Portfolio positioning
So far in this mini-series we’ve looked at how the post-pandemic period brought a juddering halt to decades-long financial conditions, and how the economic landscape might change as a result. Now we turn our attention to equity investing specifically, and how we might approach the coming decade.
Diversification
If the past decade-and-a-half was all about concentration, the coming decade is likely to value more diversification. In the 13 years following the global financial crisis there was no earnings growth in aggregate, so portfolios were concentrated where growth could be found. Global equity portfolios with 20 stocks were feted.
Going forward, earnings growth will be higher (zero is not a high bar) and more evenly distributed. For life insurance companies the yield on their portfolios is going to be rising each year, but could their earnings growth now be competitive? Is it safe to ignore the sector completely? Oil companies have changed. They have been underinvesting for an extended period, raising the prospects of a tight oil market. It will still be a cyclical sector, but managements’ focus is free cash flow and cash returns to shareholders. Is it safe to ignore the sector completely? Are there other long-forgotten corners of the market deserving a rethink? I doubt a 20-stock global portfolio is a sensible idea in the new era.
Quality
Columbia Threadneedle Investment’s philosophy is quality growth. A quality business has competitive advantages which translate into high profit margins, strong cash flows and predictability. Significant loss is hard to recover from in a portfolio and sticking to quality reduces that risk. What will be critical in the coming decade is balance sheet quality. Low interest rates made it attractive for some low growth/ROIC (return on invested capital) stocks and sectors to employ leverage to be competitive. These companies face year-by-year rises in their interest costs as their bonds mature. Unless they have the free cash flow to pay down that debt, they face a troubled future.
Growth versus value
Pre-GFC this wasn’t really a debate. While there were differences, they didn’t define the period. Excluding the tech bubble, the returns of MSCI World Growth and MSCI World Value showed a correlation of 0.88; post-GFC that fell to 0.72. Now you can start to make a career out of that difference – if you can predict it. The correlation could be meaningfully higher in the coming decade. As the maturity of the S curve of adoption slows, the growth of certain mega cap tech names will slow, just as the denominator of the average company improves. So the gap in earnings growth will be materially lower. That said, quality businesses that can compound are tough to beat. Investors mustn’t pay too big a premium for these businesses because valuation uplift will no longer bail you out.
Technology
The sector has been at the heart of our global equity portfolios for a long time. The rising tech intensity of GDP is a secular trend and one we believe could continue, perhaps even accelerating over the next decade (Figure 1).
Figure 1: tech intensity of GDP
Source: Columbia Threadneedle, as at December 2022
In addition, competitive advantage in tech can be so compelling, leading to the emergence of oligopoly or even quasi-monopoly situations. The durability of these competitive advantages is more debatable. However, the amount of value added they produce during their period of dominance is extreme. The typical software business has gross profit margins of more than 70%, and the incremental cost to serve the next customer is low, which makes these exponential businesses. They don’t inhabit the linear world of the industrials and consumer sectors, which is why it is often said that the value add accrues to the software layer in an industry.
Tech is likely to remain at the heart of Columbia Threadneedle Investments’ portfolios in the coming decade, though the names will likely change as new product trends emerge to replace the smartphones and online advertising of the past decade.
Secular trends
The majority of these don’t carry tech’s emotive debate. The ones we like are better defined and where we believe we can find a competitively advantaged company that can profitably exploit that trend:
- more spirits consumption; less beer
- more chips with everything (semiconductors)
- more electrification
- more plastic payments; less cash
- more video games; less TV
- more insurance cover in Asia
- more market share for private banks in India
- more healthcare
- more renting/sharing; less buying
- fewer potholes in our roads
- more social media; less real world (I didn’t say they were all good)
- less obesity (I can always dream!)
The hurdle of the interest rates available on cash and the yields on bonds are a challenge to equity markets. But equities have the backing of higher nominal GDP growth going forward (immediate recession prospects aside). As a result, successful equity portfolios are likely to be more diversified than in the post-GFC era, but quality compounders will still form the core of the portfolio.
While the growth versus value debate may fade in intensity, with narrowing growth differentials, there will remain a soft spot for tech given their unique characteristics as businesses.
Following the GFC zero interest rate environment, many took on risks and structures in portfolios to preserve returns. Now with “normal” interest rates, are all these alternative assets needed?
Good luck in the new era.
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Click here to read Neil’s “New Era” viewpoint in its entirety
