Whilst the investment environment is likely to become more difficult, it will not be without opportunity. Attractive long-duration investments are often underappreciated by a market concerned with detecting and predicting short-term changes in the operating environment.
Companies with structural growth tailwinds, pricing power and high-operating margins are scarce and with a more challenging economic backdrop, these quality businesses are likely to stand out. As a result, stock selection is becoming a more critical determinant of relative investment returns.
Normalisation of discount rates
Over the last few years, the market has looked expensive relative to history on some metrics. An example is the implied discount rate used by investors to value stocks, which was well out of line with the median level of the last 30 years.
This valuation anomaly could perhaps be justified at the time by the fact that short-term interest rates were zero and even long-term interest rates were below 2 per cent, or negative in real terms. Very low interest rates super charged the valuation of growth stocks in particular and enabled start-ups to access cheap capital and disrupt industries.
Over the last nine months, as interest rate expectations have increased, share prices have adjusted and the market-derived implied discount rate is now around its long-term median. At first glance, this implies that stocks are back around fair value, but this high-level analysis obscures some differences between sectors.
If economic growth slows, we might expect downward revisions in earnings for more cyclical sectors, suggesting a higher discount rate today would be justified. Among high-growth stocks, we think the sell-off has been indiscriminate, leading to some stocks with structural growth and defensive characteristics now trading at attractive valuations.
After enjoying a period of abundant liquidity and near-zero cost of capital, stocks all over the world which were once bid to extremely elevated valuation levels on growth potential alone have come crashing down as these accommodative conditions reversed. Locally, the “buy now pay later” sector was perhaps the poster child of this exuberance and has demonstrated the full impact of what happens when not only valuation multiples compress but earnings also come under pressure as customer growth and spend slows; price levers are limited; and inflation, funding costs and bad debts rise.
Whilst higher interest rates did impact most growth stocks, the importance of differentiating between stocks with shakier business models that could only thrive in a ‘free money’ era and those with some enduring relevance has become increasingly evident.
We prefer exposure to stocks with superior pricing power, competitive advantage and a sustainable path to profitability. As an example, when the market was once enamoured with the triple digit growth rates of Afterpay and happy to fund this with seemingly scant regard for a return, we found more appeal in the latent value of Xero’s customer base and relative resilience to a downturn in economic and financial conditions, despite comparatively meagre customer acquisition growth.
With growth stocks bearing the brunt of the market declines, it can be tempting to view and manage performance solely through shifts in investment style and macroeconomic predictions. In our view, managing risk through careful stock selection leads to better outcomes through the cycle, and can even lead to outperformance when the style is not in favour.
With the near-term economic outlook more uncertain, we think positioning in quality stocks with resilience to a range of conditions will continue to be key to delivering outperformance.
ESG — divest or engage?
We saw a pleasing increase in ESG activity from companies over the year including numerous commitments to net zero emissions and initial modern slavery statements. Unfortunately, the heightened focus on emissions played out against the backdrop of an escalating energy crisis, which forced investors to consider their approach to investing in fossil fuels.
For investors who have a strong ESG focus and who want to see decisive action on climate change, the easy answer is to simply divest off any fossil fuel exposure. While many super funds have encountered pressure from activists to divest, we see three main drawbacks to this approach.
First, divestment doesn't directly reduce fossil fuel production. Whether investors divest their shares or companies divest reserves, activity simply shifts from the seller to the buyer, who is more likely to operate in private markets or jurisdictions with less oversight.
Divestment can drive up the cost of capital, but this simply leads to higher profits for the new owners. Second, if investor pressure were to be successful in driving lower production, the result would be high prices and shortages in energy markets with serious consequences for household and business customers. As we have seen in Europe this year, existing energy sources can't be shut off until a replacement is ready. The energy transition needs to involve lower demand for fossil fuels, not just lower supply. Finally, divestment can lead to the risk of lower returns for investors at a time when super funds are under increased pressure to prioritise financial outcomes for members.
We are acutely conscious of the ESG risks associated with fossil fuels including the potential for lower demand and stranded assets. In our view, the key factors are the resilience of a company to a range of transition scenarios, and its ability to participate in the transition by phasing out its scope 1, 2 and 3 emissions over time. We see value in engaging with companies on their transition plans and capital allocation.
Peiting Liang, senior analyst, Northcape Capital and the Warakirri Ethical Australian Equities Fund