IIn this episode of The Ardea Alternative podcast, Laura Ryan, Tamar Hamlyn and Alex Stanley discuss interest rate rises in response to inflation and what it might mean for fixed income assets.

Despite the best attempts of forecasters, the unpredictable nature of how the market will respond to a company's earnings leaves many working feverishly to calibrate their respective positions, especially when anomalies are rife. 

For example, it is not uncommon for a company's stock price to increase when the market expects a greater decline in revenue than what is reported. Conversely, if a company does not achieve expected revenue targets (even if these revenues are positive), then it can result in a decline in the company's ticker price as forecasters adjust their valuations.
It seems that recently, earnings season has become further complicated through the introduction of new and 'undefined' metrics that impact:

1.  the 'top-line', the company's ability to drive increases or preserve its revenue stream within the marketplace;
2.  the 'middle-line', the company's ability to effectively manage their costs, improve current processes to become more (cost) efficient, and manage its overall financial wellbeing (including debt obligations, etc) and;
3. the famous 'bottom-line', the residual between how much money a company can bring in, and what it costs them to get there.

The 'bottom-line' may not always paint a clean picture, given 'up-and-coming' businesses often reinvest heavily in market share acquisition strategies (such as marketing, or developing new products). This subsequently drives up 'middle-line' costs with the hope of gaining future 'top-line' benefits. Without itemizing each variable that sits within the top to bottom line segments, we trust the point has been made - earnings season is complex. More so now, it seems, with new environmental, social and governance (ESG) metric expectations.

Many businesses are now facing significant shareholder pressure to factor in ESG metrics. Whilst driving up middle line costs now, ESG so far appears to have significant customer and employee retention benefits, as well as being the public 'right thing to do'. The cynic may challenge whether these programs are truly driven by ESG good or future 'top-line' benefit. Whereas the optimist might assert that whilst either motive could be true, greater ESG benefit cannot be a bad thing, irrespective of the method(s) used to get there. 

This discussion calls into question the purpose of a company (generally speaking, to operate in self-interest) vs. the operation of a government (establishing the rules that do not allow this self-interest to operate unfettered). It is the classic economics example of 'who pays for the light bulbs in streetlamps?' The cynic argues that through the creation of jobs and payment of various taxes, it is the company who pays for streetlamp bulbs. The optimist, true to character, would just be happy they don't have to walk home in the dark.

If earnings season wasn't already complex enough, the wider adoption of these new metrics can feel like trying to drink water from a fire hose. Like anything that is new, there will inevitably be kinks that need to be ironed out and parameters that need redefining. Perhaps the nirvana for these new metrics and their wide-scale adoption comes through regular policy and regulation revisions that encourage and guide companies to do what is considered socially better. Or maybe the onus is on the companies to willingly take on these new expectations from the community and thereby lobby the policymakers to formalise these shifts. 

Is only doing the right thing because you were told to do it enough in our customer-aware world? Either way, we suspect this debate is far from over and we watch with great intrigue how this may continue to impact future earnings seasons.
In conclusion, earnings season and finding the next best company is fraught with hurdles that are likely not made much easier with the level of information available. 

We'd argue that this is only going to become increasingly complex in an environment where pundits and analysts are doing their best to quantify and price-in a rise in interest rates, ongoing supply chain constraints and inflationary pressures that are seemingly going unchecked. 

Relying on strictly linear forms of measurement or analysis is likely to negate an investing edge and conversely, too much information is likely to saturate one's bandwidth with little clarity on how to use it. We'd argue that the best way to navigate earnings season, or any other disruptive market cycle, is to not only remain convicted to one's tried and tested investment thesis, but also keep half an ear to the ground for emerging trends to consider how these might need to be examined

Why it's all about Earnings Growth

Companies that sustainably grow their earnings at high rates over the long term are called Compounders. Investing in a portfolio of Compounders is an ideal way to generate wealth for longer-term oriented investors that tend to also beat market averages with less risk. This chart shows the tight correlation between returns of the S&P 500 (orange line) and earnings growth (blue line) since 1926. NB: Grey bars are US recessions.

Source: Macrotrends.net

Insync's focus is on investing in the most profitable businesses with long runways of growth resulting in a portfolio full of Compounders. 

Inflation & interest rate impacts 

By focusing on identifying businesses benefitting from megatrends with sustainable earnings growth, means we do not need to concern ourselves with market timing, economic growth forecasts, inflation, or the future of interest rates.

Throughout the last 100 years we've experienced periods of high economic growth, recessions, different inflation and interest rate settings, wars, pandemics, crisis and on it goes, but the one thing that has remained consistent... Over the long term, share prices follow the growth in their earnings.  

Media and many market 'experts' continue to be concerned about the risk of a sustained period of higher inflation. They worry over a short-term 'rotation' from quality growth stocks of the type Insync seek to own to value stocks. The latter in many cases is simply taken as equating to lowly rated companies and reopening stocks, such as airlines, energy, and transport. There are 3 problems with this view that can trap investors:

1. Timing - no one has a crystal ball for consistently predicting changes to economic growth and inflation rates nor the pathway for the virus.
2. Share prices have already built in the upside. The value/re-opening stocks have already likely anticipated the potential for higher inflation and the opening up of the economy ahead.
3. All boats rise on an incoming tide. The major problem with low quality businesses that are prevalent in the latter category (so-called value/cyclical stocks) is that most remain low quality and continue with low returns on capital.

In sharp contrast good businesses remain strong at this stage of the cycle. They continue delivering the earnings growth that propel share prices over the long term. This is what makes their share price progress both sustainable and well founded. 

High margins and superior pricing power from Insync's portfolio of 29 highly profitable companies across 18 global Megatrends offers "the holy grail" of inflation busting companies. Pricing power, sound debt management and margin control allow great companies to handle inflation and interest rates well.

LVMH and Microsoft) are portfolio examples that recently increased prices of their products with no impact on their sales growth.

Profitability + Revenue Growth

Short term, investors typically fret over interest rate rises and all growth stocks suffer initially, as they adopt an indiscriminate machine-gun approach to selling. 

Over time however, the more profitable businesses with strong revenue growth start to reassert their upward trajectory in their share prices, as investors appreciate their long-term consistent earnings power.

Stocks with "quality growth" attributes, such as high returns on capital, strong balance sheets, and consistent earnings growth, have typically outperformed in past situations similar to what we face today (Mid-2014 through early 2016 and from 2017 through mid-2019. Source-Goldman Sachs). 

Ultimately, any short term hit to the share price of companies with these quality attributes will be temporary, as over the long-term, share prices always reflect the underlying growth in the earnings of these highly profitable businesses.

This is in sharp contrast to stocks with strong revenue growth projections that also have negative margins or low current profitability. They are highly sensitive to changes in interest rates (These stocks propelled the short-term returns of many of the Growth funds in 2021). Many of them lack profit and cash flow, which doesn't give you much downside protection if they don't deliver. Many rely on the constant supply of new capital to fund their operations.

These types of companies have very long durations because their present values are driven primarily by expectations of positive cash flows at a distant point in the future. We call this HOPE. As the saying goes; we don't rely on hope as a sound strategy. Stocks with valuations entirely dependent on future growth in the distant future are vulnerable to a dramatic drop in price if rates rise sharply or revenue growth expectations are reduced.

This chart (performance of the Goldman Sachs NonProfitable Tech Basket) shows the downside risk to this sector of unprofitable high revenue growth companies. The index has fallen by close to 40% from its peak in February 2021. The index consists of non-profitable US listed companies in innovative industries.

Source: Bloomberg

Unsurprisingly, popular "new era" stocks held by high growth managers have also suffered a similar fate with examples noted below.

Megatrends drive sustainable growth 

Megatrends enable us to locate the sustainable outsized market growth opportunity stock hunting-grounds (as well as help us avoid those that will dwindle). They are the 'fuel' to quality company's sustainable growth earnings. We are presently in the midst of one of the most disruptive innovation cycles in technological history. 

Thus, we resist the temptation of concerning ourselves with near term timing based 'market rotations' and changes in 'sentiment'. These distractions will otherwise prevent us from generating outsized returns in the years ahead. 

PWC consulting estimates that global GDP will be up to 14% higher in 2030 as a result of the accelerating development and take-up of AI. The equivalent of an additional $15.7 trillion USD.

Source: PWC 

Internet of people V Internet of Things

Our lives are already being impacted. In the past 5 years alone, almost all aspects of how we work and how we live - from retail to manufacturing to healthcare - have become increasingly digitised. The internet and mobile technologies drove the first wave of digital, known as the 'Internet of People'. 

Analysis carried out by PwC's AI specialists anticipate that the data generated from the Internet of Things (IoT) will outstrip the data generated by the Internet of People many times over.

This is already resulting in standardisation, which naturally leads to task automation and the automatic personalisation of products and services - setting off the next wave of digital progress. AI exploits digitised data from people and things to automate and assist in what we do today, how we make decisions and how we find new ways of doing things that we've not imagined before. 

"I skate to where the puck is going to be, not where it has been." Wayne Gretzky Canadian World Champion 

From one of the all-time ice hockey greats, this very apt thought describes the way Insync frames its investment thinking. Despite the market's sentiment shift on the rotation trade, Insync's focus is on where the world is moving to. Data continues to show an acceleration in spending on pets, the rollout of 5G, health & wellness, and digital transformation. 

Major corporates expect elevated growth in technology to both accelerate and persist for the foreseeable future (according to a Morgan Stanley survey), in areas such as cloud computing, digital transformation and artificial intelligence.

CIO intentions indicate that they expect to increase IT spend as a percentage of revenue over the next three years than they did pre-pandemic. The percentage of CIOs planning to increase spend versus those planning to decrease spend is known as the up-to-down ratio. It rose to 9.0, nearly 6x the pre-pandemic 2019 average.

The best way to invest in a megatrend isn't always the obvious way!

Semiconductors are driving the digital transformation of the world. Covid19 has had a profound impact on so many industries but one of the key areas everyone has started to care about, is silicon chips. This became abundantly clear when new car purchases were dramatically delayed because of chip supply chain shortages.

Semiconductor chip usefulness has gone further than any other technology in connecting the world. The companies that produce them enable us to do pretty much everything, from the smartphones in our pockets to the vast data centres powering the internet, from electric scooters and cars to hypersonic aircraft, and pacemakers to weather-predicting supercomputers.

Their manufacturing requires a high level of specialist technological know-how as it is a highly expensive, complex and a long process. It typically takes 3 months and 700 different steps to cover a silicon wafer with intricate etchings forming billions of transistors (microscopic switches that control electric currents and allow the chip to perform tasks). 

Semiconductor chips lay at the heart of the exponential transition that we're going to experience in computing over the next 5-15 years. More than we have ever witnessed before, and it will continue to grow exponentially. For example, AI applications process vast volumes of data-about 80 Exabytes pa today. This is projected to increase to 845 Exabytes by 2025. One Exabyte = One quintillion bytes = one thousand quadrillion bytes. Truly eye-watering numbers. 

Insync's investments in the most profitable semiconductor companies enable investors to participate in 3 of the 16 enduring megatrends: video gaming, workplace automation and enterprise digitisation. Their earnings growth will continue to compound at high rates with the resulting share price growth following. This is a consistent feature of the 29 companies in the portfolio. Patience will reward.