The stocks to own as inflation rises

The ‘Value versus Growth’ argument is often presented as a dichotomy. Either you buy “bombed out cyclicals” on low multiples, or you buy high-growth, often unprofitable stocks without even considering valuation.

But in reality, there is a sweet spot in the middle. Predictable businesses with market leading positions, strong cashflows and selling at a reasonable price. These are the types of stocks that Warryn Robertson from Lazard Asset Management thinks will do well as inflation picks up.

In this article, he explains how central bank policy, government spending, and demographic changes are creating inflationary pressures, and he discusses some of the stocks he thinks are best placed in this environment.

Not your average recession

Describing the fundamental differences of a “pandemic recession” versus a “normal recession,” he explains that in the latter, deflation occurs because demand for goods and services falls while supply remains relatively fixed.

“The pandemic is more analogous, frankly, to a war. You’ve had demand fall like in a normal recession, but you’ve also had supply constraints,” Warryn says.

“Depending on whether demand moved more than supply, or supply moved more than demand, it could be deflationary. Or it could be slightly inflationary, but it's not as consistent as what you see in a normal recession.”

The Modern Monetary Theory experiment

Warryn believes the trend of low inflation – or even disinflation – that has now run for around three decades is coming to an end. Citing the unique situation of the COVID pandemic, which has pressured both demand and supply, there’s the added complication of a rising belief that national deficits don’t matter anymore.

“The tightly controlled modern monetary experiment got expanded to the general economy. People failed to recognise the Petri dish experiment and what's changed now that we've given that capital to Main Street and not just kept it within the tight confines of Wall Street and central banks,” says Warryn.

“The impacts on inflation are largely unknown. And in the medium term, we’ve also got this demographic change, with baby boomers’ now driving more demand for healthcare and associated services.”

He believes these changes are likely to be inflationary, especially given there are now more people that are either retired or at the latter stage of their lives than are in the workforce.

What does this mean for investors?

Structuring your portfolio based on what the Fed and other central banks are targeting in terms of inflation makes more sense now than it has over the last decade, explains Warryn.

While Global Equity Franchise, one of the strategies Warryn manages, has a strict valuation discipline it is not a pure value strategy. The team has a tightly controlled universe of approximately 250 global companies that consistently ticks his team's boxes in seeking out companies with:

• Predictable businesses that have existed for a long time
• Market-leading positions
• Strong free cash flow
• High margins and
• Manageable balance sheets.

While this universe includes the mega cap IT and consumer staples stocks, the team is currently not holding any of these in the portfolio today. Warryn says investors need to consider the impact of the “inertia” that has occurred during the pandemic, where many portfolios remain jammed with mega-cap technology stocks and other high multiple companies.

As an example of this inertia, he recalls hearing recently that of the 269 buy-side recommendations for the FAAANM” (Facebook, Alphabet, Amazon, Apple, Netflix and Microsoft stocks, just four of them were rated “sell.”

“These are stocks that are still trading on unbelievably heroic multiples, such as Meta, having had this monumental run for many years,” Warryn says.

“You might believe they’re going to be winners forever, that in 20 years’ time they’ll still be worth more than they are today, but over the next three to five years we’re going to have superior earnings growth from our portfolio and you’re not paying these heroic multiples for it.”

The starkest aspect of this long Growth rally has been the ever persistent re-rating of Growth over Value more broadly. Since 2008 Growth stocks have produced modestly stronger EPS growth than Value by around 20%, but the share price has appreciated more than 220%. This re-rating has been unprecedented.

Robertson believes this is now reversing which is proving a powerful tail wind for more valuation sensitive investors, with many value oriented strategies now clearly outperforming benchmarks over the last 18-month. Robertson argues that this cycle is only just beginning considering the extremes that growth and mega cap stocks traded at and the fact that the rising rate backdrop clearly favours value investors. 

Some of the stocks that have been the strongest performers in Lazard’s global portfolio in recent months include:

CVS Health – A NYSE-listed company, it combines three inter-connected businesses including the US’s largest pharmacy network, a pharmaceutical benefits plan business, and a healthcare insurance business.

“Combining those three has been a bit of a digestion problem for the company, but with a new CEO, CFO coming in it has been less wedded to the historical pharmacy network,” says Warryn.

Management has guided toward high single-digit earnings per share growth for the next two years then move to double EPS growth from 2024 and beyond: "And this is a stock that’s got high EPS growth and is trading on 12 times PE."

International Gaming Technology – One of the world’s largest operators of global lottery concessions, Warryn acknowledges the company is often mistaken for a gaming machine company.

“Yes, it has got the poker machine business but it’s less than 25% of group revenue,” he says.

He compares it with the competitor Scientific Games, which was acquired by Brookfield last November for almost US$6 billion. The scale of this transaction assumes an EBITDA multiple of around 12 or 13 times.

“The whole of IGT trades for about 7.5 times EBITDA, it's got three times the size of the lottery business that Scientific Games does,” Warryn says.

“These are the types of value propositions we like, not deep value names. We're not buying bombed-out cyclicals,” says Warryn.

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