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For more than a year now, the Covid-19 pandemic has had the world firmly in its grip. The virus has spread across the world and many countries are still in for a painful fight. As for stock markets, they tumbled at first, before rapidly embarking on one of their most impressive recoveries in history. Looking back at what we at BLI wrote on the topic at the start of the pandemic a year ago, most of our statements still remain valid.
Where we were definitely right was on the virus situation, as its spread was almost by the book. While scientists and medical professionals are learning more about the virus and the associated disease every day, the initial impressions that the virus had the potential to put a severe strain on our ICU capacities and lead to severe loss of life due to the likelihood of contagion and high mortality rates among the elderly were painfully confirmed. Although it was also confirmed that for the vast majority of people the virus would not do much harm, there are unfortunately still many uncertainties about the long-term after-effects of a Covid-19 infection.
Scientists had to move fast to get a grip on the virus, improve therapies and develop vaccines. Political leaders, especially in Western countries, have been slow learners. As the pandemic progressed, the political response seemed to be less based on scientific facts and more and more influenced by calls from a loud minority of so called “covidiots” and short-sighted lobbyists, which resulted in dismissing many of the obvious pandemic control measures (wearing masks, strict quarantine, contact tracing, massive testing to identify new clusters, travel restrictions to and from impacted regions) as either too authoritarian or too bad for the economy. The opposite holds true, however: today in those countries that decided to contain the virus as far as possible and not simply live with it, business is (almost) back to normal, while in many Western countries people and businesses are continuing to suffer. A lack of social cohesion and the selfish and ignorant behaviour of people flouting the social-distancing rules with impunity, further adds to their woes.
A surprising stock market rally, or not?
So while the pandemic’s evolution provided little in terms of major surprises, this can definitely not be said for the stock market. Who would have thought back in March last year that the markets would start a rally that would drive the main market indices way beyond their all-time highs? Who could have foreseen that we would first see growth stocks rebounding massively, stretching their already quite high valuations, before witnessing, from November on, one of the most impressive rallies in cyclical and value stocks for a long time? Is such a market reaction rational when we are still in the middle of one of the most severe crises in recent history, whose economic consequences can still not be fully assessed?
At this point, it makes sense to quote what I wrote one year ago: Nobody is able to quantify and forecast the short-term impact of the pandemic on the economy and stock markets. This lack of short-term visibility is not specific to the current situation. We are convinced that making short-term predictions is a vain exercise and that the only way to be successful investors is by taking a long-term view. We stick to our process that allows us to identify companies that offer the potential for profitable growth, not only for one or two years, but for longer periods of time, capitalising on strong competitive advantages and favourable structural trends.
These statements are, of course, still valid. Especially for fund managers like me who manage a pure equity fund, it is completely irrelevant to try to foresee market movements, as there are no asset allocation decisions to be made. It is also not my role to judge if the recent market moves and style rotations make sense. Our long-term approach and investment process does not change with the market mood and is purely built on stock selection based on quality and valuation. Market fluctuations can provide us with opportunities to make portfolio management decisions; take some profits on companies whose valuations look stretched after their recent rally, or build new or add to positions in companies that have been out of favour with investors.
Inflation? Short-term pain, long-term gains
So while market fluctuations are for us stock pickers rarely a reason for concern and more often a source of opportunities, one recent development that cannot be so easily ignored, are fears of a pickup in inflation coupled with rising interest rates. A post-pandemic boom could indeed be on the table, fuelled by excess personal savings and high pent-up demand, in addition to the huge government stimulus programmes already in place. Inflation anticipations have been the culprit for the recent correction in growth stocks, as their attractiveness is reduced when investors have to start to discount distant cash flows with higher discount rates. While we prefer to look at our investment philosophy as more of a blended approach — since it consists of picking stocks based not only on their quality but also on their valuation — it is also clear that our focus on companies with an outlook for profitable growth leads to having portfolios that fall in the quality growth category. As a result, our funds have been negatively impacted by the style rotation of the past few months that has favoured lower quality, cyclical and value stocks.
In his article “Sector rotations and relative performance of our funds” published a couple of weeks ago, Guy Wagner, managing director of BLI and manager of our BL-Global Flexible EUR fund, discusses the economic conditions that led to these rotations, puts them into a historical context and explains why these periods are unfavourable for our investment style. He also reviewed the fundamental reasons why we have opted for an investment methodology that favours certain sectors and neglects others and why it is so important that we limit ourselves to companies that generate a high return on the capital they employ. This very selective approach leads to portfolios that diverge significantly from the indices, so our investors have to be aware that they need to accept periods of underperformance in order to be able to obtain higher risk-adjusted returns than the equity markets over the long term. At the same time, they should benefit from the fact that they are invested in portfolios that allow them to sleep better than most other investors during market corrections.
And while a situation of inflation sticking around could have the potential to harm the outlook for growth stocks and remain unfavourable for our management style for a prolonged period of time, this will not necessarily be bad for the companies we invest in. Investing for inflation means choosing companies that can keep up with rising prices and that are not hurt by rising interest rates. The focus has to be on companies with strong pricing power, scalable businesses (with the ability to handle more business without having to invest a lot), and debt-free balance sheets. Companies that can generate cash, rather than consume it. Companies with a solid foundation of current profits, instead of very high-growth companies with excessive estimates for future profits. Attributes like asset lightness, low labour intensity and manageable exposure to raw material price inflation are also important. Our companies tick most of these boxes, which makes us very confident that even in an inflationary environment, they will capitalise on their strong competitive advantages to continue on their path of profitable growth. They are often dominant, sell value-added services and products, and should be able to pass costs on to their customers. True, we also own some asset-heavy companies in industrials and materials sectors, but they are the market leaders with the highest pricing power. If they suffer from price inflation, it is highly probable that their weaker competitors will suffer even more. And in the end, our companies should emerge from such a period stronger than before, as they have shown many times in the past.
So even if, as Guy concludes in his article, there is a good chance that the stock market environment will not change any time soon and will remain rather unfavourable to our management style, the economic environment for our companies looks promising. They are well positioned to capitalise on higher demand while having the necessary pricing power to eventually pass on higher input costs to their customers. And even if, over the short term, they might not be the stock market winners, over the long term the market will have to reward them for their ability to achieve profitable growth and thus create value for their shareholders.
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