- Equity Portfolio Manager
United Kingdom, Institutional
Change
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After nearly three decades of moderate growth, low inflation and ever-lower debt costs, companies now face a very different macro regime with high levels of uncertainty and a dramatic upward shift in interest rates. What the exact long-term implications will be for equity investing only time will tell, but as a first step, we believe investors should reassess the resilience of the companies they hold in their core portfolio. The impact of higher interest rates and a more adverse macro backdrop will differ between sectors and industries, but key in our view is finding high-quality companies that are well equipped to weather the storm. Below are some of the essential traits we look for, regardless of sector or industry.
Quality of capital allocation
In a higher-rate world where financing is more expensive, we believe it is even more critical to focus on identifying management teams and boards that are skilled at allocating capital for the longer term. While we see prudent stewardship of shareholder capital as a constant key tenet in the pursuit of sustainable long-term returns, we think the current environment demands even closer scrutiny of balance sheets. Companies with healthy cash reserves and low debt levels have a greater ability to absorb increased borrowing costs without the need to resort to gearing and will also have the financial firepower to take advantage of the opportunities that come with dislocation.
Diversification of revenue streams and pricing power
Access to diversified sources of revenue is an important attribute in this environment as it can help mitigate the impact of interest-rate fluctuations in specific regions or sectors. But this diversification needs to be linked with a degree of pricing power to help protect revenue. Typically, the companies we target tend to be leaders in their markets as they have increased scope to adjust their product prices, which helps offset higher interest and input costs and maintain profit margins.
A strong culture
Employers who act as good stewards for their staff can keep employees motivated and engaged, even during challenging times, which can help increase retention and lower recruiting and training costs. We think this remains an underestimated source of resilience and stability but one that is increasingly critical given persistent labour and skill shortages.
Investor confidence and stability
Having access to stable funding streams is a structural advantage in an era of diminishing credit and higher rates. Companies with good stewardship have typically achieved preeminent leadership in their markets and have a record of delivering strong shareholder returns, thereby instilling investor confidence, which leads to a decreasing cost of capital and helps ensure continued access to funding.
In combination, we think these assessment criteria offer a valuable framework to measure resilience with the quality of stewardship as a common denominator. It doesn’t mean that the companies that we identify as “good stewards” are immune to hiking rates, pricing pressures and labour shortages. However, they tend to display more resilience and adaptability thanks to a robust business model. Typically, they are leaders within their market segment and have healthy balance sheets along with strong governance and culture.
Where to find these good stewards?
Companies with these attributes can be found across industries and geographies as illustrated with some examples from our own portfolio:
- Prologis — We believe this logistics real estate provider is favourably positioned versus its industry in today’s higher-rate environment due to its limited funding needs, ample capital for opportunistic investments and a growing income stream from value-adding services. In addition, the company is in a position where it can keep raising rents to fair value despite a more challenging economic backdrop.
- Home Depot — We think this leading home improvement retailer has dealt well with the rising cost of capital and is reinvesting its high returns in its stakeholders. Notably, the company has decided to accelerate investment in its workforce, raising wages across the board. This was a proactive move by the retailer, based on a recognition that happier and more engaged employees create a better customer experience.
- Mitsubishi UFJ Financial Group — In our view, this financial services provider offers the resilience of a strong balance sheet and conservative lending practices, a result of it having had to become increasingly efficient over the long term due to the persistent low-rate environment in Japan. As well as ensuring it is positioned for a less restrictive yield curve policy in its domestic Japanese market, the bank has a strong focus on its shareholders and improving the quality of its capital allocation in an environment of rising rates.
Final thoughts
Today’s regime change means higher risk and volatility for equity investors as companies struggle to adapt. By actively focusing on industry leaders through a stewardship lens, we think investors may not only increase the resilience of their portfolio but also the potential for sustainable long-term returns across the cycle.
The examples shown above are presented for illustrative purposes only and are not to be viewed as representative of actual holdings. It should not be assumed that any client is invested in the (or similar) examples, nor should it be assumed that an investment in the examples has been or will be profitable. Actual holdings will vary for each client and there is no guarantee that a particular client’s account will hold the examples presented.
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