CGE: Looking Past Inflation Fears

Key Takeaways

• Holds companies with long-term, double-digit earnings growth
• Invests in industries backed by secular growth trends; avoid cyclical businesses
• Aims for companies whose earnings can continue to grow irrespective of broader economic environment

1. Can you first give readers an overview of the strategy? For example, what type of companies do you invest in? How would you describe the selection process?

MH Sure, the basis of this whole investment strategy is that we’re investing in the companies of tomorrow – today. So, we’re looking for businesses whose earnings continue to grow sustainably, in double digits, for a five-year view and beyond. The benefit of this approach is that many investors are short-term oriented, and as a result can undervalue companies that grow beyond the time horizon of the broader market. Broadly speaking, the market has approximately a two-year outlook. While it may allocate some value for the longer-term company growth, it assumes a degree of “fade” in the future for most companies’ earnings. Our goal is simply to invest in businesses that will beat the fade. We’re not interested in how fast a company will grow; we want to know how for how long it will grow.

2. Inflation is a headline story this quarter. Have those inflation fears had any impact at the portfolio level? Please provide details on your thinking.

MH Our portfolio management team is not overly concerned about the possibility ofa more inflationary environment going forward, because we primarily look for companies with a sustainable competitive advantage. Each company held must be in a great industry that’s backed by a secular growth trend, which is why you will not find us in commodities, banks or other cyclical investments. But once we identify the right sectors, the hardest thing to find is a long-term differentiator. The company could potentially have a world-renowned brand that’s been developed through decades of advertising, they could control a superior distribution network, or they might have patents on key pieces of R&D, which would mean that competitors simply cannot make products as good as theirs. What this means is that when input costs begin to rise, the uniqueness of their products should allow them to pass on additional costs to the end consumer in time. In other words, they should not get badly caught in an inflationary squeeze, and that is why we believe the portfolio is well placed to cope with the current environment.

3. Another major plotline is the ongoing resurgence of Value stocks. What is your perspective on the Value rotation? Has it caused drag on your performance?

MH The first thing to know is there are different types of Value markets. For example, when there’s a difficult environment and you see major indices like the MSCI World Index slide by 20% or more (as in March of last year), the most economically sensitive companies are hit the hardest. They are the underperformers. By contrast, the kinds of businesses we choose to invest in are high quality and resilient and may be able to continue to grow their earnings irrespective of the overall economic environment, which is why they tend to fair better in a difficult market environment. This was demonstrably true during the first quarter of 2020, when our portfolio was able to exceed the benchmark by over 5%. That said, when the panic fades and the market eventually recovers, it’s precisely those hard-hit companies that tend to rebound most sharply. They start from a very low base, and therefore are capable of outdistancing the high-quality companies that we prefer – for a while. What this means is that during a “dash for trash,” which often takes place in an economic recovery, our fund can sometimes trail the benchmark. Even still, the Value rotation we saw from March 2020 to April 2021 seems to be dissipating, at least for now, in favour of a more neutral environment, leading to renewed outperformance in Q2 and Q3, so far.

4. Is the market too expensive right now? What’s your take on the state of valuations?

MH This really is the topic of the day. Whether you prefer value or growth managers, it’s hard to dispute that markets are very expensive at the moment. The rise in big tech valuations after March 2020 was quite reasonable, given that the digitalization trend they have been riding was accelerated with everyone being stuck at home. But then we saw a more broad-based recovery from October onwards, when positive news started to emerge about vaccine development and distribution, and the net effect was to stretch valuations and reinforce positive sentiment. At this point in the cycle, it’s quite natural for Advisors to remind clients that it’s useful to have downside protection because markets are vulnerable to bad news. What form might that bad news take? Well, we believe three factors – the danger of tapering coming to the fore, the need for fiscal tightening, and the fact that markets are already sky high – pose potential threats to the market progress going forward. And that’s why we think it is prudent to include this sort of secular growth strategy for the equity side of the portfolio. It can give you the confidence to go play in more exciting areas without taking unnecessary risks with the core of your clients’ capital.

5. Michael, last quarter there were an unusual number of changes to the portfolio. How has it been this quarter? Have you added or removed any positions?

MH Actually, no. Nothing has changed in this strategy over the past few months. Newcomers to the fund often find this jarring and ask us, “Why don’t you do something?” Our reply is always that this is a long-term investment strategy. We pride ourselves on having minimal turnover because, as I’ve said previously, the goal is to find companies with sustainable earnings growth and robust downside protection. Historically, we have only changed around 12% of the portfolio per year, and that’s in dollar terms as opposed to name turnover, meaning that it is quite normal for us to have zero transactions in any given quarter. Essentially, no news is generally good news on this front.