BNY Mellon Investment Management: Futureproofing against disruption

Walter Scott client investment manager Murdo MacLean outlines how disruption is part and parcel of investing. Not every theme is investable today, however he sees attractive opportunities in companies with long-term horizons that can weather, and indeed benefit from, disruptive forces^[1].

Markets tend to obsess over disruptive influences that may not fully manifest themselves for decades, says Walter Scott[2] client investment manager Murdo MacLean. It is, of course, important to consider these trends, he adds, but the most powerful and enduring trends will take time to become fully established.  

“Every day we are investing in a very disruptive and rapidly-changing environment, and we need to select businesses that are capable of thriving in such an environment,” he adds.

Macro disruption

Disruption can take many forms. MacLean notes that while Walter Scott is a bottom-up driven investor, it is still important to consider how inflation, for instance, has disrupted the global macro environment and companies alike. He thinks the full extent of these inflationary pressures is yet to be felt by companies and consumers.

Higher interest rates are impacting certain companies, and MacLean says the market is “over-obsessing” over what central banks are going to do. “Ultimately, it [central bank policy] will have a short-term effect on sentiment and share prices and indeed impact companies with weak, levered balance sheets. We have perhaps not even seen the full impact of the past few hikes, let alone the latest one.”

There is no doubt the current environment will test companies in a way they have not been tested in at least 15 years, says MacLean. “In the period following the global financial crisis, the market was occasionally less focused on separating the high quality from low quality, in part because the environment was so benign and money cheap. Today we are in a period where fundamental analysis will highlight quality businesses,” he adds.

Structural disruptions

The Walter Scott team has identified several disruptive themes, one of which is the ongoing shift to clean energy and low carbon technologies. This is a key structural theme, MacLean notes, but he thinks traditional sources of fuel are likely to be needed for at least another generation, because there is a lack of credible alternatives that are also attractive economically, meaning the concept of an “energy mix” will be around for many years to come.

Staying with the energy transition, MacLean says electric vehicles (EV) are garnering attention, but they currently make up only a small part of the global car fleet. They do, however, comprise a larger portion of new cars being sold, he says, adding: “Over the long term this space will become more material, and will continue to dominate the narrative.”

Another example of a disruptive trend is Artificial Intelligence (AI), adds MacLean. He argues no one is underplaying the significance of this exciting technology, but there are not many ways to play it directly. He says Walter Scott owns two big players in the space, but notes they were not originally bought for their AI credentials, but rather because of their core businesses. “We will see whether they are able to evolve and benefit from that shift, but they appear to be well positioned to do so.”

He adds: “The markets and the media will obsess over things that are actually very small today and are not going to impact companies for decades in some cases. Some of these trends have the potential to become significant, but their impact is likely to be long term rather than in the here and now. Therefore, a considered approach is required.”

Company traits

MacLean says Walter Scott seeks businesses that possess four key characteristics to withstand the short-term pressures around disruption and enable them to take advantage of long-term growth trends.

Cashflow generation

MacLean says Walter Scott likes businesses that are highly profitable. “We do not invest in loss-making businesses,” he adds. “Even in the most challenging economic environments we do not expect these businesses to be losing money. Companies that are profitable and cash generative even in today’s environment are well placed to take advantage of long-term growth trends.”

Strong balance sheets

The higher interest rate environment negatively impacts companies with high levels of debt on their balance sheets, MacLean notes, adding: “Companies should run their businesses prudently, and be capable of weathering tougher times. For highly levered companies starting to change their capital allocation policy or balance sheet strategy when the Federal Reserve has already moved, it is too late.”

Pricing power

The ability to increase prices is important in an inflationary environment, says MacLean. He adds that sectors including commodities, real estate, telecommunications, and banking lack such pricing power because they sell commoditised products and services where the market largely decides the price. This is in stark contrast to other industries such as luxury. MacLean notes certain companies in the luxury goods space never sell their products at a discount, and this can actually increase the attractiveness of their products.

Asset light

Being an asset-light business is also desirable to Walter Scott. Companies with such business models tend to enjoy higher levels of profitability as they require less capital to be tied up in production capabilities, says MacLean. However, he adds companies that benefit from outsourcing of manufacturing and other services can also be attractive as they take advantage of industry consolidation in some sectors.

Price takers and price setters

Honing in on financials, MacLean says companies in this sector do not tend to be as profitable as Walter Scott would like. Looking at return on equity (ROE) over the past 15 years, the sectors that have pricing power and those that do not are apparent. In addition to financials, utilities and energy also tend to share weaker ROE traits and are unattractive for the same reason.

At the other end of the spectrum, MacLean says “price setters” can be found among the IT, consumer staples and healthcare sectors, and in the main they exhibit high ROE thanks to demographic, technological and other such tailwinds.

“We expect such a dynamic between sectors to continue. Focusing on companies in possession of high-quality financial characteristics will continue to be a key focus for Walter Scott going forward,” MacLean concludes.

Important Information

For Professional Clients only. Any views and opinions are those of the investment manager, unless otherwise noted. This is not investment research or a research recommendation for regulatory purposes.

For further information visit the BNY Mellon Investment Management website. http://www.bnymellonim.com