The economic fallout from COVID-19 is different from other financial crises for a number of reasons. It is health rather than financial-market based, and it has prompted an immediate and large-scale government response. And while stimulus packages, like JobSeeker and JobKeeper, have helped offset some of the economic fallout in the short term, longer term implications compounded by structural economic headwinds will impact companies and therefore investors for years to come.
What is perhaps more significant for investors is that this crisis was not preceded by an economic boom, in the way most financial crises are. This is important because the fact that the global economy was facing significant challenges prior the COVID-19 pandemic has important implications.
We believe that even when the virus dissipates, global economies are unlikely to rebound quickly from what is already a low base. Marginal businesses will struggle, and many will not survive. Those most affected are likely to be travel industry-related, traditional retail, traditional entertainment, highly discretionary products and services and commodity-based businesses.
Conversely, investors who had already recognised that the global economy was facing headwinds prior to COVID-19, and whose investment decisions were being made with those headwinds in mind, are more likely to withstand and emerge from the crisis in better shape.
Headwinds to the global economy were clearly evident, long before COVID-19
In our view, the global headwinds which were evident prior to the COVID-19 are likely to be permanent and will therefore impact long-term returns going forward. These include:
- an ageing population and a disappearing middle class, both of which restrict GDP growth;
- constraints on natural resources;
- declining monetary tailwinds;
- high government and consumer debt making households, businesses and governments more fragile;
- rising wealth inequality; and
- technological disruption which has impacted production and jobs and led to greater automation, and the use of artificial intelligence.
It is no longer possible for investors to get rich by commercialising cheap fossil fuels – there are constraints on natural resources now. Technology continues to change the way we interact with each other, and the way we produce, manufacture and buy goods – and post internet, as the middle class has declined, the world has increasingly become winner takes all – as the gap between rich and poor has steadily increased.
COVID-19 did not create these headwinds, but it will exacerbate their effect, and as a result, it is likely that the global economy will be soft for years to come.
Unfortunately, this means tough times ahead for investors.
A growth-based investment style will be the winner post-COVID
While conditions will undoubtedly remain difficult, they are also conducive to another decade of market dominance for growth-based investment styles like ours. History shows us that the value anomaly performs poorly in difficult low-growth and low-inflation environments –exactly the environment we now find ourselves in, and which we will be dealing with for the foreseeable future.
Our investment thesis is long-term in nature, and focused on fundamental quality, so regardless of changing market conditions we continue to invest only in the highest quality companies that we believe have the best potential to outperform for shareholders. These are new-world businesses – with disruptive, unique value propositions, competitiveness in large and growing addressable markets, and those which are not highly-geared. These businesses are more likely to succeed over the medium to long term as the old-world businesses, which relied on continuous globalised economic growth to perform, which lose profitability.
One of the corollaries of disruption and change has been that the world has become increasingly competitive. Average returns on equity have materially declined over the past two decades, but more than that, financial reward is becoming less and less equally shared. There are fewer and fewer winners, and more and more losers – which makes it more important than ever to pick the winners.
We seek to exploit what we believe are the key themes likely to produce alpha over time. Among these are the shift from traditional media to online/digital media, the move from cash to electronic payments (which has accelerated during COVID-19), the transition to sustainable energy and transport and the digital transformation of the workplace.
Maximising opportunities but without compromising discipline
Given the high volatility in equity markets currently, many investors attending our recent webinar were curious about our response and whether our portfolio turnover has increased.
The answer is that we have not changed our disciplined and structured portfolio construction framework. We are long-term investors, and the fundamental qualities we look for in a business do not change with changing market conditions. That’s not to say that we haven’t taken the opportunity afforded by the recent market downturn to invest in some businesses we had been tracking for years but which prior to COVID-19 were overpriced according to our calculations.
We use a 5-year internal rate of return (IRR) to set target stock weights – and over the past few months we have seen the IRR of some companies decline where the stock price has held up better than the portfolio overall. This has allowed us to sell down businesses where our estimation of average growth revenues has declined substantially, and to invest more in some stocks where the IRR has increased.
The process of topping and tailing the portfolio in this way has doubled alpha in our portfolios over the past two decades, and we therefore expect that it will translate into higher returns for our investors over the next 5 years.
In conclusion, our view is that investors with a long-term investment horizon can be cautiously optimistic about returns going forward if they are prepared to stay the course. COVID-19 continues to pose challenges for businesses and governments and there’s no question that the economic fallout will affect us all. At the same time, businesses with strong fundamentals – those with robust balance sheets, a high return on equity, a competitive value proposition and a strong competitive advantage are best placed to perform over the long term.
Mark Arnold, Managing Director, Lead Portfolio Manager & Chief Investment Officer, Hyperion Asset Management
Jason Orthman, Lead Portfolio Manager & Deputy Chief Investment Officer, Hyperion Asset Management