Does anyone remember 2016?

I remember a few things. I remember the guy from ‘The Apprentice’ was back on TV. This time they’d given him the role of US President. News headlines spoke of ‘building a wall’ and ‘draining the swamp’. The other thing I remember was the swift and savage rotation out of small cap industrials, and into large cap banks and resources.

Promises of tax cuts, infrastructure spend and the repatriation of corporate war-chests to the USA led to higher expectations for growth, inflation and interest rates. At the time it was referred to as the ‘reflation trade’. In this environment banks and resources experienced positive earnings revisions and we saw money flow from small cap industrials into large caps. You can see this on the chart below which maps the Top 20 stocks versus the small industrials. Note also the ‘relative strength indicator’ (RSI) highlighting the aggressiveness of this move.

Top 20 vs Small Industrials

Starting in late 2016, typical small cap fund manager returns were uninspiring for a period of 6 months as we moved through this transition. Key observations during this period were:

• It’s the transition rather than the absolute level of rate expectations and commodity prices that causes this shift.
• If you are going to rotate your portfolio you better do it early AND know when to rotate it back again (good luck!)
• The long-term math of what makes a stock work do not change

Fast forward to 2022 and again we’re talking about inflation and higher interest rates. Money is flowing from higher quality industrials into banks and resources. This step up for commodities and financials does make economic sense however this is not sufficient reasoning to pivot our long-term investment strategy. We merely see this sequence of events as money pouring from one side of the boat to the other, all at once:

Should we run to the other side of the boat?

In a scenario where we sell our growing free cash flow streams to fund purchases of companies with near term positive earnings revisions, we will have stacked the long-term math against ourselves. 

Owning growing free cashflow streams works not because of a specific environment in the financial markets but because the long-run mathematics are inescapable. 

Growing earnings and intelligent uses for cashflow matter most when compounding wealth. Growing free cash flow per share will always be the dominant source of stock returns over the long term whereas a contraction or expansion in earnings multiples can only ever dominate returns in the short term.

Explaining the long-term maths

A real-world example might bring this to life; currently the Small Ords trade on a PE of approximately 20x and has forecast revenue and earnings growth of around 5%. 

By way of comparison our portfolio has a PE of 25x but forecast earnings growth of 17%. If we “compare the pair”, and assume these growth rates can be sustained, you’ll find it takes just two years for earnings of the faster growing portfolio to overtake the benchmark driving down it’s seemingly ‘expensive’ PE. 

After 5 years the earnings of the faster growing portfolio is almost 40% higher than that of benchmark; this is where outperformance comes from.  

What are we doing this time round? 

Same as last time. We’re tilting the portfolio in favour of the long-term math and enduring the short-term volatility. We’re prepared to look silly in the short run because rotations don’t last forever and the real measure of a strategy’s success is its long-term compound annual growth rate.

Find out more via QVG's upcoming investor webinar

If you're interested in hearing more from the QVG Capital team please register for our upcoming invest webinar to be held on March 15. The webinar will cover the recent reporting season, QVG's portfolio positioning and the outlook for our funds. Register Here.