Shaun le Roux, Fund Manager at PSG Asset Management
The default response for investors during times of upheaval and uncertainty is to flee to safe-haven assets. These usually include cash, gold and developed market (G7) bonds, but investors’ response is typically also accompanied by a switch to quality shares in their equity portfolios as the ‘defensive’ strategy. With the ongoing war in Ukraine, levels of uncertainty remain high and the range of future outcomes wide. This time, we believe the default path to safety could be dangerous to investors’ long-term wealth. Global bonds look like a particularly poor store of value in today’s climate of negative real yields and pressure on central banks to normalise interest rates. However, we view gold as an attractive portfolio holding; and our clients own gold stocks. We also take a different view on which part of the equity market is more likely to preserve and grow capital in the years ahead.
A flight to quality is unlikely to have the desired outcome this time around
While cash is the usual asset class of choice during times of vicious market sell-offs, investors also tend to migrate to quality stocks in times of fear, selling stocks that they see as riskier. The constituents of the MSCI World Quality Index offer insight into what the market considers to be quality and the index is highly representative of the equities that have been popular in recent years. Specifically, this index only invests in high return on equity, stable profit growers with low financial leverage. This has been a spectacularly successful investment style over the past decade, outperforming the broader market in eight of the past nine years. However, we believe that this definition of quality is overly simplistic, backward-looking and fails to consider current market conditions.
As the chart below shows, the price earnings (PE) ratio of the MSCI World Quality Index almost doubled between 2013 and 2021 (from 16 to 29 times). Investors should be very aware that a significant portion of past outperformance has been driven by higher ratings. The PE ratios of these stocks have risen thanks to benign inflation and falling yields and were materially boosted by the 2020/2021 fiscal cash injection. At 22.4 times, the PE ratio of this global quality index was still high at the end of February. This is especially of concern when we consider that the ratings of these particular stocks are very sensitive to interest rates – which are rising. This is because growth stocks derive more of the value from future growth, and rising discount rates lower the value of that growth. In addition, the future prospects for many of these businesses, are likely to be severely challenged by rising input costs. Furthermore, being extremely well owned, these stocks are also very susceptible to deteriorating sentiment. Consequently, we see perceived quality growth stocks as a poor option for reducing risk in current times.
MSCI World Quality Index – Price Earnings (PE) Ratio
Changing macro conditions provide further headwinds
We think the geopolitical and economic backdrop will challenge the existing market consensus and positioning. PSG has been highlighting that we believe we have passed an important inflection point in global inflation and interest rates. Accordingly, we argue that the next 10 years are very likely to be very different to the past decade. Interest rates are going up, we see clear reasons for inflation to remain stubbornly high, and there has been insufficient investment in capacity in commodity markets. Tight commodity markets are being amplified by the Ukraine war and Western sanctions. Many cyclical sectors including energy, materials and financials tend to do well when nominal growth is rising, as it does in a more inflationary environment. Cyclical sectors (including domestic emerging market stocks) have been out of favour and hence cheap for many years amidst the flight to quality and their perception of riskiness. That perception is probably about to change.
The need for a differentiated approach
At PSG we favour a very different response to the consensual default in these troubling times. Our 3M process employs a more dynamic approach to finding quality and we explicitly consider the bigger picture dynamics at play. Our process pays careful attention to price paid and specifically likes to unearth underappreciated or obscured quality, avoiding companies where perceived quality has given rise to a premium rating and very high expectations that have a higher chance of disappointing. (The market is usually brutal if market darlings disappoint – reference the woes of Tencent over the past year.)
Fortunately, our buy lists are currently full of many good stock ideas – both from the JSE (which offers particularly good value) and in out-of-favour global sectors. These stocks are not popular and do not feature prominently in the quality indices or funds. Yet, we contend that many of the stocks that are currently perceived to be riskier (either because they are cyclical or because earnings are depressed) are actually a safer harbour for capital at present — contrary to the consensus view. This is because they are cheap and likely to see superior profit growth and rising returns on capital in the years ahead. This is where the narrow current definition of quality will fail investors – they will miss stocks where returns were temporarily depressed, instead favouring stocks where returns are unlikely to sustain the high levels of the recent past.
There are some very important (and worrying) developments in the world right now. We worry that most investors are failing to understand the significance of these developments and are investing as if the future will look like the past. This means that the knee-jerk default to what has worked in the past when searching for safety and capital growth will probably disappoint. At times like these, a differentiated perspective can add enormous value as part of a holistic portfolio.