January was a tough month for global stock and bond markets, and February has been no different. Inflation has increased expectations of interest rates rises and is putting pressure on companies’ profit margins. Russia’s invasion of Ukraine has exacerbated these inflationary risks. The conundrum for investors (and central bankers) is what this means for economic growth and the business cycle.
In the Tellsons Endeavour Fund we pay close attention to the progress of the business cycle, investing as we do across cyclical, defensive and growth companies. As a sailor must adjust their sails depending on the weather conditions, so do we. In the early stages of the cycle we let out our sails by investing more in companies offering cyclical or structural growth, but volatility as well. As the economic outlook darkens, we trim our sails, and our defensive holdings act as our hull and keel to keep the ship steady.
Growth companies have borne the brunt of this year’s volatility. Typically, these companies trade on high valuations in anticipation of high profit growth over the coming years. Higher interest rates, however, lessen the value of their future cashflows, and share prices have adjusted accordingly. For example, Facebook and Netflix are both down almost -40% for the year on disappointing user numbers. We do not own either company. Our focus instead is on those that will play a significant role in the ever-increasing need for data and cloud storage. The development of autonomous driving, tech-enabled healthcare, and gaming should be a tailwind for years to come for the likes of Alphabet, Amazon, Microsoft and Nvidia. Perhaps it’s time to replace the FAANG acronym with something new…
Cyclical companies enjoyed a strong start to the year and made-up half of our equity allocation. Higher interest rates are a tailwind for banks, while energy and mining companies offer protection against inflation as their products rise in price. However, higher interest rates and energy prices both act as brakes to the economy and, by their very nature, cyclical companies will underperform as economic growth slows. With events in Ukraine moving fast, the outlook for inflation could worsen. How the consumer fares with higher prices, interest rates and taxes to pay for the pandemic support remains to be seen – but the outlook for growth has got darker.
Defensive companies are characterised by the necessity of their products: food, medicine, electricity etc. The growth rates of such companies are lower, but more stable due to the consistency of demand. They are not, however, immune from commodity price inflation, which is putting pressure on their margins. One of our top holdings, Reckitt, has bucked that trend. The strength of their brands, like Durex and Dettol, mean they can pass on much of this inflation, while a decline in lower-margin disinfectant sales post-pandemic mean their overall margin should increase. Compare this to Unilever (which we do not own) who have warned that it will take two years for their profit margins to regain the ground lost to inflation.
Meanwhile, Astrazeneca, our largest holding, has significantly higher growth expected over the next few years due to the quality of its drug portfolio and pipeline, which we believe will only be bolstered by their acquisition of Alexion. Such growth in a defensive company is rare and I wrote last week about why I feel the market is not yet fully acknowledging it. (https://www.tellsons.co.uk/astrazeneca-not-getting-credit/)
There is some debate as to whether the global pandemic caused a renewal of the business cycle, or just interrupted the cycle that began after the Global Financial Crisis. Either way, the various macroeconomic indicators that we follow clearly show that we are out of the recovery phase and into the mid-cycle. We have adjusted our portfolio accordingly, but we will keep our eyes on the horizon to make sure we continue to optimise returns while keeping volatility low.
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