2022 started with a correction, with many of your positions taking a considerable hit. Where do we stand today?
These companies’ operating models haven’t really been damaged since the beginning of the year and they are more attractively valued.
And in the longer run?
We are also at more attractive levels. The gap between companies considered to be cheap and companies considered to be expensive has narrowed somewhat. I don’t know when we’ll reach the bottom of the market exactly, but I think we are closer to it when we see what has happened in the markets. It now looks surprisingly similar to the great financial crisis of 2008, when there were considerably more questions to be asked about the companies and the whole financial market.
Like many market participants, you have been caught on the wrong foot.
We started this year with equity valuations globally – including in Switzerland – slightly above historically average levels. That was acceptable for us, since the market had taken a little bit of an advance on what was expected to be a continuation of decent GDP growth globally in 2022. Our understanding at the end of 2021 was that most of the disruptions in the supply chain were in the course of being resolved. We expected inflation connected to these disruptions to peak in the second quarter of this year and then coming back to more normal levels, and interest rates in the US rising by about 75 basis points. At the same time, we expected lower, but still decent, economic growth rates.
What did you make of the markets’ reaction?
The reaction we saw in January seemed somewhat exaggerated: this was basically a big factor rotation, i.e. a move away from the more qualitative part of the market toward cheaper stocks. The latter are often cheap because they have relatively short periods in the limelight linked to above-average economic growth, as well as to higher interest rates in the case of banks, or higher inflationary pressure in the case of energy and commodities. In the value part of the market – in contrast to the value-creating part of the market – companies depend much more on external factors than their own strategy and operational performance. As an equity investor, we’re not terribly attracted to that.
What are you focusing on instead?
We don’t buy equity for the short-term, nor for immediate price performance, nor for dividends; rather, we buy it for value creation which we define as cash flow returns on investment©. If a company achieves high and stable or improving CFROI©s over both the medium and the long term, it performs. The first question one should always ask oneself before investing is does this company create value for its customers, and does it continue to do so? If yes, it will create value for shareholders.
How does that work together with a fund which must show short-term performance?
In the long-term it works very well; it has also been working well over shorter terms on the whole. This year, where there has been a rotation into the non-value-creation part of the market, it’s not working. At the same time, the current environment doesn’t make me feel that I must buy something that doesn’t create value either, because value creation is more resilient and does come back. The companies that we invest in tend to have higher valuations because they have a longer visibility regarding their earnings generation, so, they were very badly hit at the beginning of this year.
And then the events in Ukraine happened.
That put extra inflationary pressure on the market as a result of energy price rises. Globally, we are already seeing solutions to the energy situation: some governments seem to be adopting different approaches to countries they had previously avoided. Oil is trading in a relatively steady broad price range around USD 100/barrel and we do not see this sustainably breaking out of this range. What really surprised us were the drastic lockdowns in China which led to the current further supply disruption and which are probably a major factor in fuelling high rates of inflation.
Where are we now?
We still see the inflation trend reverting down, but not as steeply or as quickly as we previously thought. We’re hearing a lot of comments about recession which are interesting in the context of almost full employment globally, as well as in the context of consumers entering a recession in a very healthy situation, and at a time in which firms’ balance sheets are relatively solid and their order books full. It’s not going to be a traditional recession, nor do I think we’re heading towards an energy crisis like the one in the seventies.
What do you expect will happen instead?
It’s new territory and that’s why there’s so much uncertainty in the market. But as we emerge from the lockdowns in China, the supply chain disruptions are starting to resolve themselves. Remember: companies are not just sitting on their hands waiting until the situation is resolved; they have all reacted. You can’t just move the whole production from China to the US in the space of a few weeks. Rather, they’re thinking about how they could do it better in the future than during the pandemic and some actions have already been taken.
At the same time, rising interest rates are likely to be a drag on the economy.
I would argue that a technical recession is possible in some major geographies. With the supply chain situation resolving itself and higher interest rates coming in at a slightly faster pace than we presumed, there will be a cooling effect. We’re already beginning to see it: for example, retail sales in the US in April were already slightly down in real terms. We’re seeing consumer behaviour slowly calming down after the bonanza we saw linked to pandemic support. The economy’s not going to come to a grinding halt because there are so many labour opportunities; however, it will slow down, but not overnight.
What does that all imply for companies and, potentially, for the stock market?
At the moment, we’re expecting some uncertainties to which consumers will react faster than the corporate sector, because the latter will benefit from the easing of the supply-chain issues. This has consequences for consumer-facing companies: entertainment, restaurants in the US and UK, residential real estate – we’re more cautious when it comes to these sectors. It’s going to be very much a stock-picking market.
What about the war in Ukraine?
Russia and Ukraine aren’t – particularly from a Swiss perspective – important markets. However, there may be secondary effects, such as cabling and other automotive supplies, but there aren’t any major effects on revenue and costs for Swiss companies. It’s more problematic for companies with large commodity assets and for developing countries dependent on imports from Ukraine.
What effect has this had on your investment process?
We haven’t changed our investment process, because we never do. We have selectively changed some positions to avoid having too much exposure to Russia and Ukraine, and secondary derivatives from that.
Eleanor Taylor Jolidon
Co-Head of Swiss and Global Equity
View her Linkedin profile