By Carl Stick and Alan Dobbie
Financial markets’ wild gyrations have intensified still further in recent weeks. The implications of potentially generation-busting inflation finally seem to be hitting home. What happens next depends on several huge considerations: There’s the war in Ukraine, the pandemic – especially its resurgence in China – and the lifespan of the post-pandemic economic recovery. Added to that is the broad retreat from globalisation, the shift towards an older population and, of course, government policies and central bank decisions.
It’s a veritable shopping list of big-ticket stuff. Who knows what might happen when all these things collide? In our truly unpredictable world, there’s only one thing that investors like us can control: our calculation and assessment of the value of the assets we choose to hold on behalf of our unitholders.
Valuation is key for us – and it always has been. So we were understandably vexed when we heard a ‘sell-side’ sage confidently assert back in November that “valuations do not matter”. This claim supported a bullish thesis promoting a long list of US-listed ‘growth’ and technology stocks identified as being deservedly expensive because their sales were rising much faster than the wider economy. We acknowledge this call worked big time for many years in a world of muted and falling inflation, scarce economic growth and record low borrowing costs. But all things must end.
We were frustrated that the sage didn’t seem to recognise that we might be shifting away from that disinflationary paradigm (even if the war in Ukraine and the inflation spike still hadn’t happened yet.) Were we observing a world different to everyone else? What were we missing?
Well, maybe we weren’t missing much after all.
Did we predict a ‘value’ resurgence?
Back in May 2020, most investors simply didn’t countenance the possibility that inflation could make a comeback. This was reflected in the values afforded to companies, industries and markets deemed to be part of the ‘old economy’ – investors eschewed commodity stocks, and financials were absolutely not de rigueur. We felt some outcomes (including an inflation resurgence) were being under-priced, under-appreciated and under-investigated. As a result, we started to allocate a bit more money to ‘reflation beneficiaries’, like mining companies, to the oil sector and into banks.
We gave a press interview at the time that was headlined “Rathbone Income duo eye risk of ‘vicious’ value resurgence.” Back then, the headline felt too extreme, but actually it turned out to be pretty accurate. We weren’t definitively predicting that inflation would reappear, but simply acknowledging there was a risk it might.
Let’s look back and compare the performance of the long-maligned FTSE All-Share Index over the two years since May 2020 with that of some stocks widely recognised as ‘COVID winners’. The FTSE All-Share is up by 32%., but the share price of Amazon (a beneficiary of COVID lockdowns if ever there was one!) is down by 7%. For balance, we must highlight that Microsoft’s share price is up by 43%, but the third of our cherry-picked ‘pandemic winners’, Netflix, is down by a whopping 56%.
This wobbly performance isn’t just a function of the big hit that technology has taken this year. In fact, all three ‘pandemic winners’ underperformed the UK market, and the UK equity income sector specifically, very substantially in the 12 months after that 2020 headline appeared. No one, not even biased observers like ourselves, would have made that prediction. Think back to how you were probably thinking in May 2020. UK equity income was unlikely to be on your mind, yet it turned out to be a better place to be invested than the Nasdaq!
Suddenly breakneck revenue growth that does nothing for profits – and in some cases even reduces profitability – is no longer seen as such an attractive attribute.
Valuation does matter
Inflation, and the interest rates required to combat it, reduce the price multiples at which people want to buy shares. Investors use rates to discount the value of companies’ future earnings back to today: higher rates diminish the value of distant earnings. In simple terms, share prices go down when that value drops. The key takeaway here is that investors can’t forget that valuations are important or pretend that any price you pay for shares is as good as any other.
For us, as managers of our Rathbone Income Fund, valuation really matters. It’s one of our three investment pillars. We spend a lot of time trying to figure out what’s ‘in’ a share price so we can determine if there’s an opportunity for us.
It’s not a case of trying to predict the future, it’s a matter of trying to insure ourselves against as many possible futures as we can. It may not sound exciting, but it is what we believe investors in UK equity income funds require.
