By MICHAEL FLITTON
Inflationary pressures are building.
The foremost question for investors is whether these pressures will become endemic or are, in the word du jour, transitory. Squirrelling out the answer from noisy real-time data has led to whipsawing stock prices, as sentiment bounces between these two competing narratives. To understand the potential effect on our Global Leaders strategy James Spence and Fay Ren undertook an investigation of past periods of sustained inflation. In this note we attempt to draw out some inferences for the Pacific strategy.
James and Fay identified 7 distinct periods between 1972 and the current year when inflation exceeded 3% for at least 10 months.
|Inflation period start||Inflation period end||Number of months||Average inflation rate|
|Dec 72||May 83||125||8.5%|
|Nov 83||Feb 86||28||3.9%|
|Apr 87||May 93||74||4.2%|
|Feb 00||Jun 01||17||3.4%|
|Jun 04||Aug 06||23||3.5%|
|Oct 07||Oct 08||13||4.4%|
|Apr 11||Jan 12||10||3.4%|
Comparing the performance of quality equities, proxied by Global Leaders companies listed at the time, and the broader market, proxied by the S&P 500, shows high quality stocks outperformed in every period against this inflationary backdrop. The average annualised outperformance across the 7 periods was 6.5%.
Replicating this analysis for the Pacific Strategy is a challenge. There is simply not enough data. However, James and Fay proffered 6 factors within the Global Leaders Strategy that are helpful with regard to inflation protection.
i. Higher than average margins
ii. More defensible economic moats
iii. Supported by positive industry structure dynamics that favour established players
iv. Operating in largely rational market places
v. Protected by well commercialised and enforceable intellectual property
vi. High degree of value added in their operations
In the absence of data, we can instead draw inferences from the extent to which Pacific holdings exhibit these characteristics.
At this point it is helpful to retrace the genesis of the Pacific Strategy, which began with our work on Global Leaders. We observed that the global hub of innovation was increasingly gravitating towards Asia. The region is likely to contribute an increasing share of world-leading businesses over time, in our view. The strategy is focused on investing across the developmental s-curve of these firms, from those less mature to those already world-leading.
Broadly the characteristics listed above describe either attributes of the firm (i, ii, v, vi) or the environment in which it operates (iii, iv). Given the diversity of maturity in both business and industry within the portfolio invested companies lie on a spectrum across both categories.
Focusing first on commonalities and the aggregate view. Component companies within the strategy have margins 1.6x that of the wider listed region. Cash returns on capital are superior, both in relation to cost of capital and the index (CFROI 19% vs 5% for index). This points to a group of companies delivering value add, where returns are sustained by good economic moats. Intellectual property, and the broader church of innovation, is a key contributor to company competitive advantage in the strategy. We thus see attributes i, ii, v, and vi as evident in the portfolio.
Some companies are building significant moats but the potential long-term value to be added is not yet reflected in margins or returns data. These companies are strategically prioritising growth to capture large market opportunities. Kingdee, Bilibili, and Sea are good examples. More generally there is a point to be made around growth, and its role in protecting against inflation. Sales of Pacific Strategy companies are expected to expand at 24% per annum for the next two years, over 2x the index. In an environment of rising inflation, growth will be key to delivering real returns. That being said, rising rates will likely weigh on valuations, which are higher than the broader market.
Where we must concede vulnerabilities is around industry structure, points iii and iv. Here we can see two distinct pieces of the portfolio, firms engaged in capital intensive businesses and those in low intensity verticals. 45% of the portfolio is represented by Tech Hardware, Industrial Components, and Consumer Products. Our allocations here are to well-established businesses with deep moats entrenched over many years through iterative innovation and capital barriers. Here market structure is concentrated and actors mostly rational. The other 55% of the portfolio is innovative firms in more nascent markets, at least in an Asian context. These are Online Disruptors, Software & Services and Health Care. The markets here are dynamic and new entrants can be non-rational.
One positive industry structure factor is where portfolio companies tend to be located in the value chain. There is a bias towards B2B businesses, which represent over 70% of holdings. This is a function of where we have found the most opportunities. This means stickier relationships, where price is not the sole driver of demand. Quality, consistency, and flexibility are instead the priorities, providing insulation against pricing pressure. Arguably consumer facing firms in an inflationary environment face the toughest challenge.
We therefore conclude, whilst historic statistical data is inadequate, the Pacific Strategy exhibits sufficient characteristics plus the key measure of supernormal growth to have a high probability of outperforming in future periods of inflation.