Discretionary Investment Management | Ben Byrom
01 Jun 22
“To be greedy only when others are fearful” - Global Blue Chip Investor Update (Pt.3) - June 2022
If you have read the previous two investor updates you will know how we are currently positioned, what we own and the type of business we would ideally like to own, should we be gifted the opportunity to do so. What we haven’t explained is how we intend to get the portfolio from where it is today to where we would ideally like it to be. In this note, we detail that plan but as you may already know from reading part one, no plan is foolproof – especially after the ‘first punch to the mouth’ – and this market has already dealt its fair share of blows!
What’s the main objective?
We have always wanted to own some of the biggest and best companies that are aligned with our investment themes. Our focus on quality (the subject matter of part two, ‘Wonderful’ businesses at ‘wonderful’ prices) remains the same, as is our desire to buy such quality at a reasonable price. Finding ‘mispriced’ quality during the age of quantitative easing has been very difficult, however, the macro-economic landscape is changing rapidly as a disinflationary backdrop and easy monetary policy gives way to inflation, interest rate rises, and a more hawkish approach by central banks.
This transition from loose to tight, disinflation to inflation, low interest rates to a rate rising regime, creates a new set of problems, but also its fair share of opportunities.
What will be the biggest problem that we are likely to face?
A sustained inflationary environment will see materially higher interest rates. This will increase the cost of capital and therefore the discount rate investors apply to a company’s future cash flows in order to determine a net present value from which a valuation can be derived. The higher the discount rate, the lower the amount an investor would be willing to pay for that future cash flow stream. Arguably, the number of rate hikes expected by the market has already been factored in by equity prices. The unknown factor is whether inflation remains higher for longer and if further rate hikes are required.
Rising inflation will create higher input and operating costs for companies, potentially squeezing margins and profitability. Costs for energy, raw materials, ingredients, packaging etc. are already rising due to Covid disruptions and the Ukraine/Russia war. Should inflation become a sustained phenomenon, we should expect companies to incur higher wage bills and higher costs for other services, property and equipment, and their maintenance. In other words, expenses will rise and companies will have to combat this by increasing prices. This is why we have always favoured companies with pricing power (the ability to be able to raise prices – without unduly impacting volumes).
Economic growth may also be a problem. If you read the papers and study the stock market, a recession seems to be considered a highly likely outcome. With a Federal Reserve determined to destroy demand and bring it more in line with (Covid disrupted) supply, a ‘hard landing’, i.e. recession, is favoured amongst most market commentators. This is why we try and look for economic agnostic growth due to product/service quality and product/service criticality. Is the product important enough or good enough for consumers to carry on adopting it and/or pay higher prices for it?
The biggest problem investors are likely to have is with themselves. Keeping wealth intact through a bear market is tough.
Emotions can run high and it’s important to be able to see the wood for the trees as the narrative and headlines are likely to be very powerful. Negative narratives can invoke panic selling or hesitant buying and drive prices down below fair value into bargain-basement territory. For the patient (and prepared), this can be a very fruitful environment festooned with opportunity.
As Warren Buffett wrote in his 1986 letter to Berkshire Hathaway shareholders:
“What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
Are we there yet?
Whether we are there in terms of maximum fear is unknown. Based on the Fear and Greed investor sentiment index highlighted in part one, investor sentiment has been pretty dismal of late. However, just because sentiment is poor doesn’t mean a bottom is in. As Mr Buffett suggests above, predicting times of maximum fear and greed is unpredictable, which is why we have always based the decision to own what we want to own on when valuations are attractive enough, thereby compensating us for the risk inherent within the investment.
Despite trying to discover a price at which we feel stock-specific risks are adequately compensated for, we cannot do much about the overall volatility of the market. As we highlighted in part two, we want to own the very best and it is our intention to ‘load up’ when they are cheap. Quality and cheap are two adjectives that are rarely used in conjunction with each other, yet you will see them during times of maximum fear, holding hands at the edge of the precipice, where investors are throwing in their towels, vowing never to buy another equity ever again!
Deciphering what constitutes as cheap is a hugely subjective matter. As a team, we have always been conservative in the way we model and forecast for the purpose of our discounted cash flow models which we use to determine the return potential of an investment – commonly referred to as the internal rate of return (IRR). We would typically look to initiate a position in a stock that offers a 10% IRR. We set this hurdle based on the assumption that a 7% IRR, all things being equal, would attain roughly the same rate of return as the broader market. The additional 3% would act as a margin of safety should we have overlooked something in the research or the company surprises with some negative news. If everything goes to plan, we should, theoretically, achieve an above-market rate of return.
It has been almost impossible to buy “10 percenters” during the easy money years between 2016 and late 2021 (unless, of course, you selected growth and margin assumptions to suit). As stated above, we do not participate in this folly, trying instead to be as conservative as possible without unduly handicapping ourselves.
That said, the number of high-quality stocks on our reserve list entering our buy zone is increasing at a rapid rate.
The two questions that plague us right now are 1) whether 10% is enough given the uncertainty surrounding future economic growth, inflation trends, rising costs and the impact on profit margins at a time when central banks are looking to quell demand, and 2) which ones do we bring into the portfolio and which ones do we remove?
Nobody said it would be easy!
I started my investment career in 2001 during the 2000-2003 dot.com bear market. It was a prolonged and often brutal affair with lengthy periods of price declines punctuated, seemingly from nowhere, with vicious rallies that would wrong-foot many investors – often sucking them back in just before prices resumed their downtrend. It was probably the best grounding an investor could have asked for; conservatism has been seared into our approach as a result.
Unfortunately, there are few seasoned investors that had hands on the tiller of an equity strategy during the 70s who remain with us – an environment many commentators point to as resembling the scenario investors face today. However, we have studied to some degree that period and the more successful investors of the time owned companies that had pricing power and growth, and importantly they bought them on valuation multiples that were very, very attractive. To illustrate our point we will release an addendum to this series with examples from the period.
In order to give us the best chance to make money in this environment we will first need to minimise the downside. The best way to achieve this is to avoid overpriced securities in the first instance, thereby avoiding the worst of the sell-off. We believe that our conservative approach over the past few years has helped to do a large part of the sidestepping so far, the next step will then be to own the highest quality portfolio with the most attractive valuations on offer. This will require venturing to the precipice, no doubt at times of systemic or idiosyncratic turmoil and negative narrative, to grab ‘cheap quality’. We’ll make room for the most attractive all-round propositions through a process of consolidation and prioritisation with the intent of emerging with an even more robust and relevant portfolio for the environment we eventually transition into. That’s the plan anyway… now where is that smack in the mouth?
If you have any further questions about the Blue Chip strategy or any of your investments, please do not hesitate to get in touch.
The Global Blue Chip Team