Taking Stock Summer 2022

Why the market is turning to quality

Global markets once again appear nervous, after a dramatic recovery from their March 2020 lows. The sectors and companies that forged the recovery are unlikely to repeat their stellar performance. Where to from here for global equity markets?

Feb 17, 2022

7 minutes

Clyde Rossouw
Global markets once again appear nervous, after a dramatic recovery from their March 2020 lows. The sectors and companies that forged the recovery are unlikely to repeat their stellar performance. Where to from here for global equity markets?

The fast view

  • Global markets once again appear nervous, after a dramatic recovery from their March 2020 lows.
  • Given the relative unattractiveness of alternatives in a rising interest rate environment, equities still appear to be the go-to for investors.
  • However, tightening liquidity will provide a headwind to the magnitude of the equity returns achievable.
  • As we transition to an environment where returns are likely to be more modest, we believe quality businesses are well placed to generate meaningful returns for investors.
  • We believe that select global equities held within the Ninety One Global Franchise Fund, continue to offer attractive returns and therefore retain meaningful exposure within our flagship Quality SA multi-asset funds, the Ninety One Cautious Managed Fund and Ninety One Opportunity Fund.

In a world awash with liquidity and negative real interest rates, risk assets such as global equities continued their powerful comeback in 2021. As the world economy reopened from shutdown conditions, sectors that had suffered worst in 2020 rebounded strongly. ‘COVID cyclicals’ have until recently been an exceptionally fruitful hunting ground for investors.

But after a meteoric rise post the lows of March 2020, global markets once again appear nervous. Volatility has reemerged in an environment where rate normalisation in the US looks to have accelerated. Consensus suggests we will see rising rates to combat persistent inflation with a growth outlook that is reasonably robust. But how much of this is priced in? Global equity markets, as reflected by the MSCI All Country World Index (ACWI), have given back roughly 11% from their recent peak. This follows a rotation away from some of the themes that had, until recently, driven returns (speculative tech stocks, growth stocks, and high P/E1 and heavily geared equities, as well as companies that profited from the stay-at-home theme – COVID beneficiaries).

Against this more uncertain and challenging backdrop, and with global equity markets at elevated levels, we believe caution in portfolio construction is prudent. Given the relative unattractiveness of alternatives in a rising interest rate environment, equities still appear to be the go-to for investors, but we acknowledge that tightening liquidity will provide a headwind to the magnitude of the equity returns achievable.

Within equities, the common narrative is that value will emerge as the driving style, where investors look to bargain basement stock ideas. This argument is based on the view that value will benefit in an environment where investors seek companies that look cheap, and growth remains reasonably stable. We argue this view is perhaps too narrow and rather, that broader investment fundamentals will be the key to future return opportunities. As evidence, we have seen a marked shift of emphasis to company results over sentiment and expectation. Our view is that investors should consider focusing on owning those companies that can navigate a world of higher interest rates, economic stress, and geopolitical uncertainty.

Where to from here?

So, where should one allocate given that the early and most powerful phase of the cycle is behind us? History suggests that the answer may lie in strategies that focus on higher quality companies with sustainable business models and a track record of returning capital to shareholders. While such strategies tend to underperform during an early cycle recovery and in times of bull market euphoria, they have outperformed over the long run.

Take the last economic cycle that began post the Global Financial Crisis. Granted, the circumstances were different to today’s, given that the world was recovering from a financial crisis and not a global pandemic. We can, however, note some similarities. Thanks to aggressive intervention from central banks in developed economies and expansive Chinese fiscal policy, markets found a floor and started to recover. The sectors hit hardest during the recession experienced the strongest initial recovery.

We believe quality businesses are well placed to generate meaningful returns for investors.

This was, however, no guide to what was to follow. Over the following decade, the sectors driving the market higher were largely those that were totally unrelated to the early winners.

As we transition to an environment where returns are likely to be more modest, we believe quality businesses are well placed to generate meaningful returns for investors.

Navigating the ‘new norm’

Concerns about inflation have dominated investor conversations for some time now. The initial consensus that price increases would be ‘transitory’ has worn thin in the face of a pronounced energy crisis, labour shortages and supply chain bottlenecks. It is now clear that interest rates are likely to go up from here globally to combat persistently high inflation. The building tension between inflation, higher interest rates, extreme levels of government debt and slowing global growth is the key pressure point that is likely to determine the market direction and leaders for the year ahead.

As we’ve discussed in a previous article, the companies we own have three characteristics that insulate them from the impacts of inflation.2 Simply put:

  • They have significant pricing power given their strong competitive positions.
  • They are low capital intensity businesses backed by intangible assets.
  • They have healthy balance sheets, insulating them from rising financing costs.

This translates into compelling performance from quality in a rising rates environment relative to other prominent styles of investment.

Performance through different interest rate environments

Average of calendar year performance 2008 - 2021 (%)

Performance through different interest rate environments

Past performance is not a reliable indicator of future results, losses may be made.
Source: Federal Reserve economic data, Morningstar, USD, falling interest rates indicate periods where rates have fallen year on year, stable indicating where rates have remained steady, and rising where interest rates have been lifted year on year. Performance is net of fees (NAV based, including ongoing charges, excluding initial charges), gross income reinvested, in USD. For illustrative purposes only.

But it’s not just about the ability to navigate an inflationary environment and rising rates. Quality has also typically performed well during periods of quantitative tightening, i.e. when the Federal Reserve has been shrinking its balance sheet. The key attributes that quality companies possess mean that they tend to be resilient in times of economic and market stress. These 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. Performance tends to be less reliant on external factors and the economic environment and consequently quality companies have on average demonstrated lower drawdown characteristics in periods of market stress.

Conclusion

We believe that select global equities held within the Ninety One Global Franchise Fund, continue to offer attractive returns and therefore retain meaningful exposure within our flagship Quality SA multi-asset funds, the Ninety One Cautious Managed Fund and Ninety One Opportunity Fund.

However, the rebound phase is largely complete, and therefore the sectors and companies that forged the recovery are unlikely to repeat their stellar performance. Investors now need to consider those companies that are well positioned to lead markets higher from here – companies with real and sustainable earnings. It’s easy to be tempted by value, but we believe investors should not make allocation decisions based on a binary view of value or growth. You do not need to swing for the fences in the hope of scoring a home run. There is a third choice, quality, which should sit at the heart of portfolios, given its more resilient compounding return profile.

Quality appears well placed to face the looming headwinds.

Quality appears well placed to face the looming headwinds. Exposure to long-term leaders – quality companies that have competitive advantages, healthy balance sheets and a strong focus on returning shareholder capital – is key. Constructing robust portfolios requires an allocation to managers that provide consistent returns, which we argue quality offers. We believe it should not only be considered in the current environment but remains appropriate as a core portfolio throughout the cycle – given its stabilising nature.

We remain confident that our quality style of investing will equip us to navigate the inflationary environment and be resilient during periods of market weakness. While you can’t pave the roads, you can prepare for the bumps.

Defining what we do

Investing in quality companies is not simply a top-down exercise of picking the industries likely to deliver superior earnings growth over time. It’s a rigorous search to find a narrow range of specific companies with exceptional attributes. We define high quality companies as those with enduring competitive advantages that are derived from intangible assets such as brand, customer loyalty, copyrights, and unique content and networks, which can be difficult for competitors to replicate. As a result, they can become enduring franchises that consistently support high returns on capital.

These stand-out qualities provide these companies with barriers to entry and pricing power, which in turn enable them to deliver long-term structural growth and resilience, and compound cash flows at sustainably high levels of profitability, far beyond market expectations.

Five key attributes

5 Key attributes

In every case, we seek reasonable valuations relative to a firm’s underlying growth prospects. This provides potential downside mitigation in the event of a market drawdown but also scope for upside if a company continues to do well.

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1 Price-earnings ratio.
2 “Quality investing during inflationary times”, November 2021, www.ninetyone.com

Authored by

Clyde Rossouw
Co-Head of Quality

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