Dec 14, 2020
Clyde Roussouw, Co-Head of Quality
Quality companies would benefit from pricing power
Pricing power, derived from enduring competitive advantages, should benefit quality companies in an inflationary environment and help mitigate any negative effect resulting from the long-duration nature of their cash flows (to the extent that inflation leads to rising interest-rate expectations and therefore higher discount rates that reduce the net present value of those longer-dated cash flows).
Capital-light models are an advantage in inflationary times
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.
Take a long term view, but stay diversified
The reflation trade typically favours shorter-duration value and cyclical stocks. This trade can be short-lived, however, particularly if driven more by sentiment than fundamentals (as has been the case historically), and not supported by long-term sustainable growth.
Our Quality portfolios are well-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 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/economic recovery and rotation towards value/cyclical stocks.
Caution on the inflation outlook
As bottom-up long-term stock pickers, we do not attempt to make top-down macro/market forecasts. The latter is prone to error, particularly given current uncertainty, and we do not have an edge here.
We do, however, observe a number of reasons why inflation may not in fact take hold in a sustained and meaningful way. A non-exhaustive list includes: spare capacity post-COVID and an uncertain recovery; debt overhang (across governments, corporates and households); continued technological disruption; continued growth of e-commerce and discounters (further enabling price awareness and price competition); and demographics (ageing populations with higher levels of savings to protect).
Commodity-related investment: Commodity prices can be extremely volatile and significant losses may be made.
Concentrated portfolio: The portfolio invests in a relatively small number of individual holdings. This may mean wider fluctuations in value than more broadly invested portfolios.
Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income.
Derivatives: The use of derivatives is not intended to increase the overall level of risk. However, the use of derivatives may still lead to large changes in value and includes the potential for large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss.
Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company.
Geographic / Sector: Investments may be primarily concentrated in specific countries, geographical regions and/or industry sectors. This may mean that the resulting value may decrease whilst portfolios more broadly invested might grow.