At the time of writing, the JSE All Share Index is down 10% year-to-date in rand terms. The MSCI World Index has tumbled by 20% and the S&P 500 by 17% in US dollar terms. In our view, the global stock market pain has been inflicted mainly by higher interest rates, as evidenced by both the relative stability of the equity risk premium (the difference between the stock market’s forward earnings yield and the yield on 10-year bonds) and the fact that market forward earnings estimates remain stubbornly high.
Our view is that the steep rise in US short-term interest rates, which is pushing rates up around the world, will act as a drag on economic activity globally. This is of course exactly what rate hikes are supposed to do: cool the economy and thus bring down inflation. Under such circumstances, recession is an entirely possible outcome.
This is also the view of the IMF, which earlier this month cut its global growth forecast for 2023 to just 2.7% (from 3.2% in 2022). Besides inflation and higher interest rates, other (related) drivers of the lower economic growth predicted by the IMF include higher food and energy prices resulting from the Ukraine war, and China’s fragile real estate market and Covid-19 lockdown policies. Apart from the period following the global financial crisis in 2008/09 and the pandemic years, the IMF’s latest global growth forecast is the lowest it’s been since 2001.
PREFERRED BUSINESS TYPES
With this rather gloomy outlook for the global economy over the next year and perhaps longer, what are investors to do? What’s the best way of positioning an investment portfolio to ensure growth over the long term? At Sanlam Private Wealth, our investment philosophy will always centre on price, which we believe to be the dominant factor driving investment performance over the longer term. Having said this, in the face of anticipated lower global growth, there are certain ‘types’ of businesses in which we prefer to invest in the current environment:
Businesses with wide ‘moats’. What makes a company valuable is the ability to continue to earn high returns relative to its competitors and other industries regardless of the economic cycle. It’ll be able to do this if it has a competitive advantage that is sustainable, or what is known as a wide moat. At Sanlam Private Wealth, we’ve identified five main sources of sustainable competitive advantage, in descending order of importance:
- Network effects – the more customers you have, the more it makes sense for new customers to join you. Think of the advantages enjoyed by Facebook and LinkedIn.
- Switching costs – in terms of both money and effort. Imagine, for example, moving your entire business away from Microsoft products.
- Brand/patent strength – Coke, Ferrari, Cartier and Apple come to mind.
- Economies of scale – such as those enjoyed by Amazon.
- Licences – ensuring a limited number of players in the market.
Businesses with wide moats are always an excellent core for an investment portfolio, but they typically deliver their best relative performance in more difficult times. The rising tide of a strong economy tends to lift all boats, but when the tide goes out, companies with stronger business models are more clearly differentiated. A receding tide will pull most boats lower, but the strongest ones will suffer less.
In the South African context, we see businesses like Prosus (which has superb network effects, the most powerful of sustainable competitive advantages) and Richemont (which has incredibly strong brands) as examples of businesses with wide moats.
Companies exposed to structural growth. While businesses with great moats are likely to weather the anticipated economic downturn, they may still display some degree of cyclicality. To ensure an appropriately diversified portfolio robust enough to withstand a variety of outcomes, we also consider businesses exposed to strong underlying structural growth trends.
These companies are partially shielded from the wider economic reality of people having less money available for consumption by claiming a growing proportion of spend. Locally, few large businesses fit this bill, but examples include (again) Prosus and companies like Bidcorp (exposed to the secular trend of less home cooking), Clicks (people are spending more on personal care, and there’s a trend towards continued consolidation of pharmacies) and even Glencore (which has good exposure to ‘green economy’ minerals).
Businesses with self-help stories. When one is worried about what broader markets might do, it’s useful to focus on the shares of companies with self-help ‘stories’ that are more relevant to investor returns than the wider environment. Such businesses are often those that have experienced company-specific problems in the past, forcing the share price down, but where it is anticipated that these issues will be resolved. These are essentially businesses with earnings well below the levels one would expect, even at the bottom of the cycle, and which are being priced as though they won’t recover.
While these businesses may be of lower ‘quality’ than the first two types or buckets of companies, importantly, they are not cyclical. Current examples include Netcare, which is recovering from historically low hospitalisation levels since the pandemic started, MultiChoice, which has recovering African operations, and Spar, whose price is depressed due to heavy investment in new geographies.
ADJUSTING PORTFOLIOS
As always, the most crucial consideration for us at Sanlam Private Wealth is ensuring that – regardless of the bucket a business falls into – we pay the correct price for its shares. Bear markets tend to treat companies with stretched valuations harshly. Since the start of the year we have, however, been more active than usual in adjusting our clients’ portfolios to reflect our views around the evolving economic cycle and to be prepared for lower global growth over the next 18 months or so. In a rapidly evolving environment, we continually strive to position our clients’ portfolios in such a way that they’ll be robust in a variety of outcomes.
