Identifying potential as fault lines begin to show - Angles & Perspectives Q1 2023

Identifying potential as fault lines begin to show

Despite the currently gloomy macro backdrop, we remain positive about our portfolios’ ability to generate appealing long-term returns. We believe the current challenges obscure the opportunities available in large parts of global markets to buy quality stocks at extraordinarily low prices. The catch, however, is that you have to be prepared to take a differentiated view and invest in areas of the market the majority of investors have shunned over the past decade.

Conflating time horizons holds dangers, but also offers opportunities
A recent report from the IMF summarised the currently challenging macroeconomic environment quite succinctly, as follows: “We are … entering a tricky phase during which economic growth remains lackluster (sic) by historical standards, financial risks have risen, yet inflation has not yet decisively turned the corner.” Consensus has also risen that the US will enter a recession (most likely later this year), casting a further pall over the investment prospects on offer. Does the prospect of an imminent US recession mean that we have to think differently about where we find opportunities in the market, and position our portfolios accordingly?

A recession is undoubtedly bad news for some asset types and counters that tend to depend on the developed market economies (and particularly the US) as an underpin to demand. These include commodities and emerging market assets, amongst others. It is therefore not surprising that these are the assets that typically come under pressure as soon as recession concerns flare up.

However, markets are also notoriously bad at distinguishing between short- and longer-term drivers, often conflating time horizons and mispricing assets as a result. This is no different currently, with the market focused on short-term developments to such an extent that longer-term factors take a backseat. But short-term developments do not necessarily invalidate a long-term investment thesis, especially where the underpin is more deep-seated and structural in nature.

The powerful forces that shape the long-term investment landscape
These forces can be viewed through the lens of long-standing imbalances and distortions that are in the process of unwinding. They firstly stem from a period of low interest rates and highly accommodative monetary policy that drove down the cost of capital and led to a misallocation of resources on a global scale. While the prices of some assets enjoyed multi-year tailwinds and reached record levels (like mega-cap tech shares), others were shunned by the market. Value and emerging market stocks have been trapped in a perennial cycle of underperformance when compared to their growth and developed market counterparts, driving their prices into bargain territory.

Secondly, the rise of environmental, social and governance (ESG) driven investments – perhaps a little ahead of the curve, with the world still highly reliant on fossil fuels to drive their economies – has led to sustained underinvestment in extractive capacity for some resources. This creates supply side constraints even as demand is set to remain robust (or even increase) for some time.

Lastly, we should also not lose sight of bigger structural realities that shape the macro and investment context. Even before the onset of the Covid-19 pandemic, it had become clear that we had reached something of a ceiling to the easy gains which had originated from the era of globalisation. Now that the fragility of global supply chains has been exposed, geopolitical tensions are on the rise, and investment in green technologies and systems is required, we need to prepare for a world of rising rather than falling costs. While the developed world may have been able to comfortably ignore the impact of inflation for several decades, that is no longer the case.

Constructing portfolios that are suited to a different environment
It stands to reason that the investments that will benefit from these trends are not the same as the ones that fared well over the past decade or more, when the economy was underpinned by completely different drivers. We therefore believe that clients looking to build long-term wealth should ensure they are exploiting the power of these long-term factors when constructing portfolios, rather than relying on portfolios that mirror the market conditions of the past.

Areas that we believe offer investment potential include:

• Supply-constrained real assets, especially commodities and related companies – including miners, energy producers, shippers and oil and mining services companies.
• Global value stocks. Our global process has identified very attractive opportunities to buy strong businesses with favourable prospects at a wide margin of safety, especially in the UK, Europe and Japan.
• Good SA businesses at crisis valuations. A collapse in investor confidence has presented the opportunity to buy local stocks where the market has underappreciated the quality and resilience of the franchise and the likely future growth in profits (despite the challenging macro conditions).
• Gold stocks have an important defensive role to play in the portfolio. Gold appears a likely beneficiary of the macro environment of persistent inflationary pressures, constrained central banks and rising geopolitical tensions.

Price is the missing piece of the puzzle
Constructing portfolios is not a one-off exercise. If only it were as easy as buying assets once, and holding them forever! While the macro factors outlined above may move slowly in a timeframe best marked in decades, markets are dynamic and change daily. What sets us apart as price-conscious, bottom-up stock pickers, is that we consider pricing as integral to the attractiveness of an asset, and the long-term return that the investor can ultimately expect.

Thus, the sweet spot is where we see the long- and short-term factors combine, offering us the chance to acquire quality assets at attractive prices. And it is here that the market’s inability to accurately price assets in light of a conflation of timelines and contradictory short- and long-term trends presents an investment opportunity to astute investors. The trick, of course, is that you need to partner with a team of skilled differentiated thinkers, who can position portfolios to ride out the short-term noise and volatility while firmly keeping their eyes on the long-term drivers that will help to build wealth in the long run.

PSG Asset Management.