230. Profits today rather than speculative growth tomorrow

TRANSCRIPT: EPISODE 230
Published 22 December 2022 (pre-recorded 1 December 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRO]

Chris Salih (CS):

Hello and welcome to the ‘Investing on the go’ podcast. I’m Chris Salih, and today we’re joined by Steven Smith, Investment Director for the Elite Rated Capital Group New Perspective fund. Thanks for joining us today, Steven.

Steven Smith (SS):

Good morning, Chris. Thanks very much for having me.

[INTERVIEW]

(CS):

It’s no problem at all. Let’s start with the original premise of the fund, which was to exploit the changing patterns of global trade. So, let’s look at globalisation and the idea of: is it dead? Is it not dead? I mean, I’ve heard it called things like slow-balisation recently. Can you maybe give me some examples of how global trade has changed over the years, to bring us to the point where we’re at now today?

(SS):

Sure, absolutely, Chris. Maybe – just before that – maybe [I can] just start by giving a few introductory remarks and take a quick step back, and just remind the listeners of what the New Perspective fund is, what we’re trying to achieve and the types of companies we’re investing in.

So, just very briefly, to remind everybody, it’s a 49-year-old, actively managed global equity fund, and we’re trying to deliver long-term capital growth. And from its inception back in 1973, we’ve really deliberately tried to invest in, and thrive on, long-term change. So, specifically what the Capital Group New Perspective fund’s trying to do, is pursue long-term investment opportunities arising from changing patterns of global trade, changing economic and political relationships, and the various multi-generational secular shifts in the global economy.

And it really does this on a bottom-up, truly company by company basis. And what we’re doing is investing in a spectrum of multinational companies that range from those small to medium-sized, fast growing, early-stage multinationals – so, hopefully the potential future global champions, all the way up to the established multinational champions of today.

But to directly answer your question, is globalisation dead? I think the short answer is no. I think it’s easy to say that the world is de-globalising. I think it’s easy to say that globalisation is retrenching and proponents of this view would probably point to a few things. They would likely point to a slowdown in growth of global trade over the last decade. They would talk to the rise in populist political agendas, the increase in tariffs and trade war tensions. They’d probably also point to the onshoring and near-shoring of supply chains, you know, in response to the covid disruption. But we don’t think globalisation’s dead.

Instead, we think the form and the nature of globalisation is changing. And one of the big changes today, we think is in the definition of trade, Chris. So, we’ve always employed a deliberately broad definition of trade. And that definition has probably evolved. So, when we set up the fund in the seventies, it was more about physically traded goods. That’s how people define trade. I think today that definition of trade is probably at an inflection point where it’s more about the exponential growth of intangible data and information flowing around the digital economy. It’s more about services than it is about cross border, physically traded goods.

So, I guess my final point on this question would be, rather than seeing a reversal in globalisation, multinational companies, or at least the ones that we are trying to invest in, they are adapting to the changing trade environment. So yes, companies will likely remain global in their production facilities, in their client bases, and yes, companies will continue to probably outsource parts of their production and supply chain, but I think increasingly, they’ll build more locally based operations to strengthen supply chains, to improve the resilience of supply chains, to get closer to their end markets. So, I think rather than de-globalisation, I would probably call it multi-localisation or re- globalisation.

(CS):

Okay. One of the shifts we’ve seen in equity market leadership is that rotation from growth to value. I mean, it’s a bit of a strange time really to look at either of them, but maybe give us your thoughts on that and how that sort of affects the fund.

(SS):

Sure. A very good question. Very topical question. Again, first of all, we don’t view the investment landscape, Chris, in these very binary terms of value and growth. And we’re certainly not constructing the New Perspective portfolio based on any top-down views on the relative merits of one style factor over another. But, as you say, year to date, we have witnessed an extraordinary rotation in equity market leadership; crudely speaking, out of growth into value as you said. And that rotation has been one of the quickest and biggest in equity market history. So, almost touching the extremes of the TMT [Technology, Media and Telecoms] bubble bursting in 2000 … in the early two thousands.

And I think we all know the reasons behind this move: higher, stickier, more entrenched inflation than most people and central banks initially thought. And that’s led to very aggressive monetary policy tightening by the world’s central banks, and, of course, spearheaded by the Fed [Federal Reserve].

Now, when I’m asked: “can value carry on outpacing growth?” I think the easy answer is probably not to the same extent that we’ve seen since the rotation in equity markets that began in November of 2021. So, since November of 2021, value on a global basis has outpaced, has beaten growth, by about 30 odd percent on a relative basis. That’s a big number over such a short period of time. But I think there’s a more nuanced answer, Chris, to your question. And that is, we’ve seen a number of previous periods where value has outpaced growth for prolonged periods of time. So, over the 50 years that New Perspective has been around, value has led the market between ‘75 and 1984. Then again between 1987 and 1994, and then again, in the aftermath of the TMT bubble, so 2000 to 2006.

So, look, it’s happened in the past, it could happen again. And typically, as economies evolve, as they go through big structural changes, like now, what you find is that stock markets typically enter new market cycles. And when stock markets enter new cycles, new equity market leadership often forms.

There’s strong evidence as well to suggest that market leaders before and after bear markets, are rarely the same. Now the obvious question then is, well, if growth led the market for the last 15 years, and you’re saying we’re entering a new cycle, what does that mean for growth investing? We’re not writing the obituary of growth investing. We’re not certainly saying that growth investing is dead, but if the next cycle is to be defined by ‘higher for longer’ inflation and ‘higher for longer’ rates, then we need to be even more discerning, even more selective in the type of growth company that we invest in. So, we need to really focus, I think, on the quality – we need to focus on what I define as shorter duration growth companies. So, companies that can deliver and generate cash flow profits and growth today, rather than speculative growth, cash flows and profits that may or may not materialise 5, 6, 7 years down the road.

So, basically, I think Chris, going forward, equity market leadership could well be more, excuse me, less one-dimensional, less binary, not as simple as growth versus value, not as simple as US versus non-US, not as simple as large versus small cap. Simply put, a greater breadth of equity market leadership could unfold in the next cycle. And that’s good for active stock pickers like us.

(CS):

I mean, you’ve touched on it there. I mean, if we’re in a world where high inflation and high interest rates and you’ve talked about how that affects the economy, even if you know inflation halves from here, does that change the approach to the portfolio from what it may be now? I mean, can you maybe just touch on that for us as well, please?

(SS):

Sure. I think, you know, so I’ve just said that we do think there’ll be a greater breadth of leadership going forward, and we think that’s the stock … that we have entered a new cycle. As you say, even if inflation halves, that’s still structurally higher than we’ve seen for the last 10 to 15 years. And so, we have… New Perspective does have this structural flexibility, it has the ability to reposition to capture the next cycle and the next generation of global economy leaders and stock markets, because it’s a core but structurally flexible, global equity fund.

So, what have we really been doing? Well, first of all, I think the big news is we have been reducing the growth exposure in the portfolio that started in 2019. Chris, it didn’t just happen, you know, in response to the market rotation year to date. It’s accelerated into 2022, but that pivoting away from some growth companies started almost four years ago. And we’ve really been reducing different growth companies by different amounts and for different reasons. Some of those reasons include risk control purposes, profit taking, sometimes a change in the investment thesis, sometimes a recycling of … basically recycling into newer, more higher conviction ideas. And generally moving away from high multiple growth companies where the valuation is dependent on growth further out, meaning those companies are more susceptible to higher rates.

But, importantly, we still have a conviction in high quality growth franchises, but we do expect Chris, earnings growth to be the big driver, the primary driver of stock and stock market returns going forward rather than PE expansion. So, we still have a good conviction in the power of innovative companies across the economy, but it’s a focus on near-term profits and cash flows.

(CS):

Okay. Obviously one of the things that’s well known about the fund is, it has a number of managers behind it, but obviously, we are in a different world in a different cycle, and, as you mentioned earlier, it’s been about, you know, the best part of 20 years since the start of a new value rally in the back of the sort of TMT bubble. A lot of fund managers haven’t really had to deal with this type of environment before, of low rates, etc. It’s a totally different sort of beast to what they’ve been used to, to what any of us have really been used to. I mean, how’d you go about that? Are the rules the same perhaps, you know, 15, 20 years ago [to] how they are now? Is that something you have to take on board?

(SS):

It’s, again, a very good question, Chris. I definitely agree with you that there are large swathes of investors in the equity markets today that have not invested in this type of inflation environment, let alone the potential stagflationary environment that may or may not, you know, ensue next year.

So, I think because of this, Chris, you know, what we’re finding is investors to some extent are struggling to appropriately value, call them growth companies, struggling to value appropriately growth companies in this higher inflation and higher rate environment. And that’s leading to a lot of the outsized volatility that we’ve seen in growth stocks over the last 12 months or so. If you think about it, Chris, pre-global financial crisis, a 4-7% interest rate environment was considered normal. Today that is considered abnormal. So, certainly a couple of things we’re doing… what we’re doing is the very experienced PMs [portfolio managers] within Capital, are telling our analysts to really look at the last 20 and 30 years, rather than the last five years, when valuing companies, when assigning multiples, when thinking about the appropriate discount rates.

I think what gives me comfort though, is that if you look at the portfolio managers in New Perspective, there are nine global equity PMs, six of them have 30 or more years of investment experience, and two others have 24 and 27 years of investment experience respectively. So they do, they are tenured, they have a long history of investing through a variety of different market environments. If you’ve only got 15 to 20 years, and that’s still a decent number, Chris, if you’ve got 15 to 20 years of investment experience, you’ve only ever invested in basically a growth – roughly a growth market. So, the vast majority of the portfolio managers in New Perspective have been around for a quarter of a century or more. That gives me good confidence.

On top of that though, Chris, I just want to remind people about the durability of New Perspective. It’s 50 years old nearly – it’s 50 next year – so, it’s time tested. You know, when we launched this five decades ago in the seventies, inflation was higher than it is today, and protectionism was greater than it is today, and the fund still did well. And if you think about what the fund has gone through, you know, it’s battle tested, it’s hardened, it’s successfully navigated the energy crisis in the seventies, various inflationary environments and deflationary environments, big swings in exchange rates, big shifts to the structure of the global economy, lots of recessions, various financial market bubbles and burstings, unparalleled central bank monetary policy experiments and a global health pandemic. You know, it stands the test of time.

The other point, just the final point would be, you know, our analysts – having highly experienced analysts is really important right now. Our analysts are career analysts, which means they often cover the same industries and sub-industries for their entire careers, which means they become absolute experts in their field of coverage. The other point is they are investment analysts. They are not research analysts; they’;re not just recommenders of ideas, they are fully part of the money management process. So, what we are asking very briefly is all of our analysts to invest in a very small number of their highest convictions in the industry or sub-industry that they’re responsible for covering. And around one fifth of the New Perspective assets, is managed by what we call the research part of the portfolio. That’s where our analysts are managing money. So, we think at times like now, having career investment analysts is really, really important.

(CS):

And just finally, we’ve of touched on it a bit, how we see the market going, the views on globalisation, the chance that value might be a prolonged rally on this occasion. Maybe just give us a bit of an outlook for the year or so ahead and what are the changes you’d like to see coming through?

(SS):

Sure. So, let’s take the first part then, outlook for 2023. First of all, there is no single Capital Group house view. We have, you know, hundreds of different investors and there is obviously an array of different opinions. And what we’re not doing, Chris, is investing in companies and constructing the portfolio based on a 12-month view, right? This is about, you know, looking at companies and the investment landscape three to five years minimum, and beyond.

But let’s answer your question directly – outlook for next year. It is possible that we enter a synchronised global recession as the effects of tighter monetary policy, the stagflationary shocks and the weakening labour market really start to take effect. But the duration and magnitude of the slowdown or contraction will be different in different regions, most probably. And that duration and magnitude will be probably determined by, first of all, how aggressively central banks choose to fight inflation down to target or not, and the extent to which governments choose to deploy fiscal stimulus, or not.

The second big point I think with respect to next year, is that currently equity markets, especially the US, are not pricing in a recession next year, certainly from an earnings point of view; we still have a positive earnings number for next year in terms of earnings growth. So, we think that it is possible that we see another downward phase to this current bear market. And that could be driven by the earnings recession, the earnings decline, because we think earnings are probably too high if we’re to enter a recession next year.

But the good news is that stock markets, as we all know, are typically forward-looking discounting mechanisms. So, we don’t need to find the bottom of the economy or the economic contraction, before stock markets start to rebound and anticipate an economic recovery.

I think, as I said earlier, that we think we’ve entered a new cycle and we think that new equity market leadership will form, but that doesn’t mean growth investing is dead. We think that corporate earnings growth will be a bigger driver of equity returns, both individual stocks and stock markets going forward, because typically you get PE [price/earnings] expansion in low and declining interest rate environments, and we just don’t foresee that next year.

And we also think that certainly going forward that, as I’ve said a few times, that stock markets will be less one-dimensional, less binary. It won’t be as simple as growth versus value, US versus non- US; a greater breadth of equity markets leadership may well unfold.

And then just to finally finish off with your second part to your question, thinking further ahead and what could come through in the portfolio. I’ve said we’ve been repositioning gradually over the last few years; that’s accelerated into 2022, as we really try to set up the portfolio for the next three to five years.

Five points I’d just like to finish up with in terms of positioning. We do still have a conviction in the number of high-quality growth companies, but we expect earnings growth to be the main driver of future returns.

Secondly, we do still have a focus on certain growth companies, but it’s about the growth companies delivering cash flows, profits today rather than speculative growth further out. We had, and thirdly, we have been moving away from those high multiple companies where the valuation is dependent on growth further out and therefore, they are more susceptible to rising rates.

I think the fourth point is really important. We’ve been using the flexibility to change the portfolio’s positioning. We’re starting to invest more in healthcare now. So, companies where there are traditional large-cap pharma companies that have not just visible, but arguably good durable earnings growth going forward, we’ve been adding to selected smart industrial companies that we think can form part of the solution to decarbonise the global economy.

And we’ve been adding selectively to certain commodity miners and refiners. So, copper and lithium producers, for example. Those metals will form part of the solution to electrify and lower the carbon intensity of the global economy.

And then just finally, what are we doing more work on? So, we are trying to look at companies that could become the enablers, that could provide the picks and shovels that will enable Europe to accelerate its energy transition. We’re trying to identify companies that could benefit from the changing nature of globalisation that we’ve been talking about, and the benefit from the supply chain reconfiguration that we’ve been discussing.

As we think about an economic slowdown and possible contraction, we’re trying to find companies that have more visible and resilient earnings. I’ve mentioned healthcare, but we want to find more. We’re trying to also capture companies or investing companies that will be successful in capturing changes in consumer behaviour, as inflation eats a growing share of consumer wallets. And with that inflation outlook in mind, we still want to find companies that have good pricing power. So, the ability to preserve margins as costs continue to remain elevated.

(CS):

That’s great, Steven, thank you very much for joining us today.

(SS):

My pleasure, Chris. Thanks for having me. And look forward to speaking soon.

(CS):

And if you’d like to learn more about the Capital Group New Perspective fund, please visit FundCalibre.com and while you’re there, remember to subscribe to the Investing on the Go podcast.

[OUTRO]
Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.