Outlook: Despite rates in the up-trend, Quality stocks well-positioned for growth


Quality stocks – the perfect timing is now

We have always been arguing that Quality stocks are at anytime the universal answer to investing questions such as “where” and “when”. However, FY 2022 was a tough year for Quality style, which saw its high exposure to Technology stocks turning into one of the major reasons for underperformance last year. Indeed, Technology sector had a very demanding valuation in the beginning of the year as compared to other sectors (Table 1.) and, therefore, was the first to suffer when Central Banks got into the aggressive mode of raising rates to curb inflation, partially triggered by skyrocketing energy prices.

Table 1. PE Ratio of Industry sectors in the beginning and at the end of 2022

The problem is that the entire sector was dragged down regardless of whether a technology company was of good quality at attractive valuation or an inadequately valued company, which is not delivering. Take, for instance, large quality behemoths like Alphabet or Microsoft that have robust recurring revenues and dominant market position, delivering consistent growth, versus  start-up like companies with not yet quality business models such as Snowflake or Tesla. In the beginning of 2022, the former two had PB of 8 and 16 respectively, while the latter had PB ratios of 21 and 44 respectively. The decline of share price brought all their valuations down substantially. In the end of the 2022, we saw the following levels: 4.5 and 10 vs. 8 and 9 respectively. The declines in valuations were equally painful, while the quality of business models is completely not comparable.

Figure 1.  shows that the valuations declined massively in 2022, offering an attractive point to cement positions in quality stocks. The price one pays for Quality companies, however, could be higher than the market average, which is justified by excellent cash flow generation ability, strong corporate governance and lower indebtedness, which is crucial in the expensive debt environment.

Figure 1. Valuation level of quality stocks in the beginning and at the end of 2022

When compared to index securities, Quality delivers much better business performance and, what is more important, quality of financials did not deteriorate in the weaker economic mode last year and are expected to keep their defensive profile. Quality companies provide better earnings ability and higher quality of balance sheet as compared to the general market (Figure 2).

Figure 2. Operating margin and debt level of Quality stocks vs. MSCI World Index

The time of high interest rates and risks around

Central Banks have provided a clear message that interest rates will be raised and kept on a high level until the inflation is forced down to 2%. The market is ready for that and further rises seem to be priced in both in Europe and US. We should, therefore, get used to living in a relatively high-rate environment for the next few years, which should make us aware of the following:

Increased default rate. During the low interest rate era the number of zombie companies increased (from 92 to 109 in MSCI World AC Index in 2021 vs. 2018). Corporate debt has slightly decreased in the last two years after the companies have expanded their leverage during COVID times, but it still remains pretty high as debt-to-equity ratio sits at 146. Thus, one should carefully assess portfolio’s interest rate exposure as interest coverage ratio will most likely go down as debt servicing becomes more expensive and risk of filing for Chapter 11 increases. The same risk is also true for sovereign debt, which should be watched carefully after nations loaded their balance sheets with new borrowings during COVID times.

Pressure on economic growth. Last year we saw multiple GDP growth rate cuts, both for 2022 and for 2023, blaming not only the aggressive fight with inflation but also war in Ukraine and slowdown in China. IMF forecasts now global growth of only 2.7%, and OECD sees growth at 2.2%, the same as the consensus estimate of banks and research companies. One should therefore be aware of this substantial slowdown and adjust portfolio accordingly, for instance, by favoring less cyclical stocks.

AI is the next Internet

We can assume that in 2022 there was an AI revolution, watching how this technology gradually alters more aspects of our lives. AI-tools are currently available not only to the businesses but also to the consumers, who are excitedly asking ChatGPT to answer some existential questions and to write pieces of their academic theses or asking Midjourney or DALL-E to generate “Vermeer girl with pearl earring in Matisse style”. We believe, we have entered the new age of development fueled by the AI, which presumably would be as outrageous as the invention of the world wide web.

AI pushes the efficiency of operations forward in many companies and the potential to develop and integrate it even further is huge. Basically, almost any company could employ AI-powered tools to stimulate growth. It is expected that more than 80% of companies will use intelligent automation in retail and consumer products by 2025. They believe this technology could help increase their annual revenue by 10%. The biggest winners of this trend though are the ones, which have large scale and scope, the ones using large piles of data, such as Alphabet, Meta or Amazon. AI-powered world is the new reality we would face, and it is important to timely recognize the beneficiaries also on the stock market, to be earning with them from the AI provided capacities.

Fig.3 A cat smoking cigar by Picasso