As Warren Buffet once said: ‘Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years’. Wise words, which many investors would do well to heed at present. However, with equity markets reacting to the ongoing tension between inflation and interest rates, changing consumption patterns and the uncertain outlook for corporate earnings, market participants could perhaps be forgiven their short-term horizon at present.
Q1 earnings season demonstrated the prevailing market mindset. Company fundamentals are usually at the front of investors’ minds, however, in the face of the geopolitical and macro situation, investors were somewhat distracted this quarter. Moreover, although company management teams generally reported better results than the market had been expecting, the focus was very much on the outlook statements from companies, and these typically had an uncertain tone to them. This has contributed to a less-than-positive dynamic to equity markets.
The long game
The emphasis on tangible value and short-term cash flows has meant that the more intangible drivers of long-term value creation have received less attention of late. However, we believe that now is the time – more than ever, in fact – to pay attention to financially-strong businesses displaying a competitive advantage through their extra-financial forms of capital.
Such intangibles can include:
- Corporate culture
- Employee and customer engagement
- Effectiveness of R&D
- A willingness to place a high degree of importance on ESG factors
Businesses create contingent assets that can have a short-term financial cost, but pay off handsomely over the longer term. These non-financial assets are rarely found in annual reports and accounts. Information on them is hard to access, assimilate and conclude upon. However, they are nonetheless a powerful predictor of long-term financial performance.
Businesses which understand that they are more than just their capital are in an ideal position to navigate their way through the current uncertain landscape and turn their competitive advantage into financial results. Indeed, the importance of contingent assets like innovation, culture and human capital become even greater in challenging times, as was demonstrated during the pandemic, as it is these intangibles that will ensure a company is able to remain relevant for customers and add value for stakeholders.
Untapped opportunities
The fact that many investors have overlooked these sources of longer-term value creation of late, means that there are significant amounts of untapped alpha opportunities, which are latent in a lot of the great businesses we invest in.
Underappreciated alpha from overlooked companies can play a valuable part in portfolios. Not only do better businesses have strong ESG footprints, lower portfolio turnover and reduced transaction costs but crucially, the out-performance derived from non-financial sources is idiosyncratic in nature and has a low correlation to more traditional systematic, quantitative sources. They are a different ‘flavour’ of outperformance, or true alpha, and so including these alpha sources can diversify the return stream of a portfolio.
Furthermore, the benefits are significant for investors who think like business owners and invest in such businesses for the long term. By assessing each company’s competitive dynamics, we understand the risks and opportunities facing businesses and we continue to engage with management post investment, promoting principles of responsible business and effective stewardship. Great businesses also bring ingenuity and resiliency and in times of uncertainty, these two key characteristics are especially valued by investors.
Nothing stands still for long
We believe in the importance of disciplined portfolio construction and maintaining well-balanced portfolios, ready for when longer-term value drivers come to the forefront again. Diversification is key, as it minimises the effects of any negative outcomes from market unpredictability, and it is why we believe in having a team of specialist portfolio managers with a wealth of experience across sectors.
We believe that the persistence of returns from stock-specific risks is associated with great businesses at attractive valuations. Alpha is not always transmitted from companies through share prices to a portfolio in a smooth manner, but neither does the value created by these businesses disappear if share prices don’t immediately respond. As long-term investors, we know that in uncertain times, alpha will be recovered in due course. Our portfolios remain diversified, ready to capture this alpha when it is recognised by the market.
The recent volatility is also a test for management teams and business models. Change creates investment opportunities for active stock pickers and we remain of the opinion that the best businesses will be best positioned to exploit those opportunities as they emerge. We note that the market volatility has resulted in significant changes in valuations for many companies and so we are actively reviewing those opportunities where we believe the fundamentals of a business remain attractive but the valuation has become more so.
Conclusion
In sum, predicting short-term outcomes from the current macroeconomic and geopolitical uncertainties is fraught with uncertainty.
Accessing and analysing untapped alpha sources requires a philosophy, process and team that are sensitive to non-traditional information, with team members having the sector expertise necessary to filter out market noise.
Our repeated emphasis on constructing concentrated portfolios of businesses with strong competitive dynamics means that we are convinced of adding long-term value for our clients, regardless of the market environment.