3 stocks that could become the next great compounders of the coming decade
Alphinity's Jeff Thomson has recently been reading up on the Oil Crisis of the 1970s and the inflation problems of the time.
Why? Well, as Mark Twain once said, "History never repeats itself, but it does often rhyme."
"It gives you context," he said.
"In 1973, OPEC raised the price of oil by 70% in one day. The UK had to go to a three-day workweek because they didn't have enough power. They literally had to turn the lights off."
The 70s weren't that long ago, Thomson added. And while this time was fraught with difficulty, it also provided significant opportunities for disciplined investors - just as the market is now.
In this Q&A, Thomson outlines how, despite the multiple headwinds the market is facing, he and the team at Alphinity are still finding compelling long-term opportunities today.
Plus, he also explains why positive earnings surprises drive outperformance - as well as three stocks that could become the next great compounders of the coming decade.
Note: This interview took place on Tuesday, 8th November 2022.
Are earnings forecasts still overly optimistic?
In a word, yes. There's almost no question that I think earnings expectations are too high for next year, particularly. And there are at least four different but inter-related reasons why that's the case:
1. The end of an era of low rates: Quite clearly, we are coming off a period of five to 10 years of very loose monetary policy and very low cost of capital for companies. That's been embedded into many companies' business models and investors' portfolios because of that. That's normalising now.
2. COVID normalisation: The COVID period was an extraordinary time when we essentially shut down the global economy and gave everyone a lot of money, and then reopened it. And guess what? We have inflation. That normalisation of activity as people start to travel again, and get back to the office, is still working through a number of different companies in quite surprising ways.
3. A slowing economy: The third is simply the slowing economic growth that most of the world is already experiencing, which will ultimately translate into lower corporate earnings.
4. Margin compression: In my experience, the thing that analysts always get wrong is operating leverage. So, where you have relatively high fixed costs, analysts tend to underappreciate the upside to margins when things are good, and of course, the reverse happens when revenues fall. So I believe analysts are too optimistic on margins for next year.
So putting all of that together, potentially, there is a significant downside to earnings estimates for next year. For context, earnings growth for the MSCI World was approximately 22% in 2021 and will likely end up at 9-10% for this year. Currently, bottom-up consensus for 2023 is still more than 4%, which looks too optimistic. I'd be surprised if that doesn’t end up being negative. Perhaps the catalyst for that will be the fourth-quarter earnings season in January next year, when management provides full-year guidance and analysts are forced to cut estimates.
If you go back in history, in most recessions, earnings have fallen between 10% and 50%. We'll see how this plays out. At this point I'd be surprised if it's as bad as that, but certainly, I think a 10% drop is on the table, which would still be a negative surprise to most investors.
One last note. While, yes, over time, markets are correlated with earnings, there are times when markets can move in a different direction to earnings. Markets are highly efficient and always looking forward, and can be a lot smarter than most analysts, so it's harder to be as precise about the direction of markets. Historically, if you look back at previous recessions, markets can start to rally six to nine months before earnings bottom. So at some point, the market will want to look through these downgrades towards the recovery on the other side, but I don’t think we are at that point just yet.
How do recent currency movements play into that?
The US dollar has been extraordinarily strong this year, with most currencies weak against it. So if you're a US company or a US-listed multinational, it's a huge headwind. In most cases, however, this is mostly just a translation issue and less of a fundamental headwind. Of course, to the extent that there are US-based costs or manufacturing, there is also a more fundamental headwind as these companies lose relative competitiveness. These factors can be transitory and just as easily reverse if currencies move the other way.
at current spot rates, FX will likely still be a significant earnings headwind
for most of the US market at the moment, and probably still somewhat underestimated
as a drag for next year. But all of
this is reversed for non-US companies, where FX is mostly an earnings tailwind
at the moment.
Is Alphinity pricing in a global recession?
The outlook for global growth remains challenging and consequently, we are still cautious. As Jamie Dimon’s famously said, the chance of recession is 100%, we are just debating the timing and severity.
Of course, he was being somewhat facetious, but he's also alluding to an important underlying truth. I mean recessions are very painful and can have significant negative social consequences, but they're also a natural and unfortunately a somewhat inevitable part of the free market economy.
But it's not all doom and gloom, and a softer landing for the US remains a possibility for several reasons. Firstly, consumer spending has been surprisingly resilient so far, underpinned by personal savings which are still relatively high, as well as a strong labour market. People still have their jobs. Of course, we would be surprised if unemployment doesn’t rise next year, but we don’t expect a significant unemployment-driven recession at this point. So that’s an important mitigating factor. Furthermore, while there are pockets of concern as there always are, generally speaking, corporates are relatively well positioned for this from both a liquidity and a leverage perspective.
And finally, the financial system is well-capitalised and resilient, which is critical. This is not a systemic financial crisis like we experienced during the GFC. US banks are generally in good shape - meaning, they are well capitalised, with liquid and well-funded balance sheets.
So there are some good reasons to expect a softer landing in the US. In contrast, we are more concerned about the outlook for the Eurozone and the UK, where the impact of higher interest rates and energy costs is more acute.
The Global Fund can hold as much as 20% cash. You are currently holding 3.5%. Why?
We have the capacity to go to 20% cash and we would consider doing that in periods of significant market stress or systemic crisis. And clearly, the GFC would probably be an example that comes to mind, but there have been other similar circumstances in history.
Having said that, I think at this point in time, despite a lot of the macro headwinds, and we are certainly eyes wide open on that, we are still finding a lot of opportunities at a stock level. As discussed, we are very cautious about the near-term outlook for corporate earnings for the overall market, but from a bottom-up perspective, we are still finding opportunities to invest in companies where earnings are likely to surprise positively next year.
The portfolios are invested in high-quality businesses, where we believe the outlook for earnings is fundamentally underappreciated, and we are still finding exciting opportunities to invest. We also strive to be diversified by sector and country, which also helps to manage some of the macro uncertainty. Many of the most exciting investment opportunities present themselves during downturns and so we are continuing to lean forward on that.
Where the team is finding opportunities (and where it's not)
One area where we are beginning to see opportunity is within some of the high-quality growth stocks, which have performed badly so far this year. Many of these simply became too expensive over the last few years and were also not immune to cost inflation pressures or COVID normalisation.
It’s not that surprising that they have had a tough time recently, but many of these companies are now trading at far more reasonable valuations and in some cases, earnings are also beginning to inflect positively again.
One example that we have just recently added is Intuitive Surgical (NASDAQ: ISRG). It's one of the world's leaders in robotic surgery. This is an exciting and dynamic industry, underpinned by structural growth trends. The stock has fallen quite significantly this year alongside the general market. Earning expectations have been under pressure as a result of various issues including supply chain pressures and hospital productivity. For example, it has been challenging for hospitals to find nursing staff to support patient volumes. These issues are beginning to normalise and we are optimistic about the outlook for 2023.
Another significant change we have made is within some of the large technology stocks, where we have recently sold out of Microsoft (NASDAQ: MSFT) and Alphabet (NASDAQ: GOOGL), as well as reduced exposure to Apple (NASDAQ: AAPL). These are high-quality businesses, but generally reported third-quarter earnings which disappointed market expectations on both revenues and margins. These businesses are clearly not immune to overall macro growth and inflation headwinds.
At Alphinity, we believe there is a right and wrong time to own a company. This is core to our investment philosophy. While we always seek to invest in high-quality businesses (companies with strong management teams, in good industries with wide competitive moats, with high and rising returns, strong cashflows and robust balance sheets), we also always look for businesses where the outlook for earnings is fundamentally underappreciated by the market.
In our view, it’s the positive earnings surprise that drives outperformance more than anything. Furthermore, we believe these surprises are often serially correlated. For various behavioural reasons, analysts and the market are often slow to fully appreciate the full scope of positive change, and the same is true on the downside. One profit warning or disappointment is often followed by several more. So at Alphinity we always want to invest in positive upgrade cycles and at the same time be very disciplined about avoiding the latter.
our perspective, analyst estimates for many of these large technology companies
remain too optimistic. While we continue
to be great admirers of many of these businesses, and I would be surprised if
we didn’t own some of them again in the years to come when earnings
expectations inflect positively, for now, we are out.
Finding the next great compounder
Probably the best historic example of a positive upgrade cycle that I can think of is Apple after the launch of the iPhone. At the time, I am not sure even Steve Jobs fully understood just how successful this was going to be, but the broader analyst community certainly didn’t. This translated into a multi-year period where management, analysts and investors were continuously upgrading expectations and estimates, which in turn drove strong stock performance. And that's really what we are trying to identify and invest in - that multi-year earnings upgrade cycle.
One stock where we believe that is happening right now is LVMH (EPA: MC). It boasts a collection of some of the world's greatest brands, giving it unrivalled pricing power, high margins and strong cashflows. The high-end luxury customer remains strong and we believe will be resilient to inflationary pressures and general macro headwinds. We also believe the brands continue to resonate with customers in the US and across the world, with incremental customer acquisition. The eventual China re-opening sometime next year may provide further upside to earnings estimates. This is a high-quality business, which we expect to surprise positively on earnings, and which is reasonably valued on a PE of approximately 22 times. We think this is attractive for a business of this quality with a strong outlook for earnings growth.
The other stock I would mention is Waste Connections (NYSE: WCN). It's the third-largest waste management business in the US. The business mostly focuses on simple curbside waste collection, recycling, and landfill services. It operates within a strong industry structure, dominated by three or four key names, but still fragmented below that. The industry is relatively defensive, but what really attracts us to Waste Connections is its differentiated business strategy. They are mostly focused on second and third-tier markets - think rural or semi-rural markets, which are typically less competitive and where they have more pricing power. If there's one statistic that I'd call out, it’s the fact that they have managed to price 150bps above CPI over the last 20 years. So strong pricing power, with extra earnings upside from consolidating many of the smaller operators in the industry.
The last stock I want to mention is NextEra Energy (NYSE: NEE), the leading electricity utility in Florida, but also probably the biggest (by dollars) investor, developer, constructor, owner and operator of renewable energy in the US. It produces electricity mainly through solar and wind generation. There is an enormous investment opportunity associated with the transition towards renewable energy and we believe Nextera will be a significant beneficiary of this powerful multi-decade thematic. Probably most interesting in the near term is the policy support provided for investment in renewable energy by the recently signed Inflation Reduction Act in the US. This extends wind and solar tax credits, providing high visibility for renewables over the long term, of which Nextera will be a direct beneficiary.
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Ally Selby is a content editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian Group, Your...