Kirsty Desson, investment director, Global Small Caps, abrdn, discusses making the case for the ‘price-setters’.
Since 2020, demand for almost everything has been on a tear. Both consumers stuck at home and corporations flush with cash have increased their consumption, fuelled by low interest rates and massive injections of government cash. As a result, there’s been accelerating demand for everything from dog leads to cargo ships.
Meanwhile, hampered by lockdowns, Covid outbreaks, shortages and a lack of employees, producers have struggled to keep up. This has been very beneficial for the ‘price takers’ – those producers who can’t influence prices much, because they don’t have a unique product or clear competitive advantage, and instead ride the going rate.
When inflation rises, so too do bond yields as investors look for higher future returns on their cash. In equity markets, this lowers the price buyers are willing to pay for growth. Witness the recent rout in highly rated P/E stocks when the chairman of the Federal Reserve mentioned reigning in government debt purchases. Throw in energy price hikes and September proved to be a bruising month for quality growth investors. However, we believe that the stocks investors should be holding through to the end of the year and beyond, are precisely those quality growth names, many still trading at deservedly premium multiples.
Over the short term, markets are likely to remain volatile. Several companies have already issued profit warnings ahead of the upcoming earnings season and supply pressures are affecting market participants across the board, though not all equally. Take for instance, SiteOne, a US distributor of landscaping supplies for both the residential and the commercial market. The company has been enjoying strong sales growth as spending on outdoor space remains high. In an industry beset by labour shortages and inventory scarcity, we believe SiteOne stands out because the company’s mobile app has boosted productivity and inventory has remained manageable. In addition, customer and supplier loyalty, or ‘stickiness’, has improved through a partners’ programme. As a result, the company has been able to cope with rising costs by pushing through price increases, while still gaining market share. The stock is trading at a valuation significantly above that of SiteOne’s peers and we believe there is scope for upside to numbers, not to mention potential acquisitions – signs normally associated with share-price outperformance. Maintaining a weighting towards operators of high quality, similar to SiteOne, seems appropriate as we weather earnings announcements.
Results announcements involve two elements: the earnings for the quarter that has just finished and the guidance from management for the quarter and, often, year ahead. Looking forward, demand – in the form of corporate capital expenditure and consumption – is expected to remain elevated even if monetary policy normalises and taxes rise. Where we are starting to see a change, however, is in the supply side. In the manufacturing hubs of Vietnam, Malaysia and Thailand, vaccination rates are improving. This is easing some of the supply bottlenecks affecting the important textile, semiconductor and auto industries. Raw material costs, especially for metals, are lowering – partly due to government price caps and, partly, to a slowdown in manufacturing demand. The wind-down in government support schemes, plus school re-openings and better control of the virus, could mean many more people can return to work, easing the labour shortage.
Hopefully, this could mean that inflationary pressures may be at, or close to, peak. So, stocks that have re-rated solely on the back of the current supply-demand imbalances may now face less favourable pricing conditions going forward. That is why companies with a clearly defined growth strategy, independent of the external environment, deserve attention. We would highlight JMDC, the leading provider of data analytics in the Japanese health care market. The current environment should be supportive as insurance companies, drug manufacturers and medical institutions are all striving to improve efficiency, and JMDC is using its core capability to push into new areas and deliver higher value-added insight to customers. The strategy appears to be working. Near-term valuations are expensive, but JMDC’s projected growth of 30% plus for the next three years is exceptional and hard to replicate elsewhere. Against a less flattering backdrop for value-orientated stocks, long-term investors may want to consider companies such as JMDC that offer a sustainable roadmap for superior growth.
We expect demand to remain healthy over the next year, but the easing of supply-side constraints means inflation is likely to be contained to low single-digit levels. In that scenario, it is harder for ‘price-takers’ to outperform. Instead, companies that have pricing power and the ability to grow faster than, and independently of, the market look attractive, even if investors have to pay more for certainty.
The irony is that it’s exactly when highly rated quality growth stocks sell off, that investors should be either holding onto or buying into them. So it may be time to act, as the markdowns won’t last for long.