In this interview, Doug Rao, US equities portfolio manager, discusses the key themes that investors should be aware of in a changing market environment.
- Over the next three to five years, inflation and interest rates will matter more for equity growth valuations, particularly for high growth companies.
- Select tech and healthcare companies have the ability to produce wide profit margins and operate with a lower level of labour intensity than other market segments, which could make the impact of inflation less pronounced.
- As markets shift, we continue to focus on companies poised for multi-year, secular growth in areas requiring a significant amount of investment.
What is your process for identifying companies that you believe have sustainable competitive advantages?
We focus on companies that are dominant in their field and are driving innovation and change through disruptive technologies, products or business models. One of the key attributes we look for is a wide moat, which means that the company has distinct attributes that are difficult for competitors to copy. In our view, these wide moats are key to a company’s ability to sustain its competitive advantages and grow market share globally over time.
What are the implications of higher inflation and rising rates for these types of growth-oriented companies?
Over the next three to five years, we believe inflation and, similarly, interest rates, will matter for equity growth valuations. Since the Global Financial Crisis, we have enjoyed an extended period of both very low interest rates and inflation, during which historically low rates incentivised investors to bid up growth valuations. This dynamic can change quickly as interest rates rise, particularly for high growth companies with expected cash flows far out in the future.
Stock prices are a function of earnings, earnings growth and the multiples investors are willing to pay for that earnings and earnings growth. As rates have risen, earnings multiples have contracted, making it increasingly important, in our opinion, to invest in companies that can outrun ‒ through their earnings growth ‒ the multiple contraction that we have recently seen.
A large portion of the growth investing landscape is made up of information technology and healthcare stocks. Select companies in these sectors have the ability to produce wide profit margins and operate with a lower level of labour intensity than other market segments. So, while inflation will certainly matter for tech and health care companies, these characteristics could make its impact less pronounced.
What key market and macroeconomic themes are you seeing in the US and how does this impact investment decisions?
The market environment in 2022 has evolved into one of opposing forces and an uncertain outlook. While the pandemic health situation has improved in the US, persistent inflation, shifting monetary and fiscal policies and geopolitical uncertainty from Russia’s invasion of Ukraine have presented new challenges.
The ultimate impact of the war in Ukraine remains unknown, but surges in commodities prices ‒ particularly crude oil ‒ could trigger a recession. However, while the threat of inflation and an economic slowdown exist, we maintain a generally positive outlook for equities, especially relative to other asset classes. Relative advantages of equities include their free cash flow yields above that of other asset classes as well as their free cash flow growth. Equities’ potential for growth may also provide a hedge during inflationary periods.
As markets shift, we continue to focus on companies poised for multi-year, secular growth in areas requiring a significant amount of investment. High quality businesses that can capture a disproportionate share of those economies may be less exposed to external factors as more of their growth stems from capturing market share.
Where are you seeing opportunities in the current environment?
One of the lessons we learned through the pandemic is that direct digital relationships with customers are significant. Companies that have successfully forged these relationships have gained the ability not only to constantly communicate with their customers, but also learn from them ‒ to better manage inventory, working capital and other business functions. From an investment standpoint, these digital relationships have added flexibility and resilience, strengthening businesses across the economy.
We also believe there is still a long runway of growth for the large cloud platform providers. Semiconductors are providing building blocks for rising cloud server demand as well as key components in the shift to electric ‒ and, ultimately, autonomous ‒ vehicles. As manufacturers ramp up electric vehicle (EV) production, essential chips and components that weren't present in internal combustion vehicles will be in high demand.
In a similar vein is the growth of biopharmaceuticals such as protein-based therapeutics, gene therapy and mRNA vaccines. Along with the progress of these technologies, costs in pharmaceutical production will likely increase dramatically, and companies selling the various components used in their production will have powerful demand over the next 10 to 15 years.
What role do you see US equities playing in an investor’s overall portfolio?
The US is home to many of the most innovative large franchises in the world, so selecting stocks from this cohort is particularly beneficial. This is especially important in the current market environment, where external factors such as monetary policy and geopolitics are strongly influencing equity markets. We aim to identify businesses with growth opportunities stemming from sustainable competitive advantages that are likely to be less impacted by those uncontrollable external factors.
Fiscal policy: government policy relating to setting tax rates and spending levels.
Monetary policy: policies of a central bank, aimed at influencing the level of inflation and growth in an economy including controlling interest rates and the supply of money.
Yield: the level of income on a security, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, this is calculated as the coupon payment divided by the current bond price.
Investing involves risk, including the possible loss of principal and fluctuation of value.
Equity securities are subject to risk including market risk. Returns will fluctuate in response to issuer, political and political developments.
Growth stocks are subject to increased risk of loss and price volatility and may not realise their perceived growth potential.
Health care industries are subject to government regulation and reimbursement rates, as well as government approval of products and services, which could have a significant effect on price and availability, and can be significantly affected by rapid obsolescence and patent expirations.
Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general market conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.