Royal London Asset Management: Investment update: Expectations versus outcomes

It is said that happiness is a consequence of expectations versus outcomes. Anyone expecting to live a life without setbacks, unexpected events and challenges, relative to the outcome, is likely to be disappointed.

Equally, those who can accept that such things occur are likely to be more resilient and prepared. As with many things, what goes in life goes in investing. Any expectation that investing will be a straightforward and gradual accumulation of wealth will be undone by volatility and unexpected challenges. Each one will seem worrisome and a reason to not persist. But, for those who are expecting such things, they will seem like an opportunity to learn, grow and, in time, benefit from. Here are our expectations for investing in equities:

1. Each year there will be a 10% fall (a correction) due to relatively non-important but high-profile worry. Concerns around a trade war between the US and China in 2019 is an example of this.
2. Every five years there will be a 20% fall (a bear market) due to the natural rhythms of economies and markets, which have a habit of over-extending on both the up and the down. This usually comes from an economic recession, from which a recovery is rapid.
3. Every 10 years there will be a fall of a far greater magnitude, potentially more than 50%, which will have its origins in either a seismic event (for example, a pandemic) or a systemic risk/issue in the global economy coming to bear (for example, a financial crisis).
4. In time, all the above three setbacks will be offset by the powerful force of economic growth, which will reward well those who can take advantage of them.

Of course, these are rules of thumb, but they are good ones. If we expect each year there will be a correction, we will be much more likely to take advantage of it when it comes. If we expect a fall of more than 50% every 10 years, we are much less likely to take excessive risk, via leverage for example, in the other nine years. They also give us a useful framework for what is happening in markets today.

There is an increasing view that we are heading to a second-category scenario due to the Federal Reserve having to bring inflation back under control by raising interest rates, which may cause an economic slowdown or recession. Should this be true, and with the S&P 500 down c. 8.3% from its all-time high Nasdaq down c. 13% (as of 21/1/22), there may be further to fall. If these fears prove unfounded, a correction has already occurred – making it likely that equities will move higher from here. And, for anyone who believes quantitative easing (QE) and excessively low interest rates have created a bubble in assets and scenario three, there may be much further to fall. For those who don’t know, we refer you to point four above! Our view is either scenario one or two is occurring, with the future path of inflation perhaps the key determining factor between them.

Valuation is getting repriced, downwards

We are often, quite reasonably, asked about the valuation of our portfolios. Before answering, here is a summary of our views about valuation as a general topic:

1. A valuation metric, a price to earnings (PE) ratio or free cash flow yield is in isolation a meaningless number. An investment outcome, good or bad, is determined by the valuation of a company relative to the outcome the business achieves. A high PE stock can be a very rewarding investment if the company that sits behind it outperforms operationally the expectations embedded in that rating. Equally low PE stocks can be poor investment if the business fundamentals behind it are deteriorating.
2. The valuation of a company is a function of the future profits, and therefore cash, it generates and the discount rate (the cost of debt and equity prorated to match the funding structure of the company) attached to it. Although both have an influence on valuation, typically the discount rate is less important for the most successful companies as they produce profits higher and longer than expected.
3. Most of the value of a company is in its outer years. A good rule of thumb is that over 75% of the value of a company is determined by profits more than five years into the future. Some will be a more than this (early-stage businesses, for example) and some less (mature companies). On average though for anything we own today, it is its prospects from 2027 that are the most important to the inherent value. Think about what has happened in the last five years (2017-2022) to see the importance of this point.
4. Duration of growth is much more important to the value of a company than rate of growth. Much better to have the tortoise than the hare in investing! Of course, long duration fast growth is the best outcome, but short duration fast growth is a terrible one.

Using this framework and applying this to our funds, we believe the companies we own will outperform expectations embedded within them; the rising cost of debt (interest rates) will be a factor in future performance but not the key determinant; and that we own long duration businesses that have the potential to grow for many years to come, which is fully aligned with where value and valuation is created.

What we own and what we don’t

In a media driven world, every story needs a soundbite. ‘Spec tech’ is the one being used today to describe the implosion of many profitless technology companies, which were the best part of the market to invest in during the last few years. Although the Nasdaq may only be down 13% from its high, Bloomberg note that over 40% of the constituents of this index are now down over 50% from their highs! This is not a technology bust of the scale of 1999 yet, but it is capital destruction on a huge scale.

We own nothing that we would describe as ‘spec tech’ and have an aversion to profitless companies with minimal track records. Many of these come badged as disruptors, but history tells us most fail. Not owning these companies is hugely important for anyone with a definition of risk as the potential for a permanent, material loss of capital as this is by far the most likely part of the market where this could occur.

In the short run, however, their decline can cause a fall in the share prices of lower risk and much more established companies in similar industries. We do own some of these. Companies such as Microsoft, Intuitive Surgical and ASML have all fallen more than 20% from their highs in sympathy. These, and other such examples, will be just fine as businesses over time, with huge and established market positions in industries with many of years growth ahead of them. They are also very profitable. Falls of this nature can create interesting opportunities to add to our holdings at lower prices, and we will be looking to do so in the coming weeks especially if markets fall further. The epicentre of capital destruction in today’s markets, ‘spec tech’, we will however stay well clear of.

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.