Richard Saldanha and Francois de Bruin give their thoughts on how and where investors can find resilience in challenging economic environments.
Read this article to understand:
- The importance of competitive advantages and network effects
- Why valuation discipline is critical
- The role of ESG in finding sustainable cashflows
The largest inflation shock in a generation; developed market policy rates at their highest levels since the global financial crisis; increasing uncertainty around economic growth. Throw into the mix heightened geopolitical tension and international fragmentation, it is easy to see why many investors have stayed on the sidelines in 2023.
While these conditions have challenged all asset classes, there have been notable outliers, none more so than the handful of US companies linked to the boom in artificial intelligence (AI). If it were not for the contribution of the “Magnificent Seven” (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla), which had returned 92 per cent on average in the year to October 25, both the S&P 500 and broader global equity indices would be flat (Figure 1).
This raises important questions for global equity investors, not only about concentration risk and the wider application and impact of AI across sectors, but also about how to construct resilient and appropriately diversified portfolios.
Figure 1: YTD returns of the S&P 500 and the “Magnificent Seven” (per cent)
Source: Aviva Investors, Eikon. Data as of November 3, 2023.
In this article, Richard Saldanha (RS) and Francois de Bruin (FdB), co-managers of the Aviva Investors Global Equity Endurance strategy, discuss how and where they are looking for resilient stocks, and the importance of competitive advantages, network effects, valuation discipline and environmental, social and governance (ESG) considerations.
In short, how do you define resilience in a global equity context?
FdB: Resilience is when your short-term environment is subservient to your long-term objective and outcome. While it has been a year of significant change, we try and focus on factors that will have a lasting impact. This applies both to the type of companies we look for and our own behaviour.
RS: It’s about being able to sustain performance through periods of stress, whether they be macro or micro related. Often this is something we can attribute to the nature of the business model or even the industry a company operates in.
Aside from the performance of a small number of tech stocks, we seem to have entered a more challenging environment for equities. What are the main implications for valuations and performance?
FdB: In broad terms, global equity markets have seen moderate growth this year. But despite appearances, it has been an eventful period. We witnessed some of the largest US bank defaults in history; the hype around generative AI propelled markets upward; and the rise of Danish pharma company Novo Nordisk to become the most valuable company in Europe. All of this has taken place in the context of the highest interest rates for over a decade.
Managing money in this environment requires a deep understanding of the fundamental drivers of individual holdings
While aggregate performance may appear relatively muted, there is substantial dispersion in performance between companies. Managing money in this environment requires a deep understanding of the fundamental drivers of individual holdings.
RS: Tech has led the way, but looking ahead this performance may be challenged, especially if we are in a higher-for-longer interest-rate environment. If you're looking for companies with competitive advantages and durability in terms of underlying cashflows and earnings prospects, in my view you can still find opportunities, but you need to be selective.
In sectors like health insurance, insurance broking and pest control, there are resilient companies trading on attractive valuations, which we believe can deal with the uncertain economic environment.
What are the main competitive advantages that point to long-term outperformance?
FdB: Competitive advantages allow the persistence of cashflows over the long term. The common advantages we see are brand strength, switching costs and intangible assets. But the most attractive competitive advantage in our view is network effects, the idea that the more customers a company has, the higher the value of its products and services for each customer.
Having a strong brand should lead to repeat business. Take a company like Nike, whose strong brand points to future demand. Switching costs make it difficult for customers to switch providers. Apple is a prime example, with its ecosystem of apps that keeps users from migrating elsewhere. With network effects, you get both brand strength and switching costs, which get stronger as the business grows.
Network effects can be observed across a range of sectors and industries
RS: Traditionally, when one thinks of economic moats, it’s all about having strong brands and then deriving economies of scale on the back of growth. What we have seen over the past decade is the proliferation of what we call a modern type of moat, namely network effects. Whilst this has been underpinned by the advent of the internet and the digital age, it is not exclusive to technology stocks.
Network effects can be observed across a range of sectors and industries – this is especially important in terms of the diversification they can provide in a portfolio.
How are network companies, such as payment card providers and insurance distributors, affected by economic downturns or uncertainty?
FdB: Companies with network effects often end up in a “winner takes all” situation. In a downturn, companies with a monopolistic position have better control over supply and demand and, thus, are more resilient.
Another aspect to consider is the competitive landscape. In an environment with high interest rates and challenges to economic growth, incumbents are in stronger positions. Competitive threats are reduced as companies don’t enjoy the same access to capital, making it harder to compete. Downturns often lead to rationalisation, with customers gravitating towards well-established brands and robust networks.
Companies like Visa, MasterCard, S&P Global, Moody's, Google and Microsoft should be well placed in more difficult conditions. Their advantage doesn’t stem from favourable demand factors, but from a favourable supply environment, due to the difficulties faced by competitors.
Additionally, these companies maintain strong balance sheets, ensuring their ability to sustain cashflows.
RS: In insurance broking, AJ Gallagher provides products and services tailored to regional enterprises, an area that is extremely fragmented from a competitive standpoint (over 18,000 brokers in the US alone). The beauty of its model, and where network effects really come to the fore, is in having a strong local salesforce that has an in-depth understanding of niche industries and, more importantly, deep customer relationships. Its strong networks, coupled with high switching costs, result in exceptionally high customer retention. This business has weathered prior recessions, which gives us confidence in its ability to navigate uncertainty.
Value-add services should further enhance the resilience and durability of payment companies’ business model
In the case of payment companies, the network effect is about having a large number of merchants and customers on the same platform. Take Visa, for instance, which has four billion cards in circulation worldwide that are accepted in over 100 million merchant locations. This is an extremely powerful moat and its dominant market share both in the US and globally. What is even more interesting for us is that we are seeing growth in areas such as value-add services – such as fraud prevention and data analytics for merchants. This should further enhance the resilience and durability of the business model.
It can’t be healthy for stock markets to be dominated by a small number of companies. What are your thoughts?
RS: While concentration risk remains an issue, valuation is a bigger factor. The price you pay for a company is important, as it can give you a margin of safety.
We own the likes of Microsoft and Alphabet. They are companies benefitting from network effects, and are well-positioned for the evolving world, particularly in the realm of generative AI. As they were shunned by the market last year amidst the sharp rises in interest rates, these were the companies we were buying: we saw value and have a high degree of confidence in their business models. This year we have been happy to take profits given the strong re-rating we have seen, although we continue to like the long-term fundamentals in both companies.
Recently, we have been looking to more defensive sectors for opportunities – healthcare being a prime example. The US health insurance industry has proved remarkably resilient over history, yet this year has largely been out of favour as investors chase the next AI-related opportunity. This is where we have been happy to step in where we believe valuations are compelling, and see long-term resilience in names such as UnitedHealth and Elevance.
FdB: Just because some stocks have performed well, that doesn't guarantee they will continue to do well. You need to understand why they are doing well, assessing whether the valuations align with the growth opportunities.
Nvidia is a leading player in AI and looks to have good growth prospects, but the durability of that growth for the price investors have to pay today is uncertain. There are companies elsewhere trading on much lower multiples that we believe can deliver dependable earnings and cashflows.
We are benchmark-agnostic in our approach. We focus on cashflow growth
We are benchmark-agnostic in our approach. We focus on cashflow growth. Sometimes we find opportunities in the growth cohort, as asset value influences cashflow growth. But equally, we recognise the importance of the level of cash and overall value.
Last year, we added more growth-orientated names because that's where value emerged. This year we have added more value-type names. For us, the focus is on finding mispriced resilience at appropriate valuations in companies we feel have competitive advantages that will propel cashflows over the long term. If we saw opportunities in the “Magnificent Seven” at a reasonable price based on fundamental analysis, we would consider them.
RS: Our portfolio places a strong emphasis on quality. By quality, we mean companies with high returns on capital, sustained high gross and operating margins, and capital-light business models. Regardless of what others in the market might define as growth or value, that quality element is enduring.
How can equity investors protect portfolios ahead of a possible downturn?
FdB: The central considerations should be competitive advantages and durability of cashflows.
A key feature of the past decade was low interest rates. During that period, valuations were less of a focus – cash was not yielding much; the percentage of negative-yielding bonds was high.
The central considerations should be competitive advantages and durability of cashflows
That has changed. Now you can get a five per cent return on cash. For a stock to show up well in that context, the durability of cashflows and discipline around valuations are critical. They are a way to assess quality and compete with free cashflows.
In our strategy, the free cashflow yield (the cash flows generated by a business, typically adding back depreciation to reporting earnings but subtracting capex required to generate those profits) is 4.3 per cent for the next 12 months, which is competitive with cash. When you consider the potential for those yields to compound at low double-digit rates, it could become attractive from a valuation perspective.
Figure 2: S&P 500 earning yield versus risk-free rate (per cent)
Past performance is not a reliable indicator of future returns.
Source: Aviva Investors, Bloomberg. Data as of October 31, 2022.
RS: A key element is looking at companies’ ability to sustain high returns on capital. On average, our companies are capital-efficient, being highly productive with every dollar of capital we provide them with. Importantly, they can convert close to every dollar in underlying earnings into free cashflow, which can be reinvested for future growth. By investing in capital-light businesses with strong balance sheets, it gives you a degree of protection in a world where we are likely to see an elevated cost of capital for companies due to higher interest rates. The other aspect is sustained profitability, which we see as the best defence against inflation and rising input costs.
How do you identify companies with the ability to grow regardless of the economic cycle?
FdB: There are a range of factors. Quantitative measures, such as high returns on invested capital, high growth and operating margins, and high levels of free cashflow conversion all indicate high levels of profitability.
From a qualitative perspective, you need to understand competitive advantages
From a qualitative perspective, you need to understand competitive advantages. A third key element is the degree of cyclicality in cashflows, which can be a function of the industry a company operates in. For example, payroll services companies like ADP tend to be more predictable and less cyclical compared to energy companies or those in capital-intensive sectors like banks.
A fourth element is the duration of that cyclicality. We tend to focus on longer-term structural drivers like the penetration of e-commerce or transition from cash to digital payments.
Where you see risks in terms of cyclicality, you can try to hedge them. For example, the mortgage market is going through a difficult period because of higher interest rates; you could offset that by exploring industries that may benefit from it. ADP benefits from higher interest rates due to the vast amounts of cash it holds on behalf of clients before distributing payments, also known as float. Even Visa and Mastercard have degrees of float benefits.
RS: History can also be a valuable guide, informing us about companies’ ability to navigate challenging environments. You think back even over the last couple of decades and companies have had to deal with the Global Financial Crisis, the pandemic, various geopolitical events and most recently a significant rise in interest rates. You can look for industries that demonstrate resilience, but within those, you need to identify companies with the strongest competitive advantages.
What role does ESG analysis play in assessing a company's resilience?
FdB: ESG considerations are critical in ensuring the durability and sustainability of cashflows. From a governance perspective, understanding the alignment of interests among management teams, their incentives and policies for managing external risks is crucial.
Climate risk is one of the biggest challenges we face. It’s imperative to understand whether companies have a net-zero alignment, how capital-intensive their assets are and how they are positioned to transition to a low-carbon world.
A big emphasis also goes on people and the intellectual property that allows those cashflows to compound over the long term. Effective stakeholder management, from employees to customer engagement, is also critical.
There are opportunities in companies that provide solutions to environmental and societal challenges
RS: People often focus on ESG as a risk-mitigation tool, but there also opportunities in companies that provide solutions to environmental and societal challenges. For instance, we know there is currently a huge level of expenditure in the US on healthcare. We see an opportunity for companies such as Elevance, which is leading in the transition towards value-based care (focusing on improving patient outcomes). This should help reduce some of the administrative burden.
From a social perspective, the products and services in the payroll and payment sectors play a vital role and are important to the end customer, by ensuring wages are delivered in a timely manner as well as helping companies attract and retain talent.
Have you adjusted your portfolio recently?
FdB: We've not made significant changes; our strategy has remained consistent. We have added AJ Gallagher and ADP.
AJ Gallagher has been in operations for over 70 years, led by three people all bearing the Gallagher surname. This long-term continuity demonstrates the alignment in management interests. ADP benefits from a higher level of float – it holds substantial amounts of cash on its balance sheet on behalf of its customers and is benefiting from a higher-rate environment. The same principle applies to AJ Gallagher, where premiums are collected before being disbursed. This structure offers some degree of hedge, as we mentioned before.
The rationale behind our approach is to prioritise downside protection first, because if you lose 50 per cent, you need to make 100 per cent to regain your initial capital. Predictability and safeguarding against downside risks is our first rule. But we add a rule to that, and that is to make money. It’s important to recognise the long-term likelihood of equity markets growth.
Figure 3: Probability of negative returns for the S&P 500 (per cent)
Past performance is not a reliable indicator of future returns.
Note: Data from 1929 to June 2022.
Source: Source: Aviva Investors, S&P, Bloomberg, BofA US Equity & Quant Strategy. Data as of June 30, 2022.