Innovation at a discount

Angus Muirhead: I think it’s a very natural reaction. Nobody enjoys losing money, and it’s human nature to cut our losses when we experience pain. Risk aversion can, of course, be very useful in certain situations and is linked to our fight or flight survival instinct. However, in other situations, it can limit our ability to make rational decisions.

The current market backdrop provides the perfect storm of myriad fears and uncertainty. With negative sentiment all around, the perceived fear of loss is so great that it becomes difficult to see any potential opportunities.

The market often goes through these periods of extreme sentiment, both positive and negative. The negative periods often stand out more because the movements tend to be sharper. You could say that the market goes up on an escalator and comes down in an elevator. Predicting the short term is notoriously difficult and this is why our thematic strategies focus on long-term secular trends.

It’s difficult to imagine exactly how the current situation will be resolved, but we should remember that most of the things we’re concerned about are already in motion: inflation, rising interest rates, war in Ukraine, COVID lockdowns in China, supply chain delays, and a fear of recession. They’re also related. End the war and beat COVID and the other issues should dissipate.

If we cut our losses at this point, it feels to me that we are late and reacting to issues that the market has already largely discounted. Equity markets started to price in many of these issues from October 2021 and other risks have started to be priced in over the last few weeks and months.

Unfortunately, we can’t say that with any real certainty. Nonetheless, we can say that the price of most securities has fallen sharply and that valuations are generally more attractive now than a few months ago. Of course, the caveat is that the economic outlook is likely to be weaker than was expected six months ago due to higher interest rates, higher input and labor costs, and supply chain challenges. Therefore, we should assume lower revenue growth and earnings power for some companies in the valuation model.

In many cases, yes. But remember, the stock market is vast and no company is exactly the same as any other company, so the extent to which the growth and earnings power of a company are affected by these issues is highly heterogeneous. Currently, in spite of the market sell-off and the challenges in the world, many of our portfolio companies are reporting very strong end demand from clients. Therefore, we believe it is critical to perform deep-dive fundamental analyses and to be highly selective in stock selection.

I think that shift has already happened. However, we should also be careful about the definition of value stocks. Does “value” simply refer to low valuation multiples? Our view is that “cheap” is often not a good indicator of value. It’s more important to identify exceptional companies and to buy them at a price below your estimate of intrinsic value. Growth, in revenues and earnings, is of course a key component of the calculation of intrinsic value, and therefore the terms growth and value cannot be unbundled.

Everything has sold off to some extent, in particular innovative, small to mid-size companies with great long-term growth potential, but which are not yet operating at scale or have yet to break even.

As markets have pulled back, most stocks in our pure-play thematic equity universes are now more accessible in terms of valuation. So we are using this opportunity to “high grade” our portfolios. Buying the stocks of companies in which we have the greatest conviction and where we find excellent management teams, strong business models, ESG credentials, IP (intellectual property), and well-differentiated solutions. In most cases, we are looking for the ability to consistently stay ahead of the competition through innovation.

With so many significant macroeconomic and geopolitical issues in play, equity markets are likely to remain volatile. Nevertheless, periods of extreme volatility often create opportunities for the long-term patient investor. An age-old adage is that time in the markets is worth much more than timing the markets. The challenge is to try to imagine the most logical scenarios. Not to predict, but to plan for a number of different outcomes.

It is likely that some signs of resolution around the key issues will be necessary before we see a genuine recovery in the market, but sentiment often recovers on the expectation of a brighter future, long before it becomes reality. As a result, we prefer to stay invested, but be highly selective in our exposure.