It could be they are starting to comprehend the fact that the world is in a debt trap, as suggested in a recent FT article by Ruchir Sharma of Morgan Stanley, and that higher rates are unsustainable without triggering an economic collapse. Sharma notes that total debt has tripled over the past 4 decades to 350% of global GDP.
As central banks dropped interest rates and printed money this has flowed into stocks, bonds and increased the scale of global markets from the same size as global GDP to four times the size! The number of countries in which total debt amounts to more than 300% of GDP has risen over the past two decades from half a dozen to two dozen, including the USA.
Fund strategyÂ
As portfolio managers we endeavour to buy strongly cash generative companies with low debt or net cash positions. Average net debt to equity in the portfolio is 10%, with half our portfolio companies sitting on net cash, and fewer than a handful having any noticeable debt at all, and those are mostly financing acquisitions or capacity rollouts.
We focus on companies with high gross margins and an ability to pass through inflationary pressures, whether these stem from higher energy, raw materials or logistics/supply chain issues. Avoiding commoditisation has been crucial to the fund’s outperformance in recent years and we will continue to adhere to this practice. The portfolio is comprised of many companies with long term structural growth tailwinds. It plays into behavioural change, whether at the business or consumer level, and accesses long term growth trends. We are going through a period of transition, digitalisation and decarbonisation are two of the most obvious examples, and companies that are facilitating this are finding extraordinary levels of demand for their products and services.
We believe this demand will hold up regardless of the interest rate environment. When printing money seems to be the default solution to the debt problem, anyone holding currencies or bonds is going to see real values eroded. At any given moment equities are only worth what anyone is prepared to pay for them. But over the long-term, European equities have delivered 5% average annual real rates of return (i.e. over the rate of inflation).
We structure our portfolios to deliver well in excess of that by only investing in companies capable of generating cashflow returns (CROA) of 15% or more on their assets. Our contention is that over the long term the stockmarket return of a company should approximate its CROA. It is unlikely to exceed it. The current CROA in the portfolio is 32%.
This is a nominal return, but its high level suggests that even with higher inflation, the portfolio should be capable of delivering a double-digit real rate of return, and comfortably outperform the average return of the benchmark index long term. Markets are awash with liquidity and this needs to find a home somewhere, so asset price inflation is inevitable, and money is likely to seek out higher returning assets. Liquidity in the system is also supporting relatively high levels of corporate sales and earnings growth, which in turn is supporting valuations.
That does not mean to say that this will persist indefinitely, and we are very conscious of the need to monitor holdings to ensure PEs and PEGs remain defensible. From the foregoing, it is hopefully clear that our concerns going into 2022 are more of a systemic nature, rather than being portfolio specific. We are concerned by the sabre rattling on the Ukrainian border and China’s intentions regarding Taiwan, and further turbulence emanating from these regions cannot be ruled out. But as for our portfolio, it is attractive. Going into the Christmas season, we should like to wish our readers and investors a peaceful, healthful as well as prosperous New Year.
