This time around it looks like the rapid raising of interest rates to fight inflation is the capitulation phase and we are still waiting for a recovery catalyst. The spark could come from a resolution to the war in Ukraine, a mild winter to help Europe find its feet or a Fed pivot. Unfortunately, no-one can know either when or how the reversal will come. We only know that it will.
Hope springs eternal
Because of the uncertainty, it is also natural to cling to any encouraging news buried beneath the gloomy headlines of inflation, recession and conflict. Alongside employment data remaining buoyant, a source of hope is that companies have been more resilient to rising costs and slowing growth than many investors feared.
That optimism is about to be tested with businesses soon to report their third quarter earnings. Although analyst forecasts have fallen in recent months, they still expect companies to report higher profits this year than last and deliver further growth in 2023.
We can see in our everyday lives how companies are passing higher input costs on to consumers by rising prices, particularly for food and fuel. With household incomes struggling to keep pace with inflation, however, there will come a point for many companies when demand falls – particularly as interest rates rise – and earnings will suffer.
It is likely that we are already there and companies upcoming results will fall short of analyst expectations as economic reality bites. Recent Bloomberg economist surveys project a 50% chance of a US recession in the next year, while the odds in Europe are 80%. With investors clutching at fewer and fewer straws, disappointing earnings or companies talking down their future prospects, could leave equities looking vulnerable.
Survival of the fittest
What does this mean for your investments with SKAGEN? Unlike passive funds which track entire stock markets, we only invest in companies we consider to be the best, based on detailed analysis of their prospects weighed against their valuation. They generally reported strong second quarter earnings and continue to perform in line with our expectations. The fact that our funds usually contain fewer than fifty stocks, rather than hundreds, means we can monitor them closely and engage regularly with their management teams.
Our active approach also allows us to create geographically diversified portfolios that combine holdings geared towards different stages of the economic cycle in order to mitigate the risk of recession. For example, financial services companies typically benefit from higher interest rates while defensive stocks like utilities, health care and consumer staples tend to outperform during economic downturns.
A particular consideration during periods of high inflation is selecting companies with strong balance sheets and the pricing power to pass along cost increases, usually those with dominant market positions or differentiated products. Finally, periods of market stress provide great opportunities to pick up bargains in sectors where valuations have come down, for example technology recently (see text box).
History shows that stock markets have an amazing ability to look into the future and detect when the ground will be firm again. Based on the next 12 months expected earnings, the US S&P 500 index currently trades in line with its long-term average – valuation signals are more optimistic than investor sentiment suggests.
Their forward focus also means that markets tend to move well before the economic terrain softens and then hardens (see chart). The S&P 500's current fall of 23% is in keeping with previous recessionary declines, which could mean that we are hopefully closer to the end of the latest market slump than the beginning.
Stock markets have suffered median decline of 24% during previous recessions
Source: Y Charts, as at 23/09/2022
However, valuations remain the best predictor of long-term returns and currently provide some excellent buying opportunities for those prepared to hold on for a few years. The key to successful investing – especially during periods of market stress – is contrarian thinking and patience. That's true whether we're heading for a recession or not.
Finding value in growth
While markets overall aren't necessarily cheap versus historic levels, sectors like technology where valuations have fallen significantly contain companies with strong growth prospects on sale at knock-down prices.
SKAGEN Vekst invested in Alphabet at a compelling valuation in August. Google's parent company has demonstrated solid earnings growth and is also committed to paying out its huge annual free cash flow, representing an attractive total return. The company, which is 1.3% of the portfolio, has not been immune to the sector-wide slow-down but the portfolio manager has gained more confidence in its ability to withstand competition relative to its peers.
SKAGEN Focus recently bought into US technology company NortonLifeLock (previously Symentec) at a valuation of 11x current earnings power, which is very attractive given its high margins and growth trajectory. The global market leader in consumer cyber security represents 1.5% of the portfolio and the portfolio managers estimate 55% upside from its purchase price.
Source: Factset Earnings Insight, 16/09/2022