From abundance to scarcity

It has been a tough year so far for investors, with broad-based declines across assets. The equity market sell-off has been pretty indiscriminate, with few places for investors to hide. So what is the overarching theme amid a very challenging investment environment?

In a nutshell – markets have run out of liquidity. We have seen around US$1.2 trillion of liquidity withdrawn from the world’s financial system. Essentially, the ‘happy days’ of stimulus and ‘free money’ are over. While the US Federal Reserve initially responded too slowly to rising inflation, it has been playing catch-up over the last few months, hiking interest rates aggressively. Other central banks have also raised interest rates to stem the inflation tide. Even the European Central Bank has moved away from negative interest rates, hiking rates for the first time in 11 years.

Big valuation reset

We have seen a shift from abundance to scarcity due to tighter financial conditions and supply chain disruptions. This has benefited some sectors such as commodities and has weighed on others such as technology. Profitless tech companies have been particularly hard hit by the higher cost of capital. These companies attracted a lot of the free money based on the promise of returns sometime in the distant future – without having much to show in terms of cashflows. It is very easy to build a platform business with free money. But those businesses are clearly out of favour, with share prices plunging as borrowing costs rise and the prospect of a recession looms.

Earlier this year, investors gravitated towards commodities, with energy companies enjoying massive outperformance amid a soaring oil price. The big valuation reset is well illustrated when looking at the changes in the market cap of oil company Exxon Mobil and that of video conferencing company Zoom over the last 2 years.

Figure 1: From new to old…
Market capitalisation of Exxon Mobil and Zoom

Source: Bloomberg to 1 June 2022.

Reflecting on Figure 1, it is hard to believe that in November 2020, Zoom enjoyed a higher market cap valuation than one of the largest and most prominent oil companies in the world. That process has clearly unwound.

Oil: ditch the scarcity mindset

Ongoing fears of fuel shortages have kept the oil price high as investors fret about supply, given Russia oil sanctions. But despite western sanctions, the latest intelligence reports indicate that 95% of Russia’s oil is finding its way to the market. It is also interesting to note that the ruble is stronger now than what it was before Russia invaded Ukraine. The world is not short of oil; in fact, we estimate there is a small surplus. A scarcity mindset has encouraged hoarding, which in turn, has helped to keep the oil price elevated.

The recent decline in the oil price did not surprise us. While oil supply concerns have overshadowed markets, investors have woken up to the possibility that an economic downturn could lower demand for fuel.

Material risks to poor-quality, cyclical parts of the market

The big debate among investors is whether the higher interest rate trajectory is going to lead to further market weakness, driven by corporate earnings concerns. Asset classes and sectors have been punished across the board this year and it is likely that markets have passed the peak of pessimism. Of course, markets still face headwinds such as higher capital costs, deteriorating growth prospects and inflationary pressures. But a lot of the ‘bad news’ is already embedded in stock prices.

We believe it is key that investors seek to invest in companies that have earnings and cashflow resilience. Poor-quality cyclical businesses (e.g. energy, steel and shipping) are looking vulnerable and have the most earnings risk. As negative earnings surprises come through over the next few months, we think the market is going to rotate back to higher-quality companies. Commodity prices have already started to weaken, and industrial activity is ebbing.

Stock selection now more important than ever

In a world where liquidity is scarce, it’s crucial to consider businesses’ ability to generate cashflows and profits and whether companies need access to capital, which is becoming far more expensive. The stocks in our Ninety One Global Franchise portfolio trade on a 4% free cashflow yield, which is ahead of the market. Free cashflow yield is an important indicator of how capable a company is to make good on all of its obligations. In essence, it is a solid pointer of how financially stable a company is.

Our quality holdings have three key attributes – pricing power, low capital intensity and healthy balance sheets – which help insulate these businesses from the damage inflation and rate hikes can bring, enabling them to deliver resilient earnings growth. Take a company like Visa, for example, the world’s largest payment network. The company’s competitive advantage is based on a combination of technology, brand and network effects.

This portfolio holding has shown its mettle during tough times. Despite market and economic volatility, Visa recently reported an increase in net revenues of 19% year on year, primarily driven by a 51% jump in cross-border revenue. Visa achieved this revenue growth, even though Russia impacted 4% of revenues. Spending trends continue to be strong, with processed transactions increasing by 16% and the growth in cards reaching 8% year on year. The company has a healthy balance sheet with limited net debt and strong free cashflow growth.

Figure 2: Core qualities that build resilience

Sources: Ninety One and FactSet, 30 June 2022. Re-weighted excluding cash and equivalents showing metrics of the constituent companies since inception.

Fundamentals remain good

Looking beyond short-term sentiment, we do not believe the current environment has significantly changed the fundamentals of the companies we own, which continue to compound cashflows at attractive rates. We remain comfortable that the quality attributes we seek (enduring competitive advantages, dominant market positions, strong balance sheets, lower cyclicality, low capital intensity, sustainable cash generation and disciplined capital allocation) are all well suited to both current conditions and for uncertain times ahead.

The companies we own have invested substantially to reinforce their business models, with significant exposure to key long-term trends such as data usage and digitalisation, ageing populations and health care, and nutrition and wellness.