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.

Hamish Douglass discusses why the less-threatening Omicron variant still comes with inflation implications, why he's recently invested in two companies exposed to structural growth in global travel and why today's stock market reminds him of 1999's. 

Sailing into the wind is a sailing expression that refers to a sail boat's ability to move, even if it is headed into the wind.  To reach specific points, alternating the wind's direction between the starboard and the port is sometimes necessary.  Equity markets similarly require the same agility to adjust for different market cycles and macro implications to deliver consistent returns for clients.  The last (almost) two years of Covid-related repercussions have certainly tested even the best skippers' navigation skills and having the flexibility in your process to adjust when necessary has been invaluable.  As we head into 2022 with concerns around economic growth and monetary stimulus likely peaking, the earnings cycle potentially maturing, and equity market valuations optically high, investment risks appear to be rising.  At Alphinity we continue to let earnings leadership, on a stock by stock basis, guide us through the next phase in the cycle, wherever earnings upgrades may lead us (rather than being tied to a specific style or macro outcome).

2021 - A normal, abnormal year

Nothing about the last 24 months since the Covid pandemic started has felt normal.  Global equity markets (with Australia no exception) have however followed a surprisingly normal recession and recovery pattern, albeit faster and more aggressive than usual.  Consistent with historical patterns, the first stage of the market recovery in 2020 was driven by valuation multiples expanding, with the market pricing in future earnings growth, which did not disappoint and drove the second stage of the recovery into 2021.  The two charts below illustrate the similar return drivers of the MSCI Australia and MSCI World Indices, with the former enjoying stronger earnings growth, but also a larger multiple contraction at the index level over the last year.  The key question from here is the expectation for each of these drivers (earnings and multiples) as we head into a new year.

MSCI Australia following a normal post-recession market pattern - up c60% since the trough with the PE expanding from 14.5x to 20x, currently back down to 18x

Source: BoAML Data

MSCI World has added c97% since the trough in March'20 with the PE expanding from 12x to 20x, currently back at 18x.

Source: BoAML Data

Different points in the earnings cycle heading into 2022

Global earnings revision breadth (or earnings sentiment as measured by the Alphinity Diffusion index, being the number of companies getting earnings upgrades vs downgrades) expanded to 30-year highs as analysts started pricing in the strong demand recovery and unprecedented corporate pricing power. Similarly in Australia, earnings sentiment soared to highs last seen in 2003, peaking in April 2021 driven by the early cycle commodity pullback, dropping into negative territory during lockdowns and finally stabilising in November 2021. Generally, these small upgrades still favour pro-cyclical earnings, but we are seeing some selective defensive positive earnings revisions coming through.

Australian earnings cycle - Less clouding, but not yet clear

Source:  Alphinity, Bloomberg, 31 December 2021

Globally earnings upgrades are still dominating, but the trend is narrowing to fewer stocks. In terms of relative sector earnings revisions, the picture is getting more mixed compared to the clear cyclical and growth leadership we have seen over the last 12 months with some defensive sectors slowly creeping into positive territory.

Global earnings cycle - Still positive but losing momentum

Source:  Alphinity, Bloomberg, 31 December 2021

High valuations offer less support and high dispersions increase vulnerabilities

Despite the recent multiple contractions seen during 2021, most global equity markets are still trading above their long-term averages driven in part by low interest rates and excess liquidity. Strong performance in the last 18 months has seen pockets of the market becoming particularly stretched and therefore vulnerable to material changes in earnings and interest rate expectations, real or perceived.  The valuation dispersion between the highest (80^th percentile) and lowest (20^th percentile) rated stocks is at a record high for the ASX200 and the MSCI World Index, with unprofitable tech a particular standout.  Factor and style dispersion were also extremely high during 2020, which makes sense for a year marked by very high uncertainty or a recession and extreme volatility. This dispersion has reduced a bit during 2021 but remains at unusually high levels across several styles, such as value vs growth, given the strong recovery in the economy.

Source:  Alphinity, Bloomberg, 31 December 2021

Global equity markets still trading above their long-term average valuations

Source:  Bloomberg, 31 December 2021

Adjusting the sails for the winds of change

Add to this peaking, but still robust, global economic growth, stubborn inflation data, likely less central bank support and ongoing uncertainty around new Covid variants such as Omicron, is probably going to make navigating macro influences on markets more challenging this year. The increasing points of uncertainty suggest a more diversified, balanced approach will be required, focused on individual company stories rather than large thematic biases, with flexibility to react to material changes in the investment environment. Introducing some defensive characteristics also seems prudent, as long as you can identify the relative earnings story.

Across our Australian funds we continue to follow the individual company earnings and where upgrades are coming from.  Along those lines we have added to some more defensive positions such as Sonic, Amcor, Medibank and Treasury Wineries in the last few months.   Global packaging company Amcor for example, offers a defensive earnings stream with strong cashflow generation and a solid balance sheet, which allow management the flexibility to do recurring buybacks and potential bolt-on acquisitions.  Amcor has beaten earnings and upgraded its outlook at the last 6 quarterly reports, primarily driven by better than expected synergies with Bemis, but also better than feared passthrough of higher resin prices.  Amcor's defensive qualities should see it deliver a steady return over the next 12 months and outperform the market on any potential correction.

Amcor - offering a defensive earnings stream and strong cashflow generation

Source:  Alphinity, Bloomberg

On the global side, we have continued to incrementally reduce our cyclical and higher PE growth exposure in favour of high-quality defensives such as Pepsico, Nextera and Nestle.  Pepsi is a high quality, defensive consumer stock with strong pricing power and under-appreciated long-term revenue growth driven by strategic reinvestment under a new CEO, a mix shift to the higher growth snacks segment, targeted M&A and market share gains in beverages.  Recent third quarter results displayed broad-based strength across the business, with management committed to offsetting rising inflationary pressures by leveraging strong brand investment and innovation to drive price increases and revenue management.

Pepsi - driving earnings growth through strong pricing power and innovation

Source:  Alphinity, Bloomberg

It seems likely that 2022 will be a more challenging year for markets, especially given the higher valuation starting point.  It is through choppy waters like the present that we rely on our agile, style agnostic process to get us to our destination.  As Thomas S. Monson once said, we cannot direct the wind, but we can adjust our sails.

Author: Elfreda Jonker - Client Portfolio Manager

In this episode on the Good Value podcast (recorded Monday 31 January, 2022), Jacob Mitchell and Alison Savas discuss three key themes to watch in global markets in 2022:

• Rising real yields in the US
• The potential for China to loosen
• Europe to outperform on a normalisation in services spending and a potential household re-leveraging cycle in the West. 

They also share Antipodes' stock to watch in 2022 - Seagate Technologies (NASDAQ: STX)

The last time Australia's official cash rate had a five in front of it, the world was going through the biggest financial crisis since the Great Depression. Within the next two years, rates could be back up at that level, bringing a world of pain to borrowers, equity markets and business balance sheets.

The prediction comes as share-markets around the world tumble amid expectations the US Federal Reserve will within weeks kick off the next interest rate-rise cycle. 

"We've already seen rationalisation start to come into the market. We can see that institutions and investors as a whole are no longer prepared to just pay up for these high-growth, expensive companies, many of which are not actually generating profits" 

If you look at the irrational behaviour happening over the last 12 months, it's resulted in 60 out of the ASX top 200 companies not being profitable. That's alarming.

While capital market conditions were favourable over the past two years, with excess liquidity pumped into the system, these hyper-growth businesses were the outperformers. However, these sorts of businesses are highly reliant on capital markets supporting them; they've got to keep going back to the well to survive. 

That well will run dry quickly if rates jump up to the level, we forecast. I see the Reserve Bank kicking off its own rate-rise cycle by the middle of the year, well before the 2024 start date the central bank was tipping just months ago.

The pressure on the RBA intensified last Tuesday, when headline inflation in the year to December 31 was revealed to have surged to 3.5 per cent, while underlying inflation was 2.6 per cent. Many now expecting the central bank to move this year.

I am predicting that the fallout for equities from the rate move would result in the share market contracting up to 15 per cent this year. The S&P/ASX 200 Acc. was down over 6% in January on the mere suggestion of a new rate-rise cycle. 

"We think there's a real risk now that rates are going to increase by amount to 3 - 5 per cent over the next two years"

The RBA might try and hold fire as long as they can, but then I think they're going to have to accelerate at a greater rate than what they would have preferred. You could easily see that 3 to 5 per cent occur over an 18-month period from July 1 this year.

If you also think about the amount of debt people and institutions have taken on over the last few years, you lift that cost of debt from 2 per cent to 6 per cent or 7 per cent over the next 24 months and it can have dire consequences not only on the property market, but also on equity markets and business balance sheets.

The key for investors looking to emerge unscathed is to ditch the recent investing mindset. 

"Investors who continue with the mindset of traditional investing over the next five years could risk giving away a significant amount of the wealth they've generated over the last five. Now more important than ever, investors need to apply a lot more active management to their portfolio, as opposed to the buy and hold index approach that worked very well over the past decade - invest for tomorrow, not yesterday"

The alternative investment manager isn't suggesting investors completely back away from equities, but to reconsider how to best manage that equity allocation. To this point, the Lucerne Alternative Investment Fund (LAIF) has in recent months increased its exposure the energy sector, which has outperformed as constraints to supply chains continue. Ironically, this was a sector ignored by much of the market in recent times with the push toward clean energy. "We feel there is more upside in this sector and some market commentators believe oil could reach USD200 per barrel".

Our message to investors out there is to get in front of this and start to think differently. Move away from that herd mentality, which only works well until it doesn't. 

LAIF, which actively manages a portfolio of alternative funds covering asset classes and themes including long-short equities, volatility, precious metals, resources, digital assets and convertibles, returned ~24 per cent last year, bettering the 22 per cent in 2020. For this year, the fund is tipping it can achieve an 8-12 per cent return, after delivering a return of ~1.5% In January. 

Author: Anthony Murphy, CEO