Substance Always Wins Over Style
CIO Robert Horrocks, PhD, explains how inflation has brought with it aggressive shifts in investment themes but ultimately it’s the attributes of companies that determine portfolio returns.
The year 2021 was the year when many of the trends of the past decade suddenly reversed. These trends are all related in some way to the inflationary environment and their aggressive change in direction began to take hold last year amid the onset of rising prices.
The first trend concerns the relationship between growth stocks and value stocks. This might be described as the difference in performance between stocks whose value lies mostly in the far future versus those where a much greater proportion of their value lies in the present and immediate future. The value of growth lies in the return to patience and therefore must surely be tied to real interest rates. Consequently, any event that will raise business costs and interest rates, thereby depressing profits and raising the discount rate, is likely to hit those companies hardest. And so it proved to be in 2021—with biotech companies, innovative tech companies, and many of the exciting IPOs of last year losing much of their value. Put bluntly, investors’ patience ran out when it came to unprofitable growth businesses.
While there have been some sharp corrections among growth stocks, it doesn’t necessarily mean that in inflationary times, investors should bluntly favor value over growth. There will be many growth stocks that I’m sure will do well. And I’m not going to try and predict further swings in growth and value styles but will happily state the obvious that the valuations of some secular growth companies now look a little more attractive relative to quality defensives.
Much like ‘growth versus value,’ mega caps had been trouncing small caps for the past few years. This trend, too, reversed in 2021 and is probably due to the fact that more liquidity affords marginal companies an easier financing environment. Perhaps pressures on global supply chains have also given some companies a rare opportunity to increase bargaining power. So we may be embarking on a period where the earnings capability of smaller, innovative companies increases and the value of these stocks gets increasingly recognized by the market.
The next reflationary trend-reversal was that of the sudden outperformance of more cyclical businesses. These included some manufacturing companies as global inventories were rebuilt, some consumer discretionary sectors, as the extraordinary counter cyclical behavior of consumer buying in the West continued, and of course raw materials and financials which often benefit from reflationary environments. We may see expansion in 2022 among such cyclical sectors as manufacturing, retail and leisure, and financial services. But again, this is by no means cut and dried. Over the past few months, for example, some manufacturers have been hurt by supply chain shortages while fast food-chain operators have struggled with high labor costs. Conversely, semi-conductors have been strong as the chip shortages continue and some multinational consumer stocks have also fared well.
So as we digest the volatile start to 2022 and look ahead to what could be a challenging and unpredictable year, we can undoubtably expect to see inflation continuing to impact investors’ portfolios through various style shifts. But it is crucial we stay focused on the fundamental strengths of individual companies, particularly in emerging markets, whether they are deemed to be growth or value, large cap or small cap, cyclical or secular, as we seek out the sustainably growing quality franchises that are out there.
Robert Horrocks, PhD
Chief Investment Officer