With the clocks going forward and nights lengthening, we're far enough into 2022 to assess the year's current market conditions. And one thing is for sure - uncertainty seems to be the new normal. In this article, Jamie Ross, Portfolio Manager of Henderson EuroTrust, explores the factors behind the growth to value rotation and how they have impacted the Trust. Jamie also highlights why quality growing businesses are essential for navigating a volatile and uncertain market environment.
A perfect storm?
In 2021, conditions were far from straight-forward, yet equity markets still closed the year with double-digit returns, and investors were more optimistic about the year ahead. However, a few months into 2022, it's clear that this year will be much trickier to navigate.
Supply chain bottlenecks caused by the Covid-19 pandemic continue to prevail. With the collapse of world trade in April 2020, economic activity ground to a halt, but as lockdowns were lifted, a demand surge led to supply shortages, which have been more intense and have lasted longer than initially expected. Consequently, the cost of living in Europe has risen on the back of soaring oil, gas, food, and electricity prices as businesses try to pass on rising input costs to consumers. These imbalances, which are particularly acute in Europe, have been further exacerbated by the war in Ukraine. With inflation at record highs in some parts of the world, central banks have begun raising interest rates, and some have already started reducing their quantitative easing measures.
Against this backdrop, investors have been rotating away from growth into value stocks. Year-to-date, the MSCI Europe Value Index is up 2.2% compared with a -9.8% return for the MSCI Europe Growth Index.i Before the rotation, growth stocks - especially tech companies - had rallied strongly as global workforces transitioned to working from home and friends and family tried to stay in touch during lockdowns. Though structural and consumer trends are here to stay, some of these growth stocks have become victims of their own success. Moreover, with some investors chasing growth at any price, valuations had become stretched, further denting sentiment towards these stocks.
With the "inflation is transitory,” narrative now firmly put to bed and central banks raising interest rates, it is no surprise that growth stocks have struggled. Rising interest rates and inflation are bad news for growth stocks, at least initially, because they erode the future cash flows that growth stocks are heavily valued on. Value stocks, meanwhile, have found support from a strong economy and surging commodity prices. This has led many to question why investors should invest in growth stocks in such an environment.
In quality, we trust
At Henderson Eurotrust, our objective is to provide our shareholders with a superior total return from a portfolio of high-quality European companies over the long term. While the last 6-months or so have been challenging, it's important to remember that we are long term investors and firmly believe that quality, growing businesses will outperform lower quality companies over time – our long-term outperformance is a testament to this approach.
Source: Bloomberg as at 11/04/2022 Note: share price total returns in GBP
While lower quality companies may have periods of resurgence - such as we are seeing now – these businesses are still facing significant challenges as the pace of disruption and innovation increases. For example, in transportation, cheaper and faster competitors are reshaping how we move people and goods, while in retail, online competition is driving prices down and challenging the pricing power for traditional bricks-and-mortar businesses – a point made clear during the pandemic. Within the energy space, companies are coming up with sustainable ways to produce and store clean energy as the world weans itself from fossil fuel, posing a challenge to traditional energy producers.
We maintain our firm belief that, over the long term, companies with sustainable barriers to entry and thus able to generate high and sustainable return on invested capital, will outperform. We therefore believe some of these value recoveries to be transient, and we will not lose faith in our long-term strategy. In fact, we are using this difficult environment for quality growth as an opportunity to move further toward this style bias. Simply put, we are finding opportunities to buy what we see as high-quality long-term investments at reasonable valuations in this market environment.
The quality stocks we look for are those which have a competitive advantage within their industry. Companies with strong pricing power compared to their peers, that can deal with rising input costs while still generating growing earnings, no matter what the economic forecast. High-quality businesses capable of generating returns above their cost of capital that allocate excess capital appropriately are the perfect holdings for our portfolio in these uncertain times.
Another thing to point out is that the highest quality companies also place Environmental, Social and Governance (ESG) factors at the heart of their business. This is often derived from solid management teams who devise comprehensive strategies to deal with factors likely to affect their business in the future. Europe is at the forefront of sustainability - more companies across the continent are putting ESG at the heart of everything they do than anywhere else in the world. These businesses have not fared well in the market rotation, but we maintain a healthy, and growing, exposure to them. Not only are these companies doing the right thing for the environment and the society in which they operate, but they are also better equipped to achieve attractive long-term growth and returns.
A long-term perspective
With the short-term market outlook uncertain, it's essential to maintain a long-term perspective. Now, that's easier said than done because it means looking beyond the noise, the macro-economic indicators, and short-term earnings reports. Of course, periods of weakness are part and parcel of investing. However, it's the conviction you have in your strategy and the underlying businesses that helps you through the tough times. That is why we will continue to focus on picking quality companies that can provide consistent and sustainable long-term returns for our shareholders. Quality matters now, more so than ever.