As we move deeper into 2023, consensus suggests that the global economy is slowing. The IMF flagged as recently as April that developed economies are likely to see an “especially pronounced growth slowdown”, more than halving to 1.3% this year. Inflation is proving to be a significant culprit, remaining more persistent and elevated than anticipated.
As a result, there has been little let up to the hawkish rhetoric from central banks as they continue lifting interest rates, with the Federal Reserve announcing a 10th straight increase in May. This has had consequences – as we have seen in the US banking sector – and we expect markets to remain choppy in the short term.
As the economic outlook comes under increasing pressure, earnings growth will become squeezed. Therefore, it is the resilient earnings demonstrated by high quality, global businesses that are going to become increasingly important for investors. Revenues tend to be repeatable because these companies typically offer products and services that people need: ranging from medical device makers to software providers through to staple food producers.
These defensive characteristics have enabled quality companies to survive multiple economic cycles with their market position and competitive economics intact, while delivering returns to shareholders that have typically been not only stronger than the market, but also relatively defensive and uncorrelated.
While much of this sounds compelling in theory, there are many examples of quality companies persistently delivering tangible fundamental performance that is rewarded over time. We are admirers of a Dutch lithography equipment maker that provides the machines that are critical in the semiconductor manufacturing process. The company has a monopoly position in an industry that has compelling long-term structural growth dynamics. What’s more, demand for this mission critical equipment remains healthy. Their long-term order book stands at over 40 billion-euros – a record for the company – offering long-term visibility. A company that has net cash and free cash flow conversion of close to 100% should be able to weather short-term shocks to both the macro environment and even its own industry.
Another example of a business with earnings resilience is a global payments provider, which has around 4 billion cards in issuance. This provides significant barriers to entry for rival providers, such is the strength of the network effect. Importantly, the company is protected from inflation because its fees are linked to the transaction value. Moreover, they are well positioned as cross border volumes – a key metric for the company – continue to recover from their COVID lows.
Throughout the quality spectrum the same theme of free cash flow and profitability comes through. In the travel space – an industry decimated by the pandemic –one online travel provider that we follow is well positioned in a downturn due to its variable cost base and capital light nature.
Additionally, the company is growing through the recovery such is the strength of its brand. Its net cash position - built from its persistently high level of free cash flow - means it’s not saddled with expensive leverage, providing the company with options. The company can choose to pay down existing debt, consider returning cash to shareholders via buybacks or invest back into itself to grow. Lower quality companies simply don’t have this optionality.
Looking ahead, with much uncertainty regarding the future direction of markets, we believe that a focus on quality companies could stand investors in good stead. There are numerous long-term structural growth stories across the globe, all possessing considerable resilience in more challenging times, but it requires significant expertise to identify these opportunities.