing technology those actions require.

Similarly, in looking for growth businesses with the three-to-five-year investment horizon, Rohn says that given the very broad brush that has penalised longer-duration growth companies due to the recent increase in interest rates, attractive opportunities are being found in sectors such as healthcare, technology, consumer discretionary and communications.

Stephanie Spicer, Head of Content, Quill PR

1. https://fred.stlouisfed.org/series/CPIAUCSL

This information is for informational purposes only and should not be considered investment advice. Past performance is not a reliable indicator of future returns. The views expressed are the opinion of the Manager and are not intended as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell any securities. The views expressed were current as at December 2022 and are subject to change. Past performance is not indicative of future results. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. You should not assume that any investment is or will be profitable. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. TWIM is the appointed Alternative Investment Fund Manager of Alliance Trust plc. Alliance Trust plc is a listed UK investment trust and is not authorised and regulated by the Financial Conduct Authority.