As we enter February 2022, perhaps the the Search for Value in equity markets is becoming a ‘Shift to Value’.
Volatility has increased both in overall markets and in individual stocks, as bond yields rise in anticipation of rising US interest rates and longer-lasting inflation. Higher interest rates, in theory, have a contracting effect of how future profits are valued, particularly ‘longer tail profits’ so-called growth companies such as in the technology sector. This has seen prior high-flying areas such as the Nasdaq Index start to underperform, with some individual high growth companies having 20%+ falls in a day, such as Netflix and Peloton.
It is not difficult to understand why this shift away from high growth (often with little or no profits) may be more than just a few weeks’ trading patterns, and perhaps could become more of a longer-lasting ‘Shift to Value’. The global equity markets in recent years have been dominated by the search for growth, with ever lower interest rates also boosting the relative valuation of long duration growth sectors such as Technology. The premium valuation for growth sectors (as measured below by revenue growth) has become more extreme in recent years, i.e., investors have significantly ‘bid up’ the valuation of higher growth companies/sectors.
But now we are looking at rising interest rates, longer-lasting inflation, and a more moderate rate of growth as the post-pandemic consumer binge slows down. In periods of rising rates, one could argue that equity performance is more aligned to earnings growth rather than valuation changes. Perhaps surprisingly, despite the current high market levels, there are several sectors/industries where valuation remain attractive, sectors that have been out of favour, but where earnings are starting to rise again, such as Materials, Industrials, Financials, Energy and even, believe it or not having been through two years now of Covid-19, Healthcare.
Over the next few months sensible investors would do well to shift towards companies that have good ‘old-fashioned’ characteristics: good cashflows, good margins, reliable and visible earnings growth at reasonable valuations. And as luck would have it, these are the type of companies we hold in our Global Equity Income Fund (with the added benefit of attractive and growing dividends). Companies such as Nestle, Diageo, Mondelez (Cadbury), Johnson & Johnson, Smurfit Kappa and Texas Instruments.
CRH, the leading building materials and infrastructure company headquartered in Ireland is also within the fund. Despite strong share price (and good operational cashflow/revenue /dividend growth), the shares have not been re-rated, its valuation remains around the average of the past 7 years. They still trade at just c.16 times earnings, or to put it another way, an earnings yield of over 6%. They are a well-managed, successful, globally diversified business, with strong and recurring demand for its products (that cannot be digitally disintermediated). Imagine trying to put that business together today from scratch.
The strategy may appear boring to some investors, but 2022 is going to be a year where boring is good! Many of the GEI Fund holdings have performed well during the past couple of volatile and challenging years, maintaining or increasing good revenues and cashflows and dividends, and poised to continue these into 2022 and 2023. And now, as we move into a higher interest rate environment, with the high growth shares still very highly valued, investors are starting to recognise the attractive valuation and income characteristics of the more boring or stable companies and to shift into them.
To illustrate this, look at the admittedly very short term since end November, performance of our Global Equity Income Fund (white line), populated by those boring, financially strong companies, versus the higher growth-oriented Nasdaq Index – the GEI Fund has outperformed the Nasdaq by almost 14%.
Note also in recent weeks the relative lack of volatility in our GEI Fund, another positive factor of having boring but resilient companies. Boring can mean exciting returns!
Pramit Ghose is Global Strategist with Cantor Fitzgerald Ireland.
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