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CIO Update: Survival of the fittest

After a rollercoaster year, stock markets dipped again in December but managed to eke out positive returns for the final quarter. Unfortunately, it wasn't enough to prevent their worst annual performance since the 2008 financial crisis as rising inflation and geopolitical tensions combined with economic slowdown to push global equities down 18%[1].

After three consecutive years of double-digit returns, valuations had become increasingly stretched and any hopes of the post pandemic bull market continuing through 2022 were soon dashed by economic reality. The end of zero interest rates inevitably hit growth stocks hardest, particularly those whose price tags provided no margin of safety, which went into free-fall. 

The disconnect between valuation and realism put telecom (-35%) and technology (-31%) sectors among the largest fallers, while the deteriorating economic outlook saw similar drawdowns across consumer discretionary (-32%) and real estate (-24%) stocks. Energy (+35%) was the only sector to deliver positive returns for the year, boosting regional markets like Norway and pockets of Latin America, and also helping value to outperform growth by almost 20 percentage points for the year[2].

I'm pleased to report that our equity funds largely enjoyed a strong final quarter with all bar one producing positive absolute and relative returns. SKAGEN Kon-Tiki and SKAGEN Focus performed particularly well, thanks to China's reopening and Japanese bank stocks, respectively, and overtook their benchmarks for the year. The outlier was SKAGEN m2 as the macroeconomic challenges facing real estate markets continued into the final quarter. You can read more in the latest reports here.

Focus on fundamentals

Despite being a short and arbitrary period, the positive calendar year returns delivered by the majority of our equity funds relative to their benchmarks after costs shows the benefit of active management – choosing individual stocks rather than passively tracking the entire market. This was most clearly illustrated by the US where poorly performing mega-cap growth companies dragged down the entire market. This saw the majority (58%) of stocks outperform the market (see chart), helping most (62%) active managers to beat the index[3]. 


In the new era where higher interest rates mean that capital has a cost, investors need to focus on fundamental factors to pick the winners from the losers now that markets are no longer supported by quantitative easing. There are also signs that with inflation slowing, investor attention has shifted from trying to second-guess central banks to earnings and stock selection once more. This is evidenced by the muted stock market reaction to recent economic data announcements.

Another reason for going active is the growing likelihood of us soon entering into recession (if we are not already there). How hard or soft the landing will be is a subject of much debate, but there is little doubt that company profit margins will come under increasing pressure and it will therefore become more important to properly understand business fundamentals, the quality of management teams and the drivers of success (or failure).

To quote Mohamed El-Erian, Market Strategist and Chief Economic Adviser at Allianz, speaking at our New Year Conference: "Passive is no longer the response to good investment because the world is highly differentiated. Active management has a much better opportunity to outperform than it had in a world where the only issue was liquidity. In the world we're looking at, we're going to get massively different outcomes for different companies and sectors."

Active investors can also target winners and avoid losers in different geographies, especially if like SKAGEN they have the freedom to go wherever the opportunities are best. A good example is emerging markets which have been boosted by China relaxing its Covid rules and a weakening dollar but where company valuations remain well below long-term averages. Similar discounts are available in Europe, in contrast to the US where prices remain above-average. This wide dispersion in valuations creates a supportive environment for stock pickers to outperform.


Experienced pilots

Looking ahead, investors' attention in 2023 is likely to shift from inflation to recession and we should expect further waves of positive and negative sentiment as the economic picture and its impact on company earnings become clearer. This volatility helps long-term investors like SKAGEN to pick-up bargains – particularly given the market's tendency to overreact – and we have an extensive research library of companies which are ripe for investment at the right price.

Once we have descended through the economic and geopolitical clouds, the landing will probably be equally bumpy, perhaps more so. Having the safety belt of SKAGEN's experience to select the right companies will help navigate the turbulence and the runway for common-sense value investing is a long one.

All information as at 31/12/22 unless stated.
[1] MSCI All Country World Index in USD
[2] Source: MSCI. All figures in USD
[3] Source: Strategas Securities

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