2022 has started with more of a whimper than a bang. Growth stock investors have already had a challenging 2021 with four periods of drawdown. At Aubrey we ended the year nearly three percentage points ahead of the benchmark, even though we did not invest in ‘reflation’ sectors: we do not invest in fossil fuels, and do not own banks or large pharmaceuticals. Our technology stocks did well, and individual stock selection within the Consumer and Industrial sectors also contributed to the outperformance.
How are we faring thus far in 2022? Predictably the portfolio has lagged the benchmark as a result of the technology sell-off, but not by a great deal. What is interesting is how well a number of our companies have performed, driven more by long term secular trends than short term angst about the direction of interest rates, or for that matter geopolitics, where the presence of Russian troops on the Ukraine border is hanging like a pall over investor confidence. Or is it? One wonders whether an invasion is really factored into stock market valuations. Of course, if the worst happens markets will be down, and possibly a lot.
We have not had a war in Europe since the early 1990s, and as I started my career in September 1992, 6 months into the Balkans conflict, I thought I would remind myself of stock market performance at that time. Looking at the German Dax, the index fell around 25% between May and September 1992 and then rose some 61% between September 1992 and December 1993. Hindsight is a wonderful thing, and those clever enough to get out in May and back in in September and hold to the end of 1993 would have done extremely well. Even had you not sold in May 1992 but just held on through the drawdown, you would still have been 26% ahead by the end of 1993. For the next two years you would have made no money at all, unless you had been a very clever market timer, as the DAX essentially traded in a range which it did not break out of until 1996. It then nearly doubled over the next 20 months to August 1997.
Source: Aubrey Capital Management
While this may be instructive for background, it is worth mentioning that at Aubrey we do not invest in indices, we are benchmark agnostic. Our funds typically have no more than 5% overlap with their respective benchmarks. Our strategy for outperforming them is based on the premise that a stock’s return will, over time, reflect the underlying wealth creation of the business itself.
The European index has over the long term delivered 5% real rates of annual return, i.e. pre-inflation, so we structure our portfolios with stocks capable of self-financing real rates of growth of at least 2-3% more than that. We then add an allowance for inflation, a margin for error, as sadly not all our investments are a complete success, and we end up with a portfolio comprised of companies that can self-finance growth post inflation of at least 15% p.a. Our current average self-financing growth rate in the portfolio is double that, i.e. 30%, because we are able, in Europe, to populate a concentrated portfolio with the shares of 30-40 highly profitable, cash generative companies, with minimal levels of debt. The current net debt to equity in the portfolio is 11%, and over half the companies have net cash on their balance sheets.
Why might this particularly be so right now? 1) tectonic shifts in the business environment abound, for example, digitalisation and decarbonisation, that are leading to exceptional business opportunities for the right companies 2) the impacts of stimulus – i.e. money printing. We are seeing market volatility around the negative consequences of the withdrawal of stimulus just now, but the changes taking place in the corporate landscape will be longer lasting and the portfolio very much plays to those themes.
On the subject of interest rates, we do not believe they will move so high or so fast that real rates of interest will turn positive any time soon. This should be good for equities, particularly for companies that are debt free, as the majority of our portfolio companies are. Inflation is going to hit mass spending, no question. Prices are going to be raised, and given the savings accumulated during lockdown, some consumer companies may do well, but consumers will be choosey. Consumer staples could be challenged as well as more discretionary spending. I recently saw a comment from the CEO of an Italian pasta company, that prices charged to supermarkets could rise 38% to €1.52 per kg by the end of January, compared to prices in September last year. Prices for durum wheat used for pasta rose 75% in 2021, following a drought in Canada, a major producing area. Brazil, another major food producer, was challenged by terrible weather last year. Italians on average consume 23kg of pasta per annum. Will they consume less, or just defer spending on non-essentials? What will consumers spend their pandemic savings on in 2022, assuming they have any, which is not a given for the majority.
Higher taxes and higher energy costs will eat fairly quickly into whatever has been saved. These are all challenges for the investor in 2022.
From a portfolio management point of view, we will have to stay very selective in what we hold. As growth stock investors, we will not be bottom fishing for value, which has proven unsustainable as a long-term strategy. However, we will be looking for valuation opportunities within growth sectors with structural tailwinds.
The indiscriminate selling of growth stocks at the start of the year has created some pricing opportunities on a three year forward view. The valuation on our portfolio is attractive by historic standards, particularly relative to growth, which we expect to average over 30% in 2022. We will remain very disciplined in applying our 15% ROE, CROA and EPS hurdle rates, and ruthless when it comes to Price/Earnings to EPS Growth ratios (PEGs), selling or trimming when PEGs rise much above the 1.5x limit we apply at purchase. These tried and tested financial disciplines have contributed to our long-term outperformance, and although they do not guarantee absolute returns in any given year, they deliver real rates of return well above the benchmark, and the peer group, over longer periods.
