The optimism in European equity markets has continued over the summer despite the doubts raised by the new COVID-19 variants, coupled lately with worrying news on the geopolitical front. The underlying reason remains essentially the same: the apparent economic recovery in all developed economies. EDM Strategy is up +4.6% since the end of June, once again outperforming the MSCI Europe NR, which posted gains of +3.9%. Since the beginning of the year, the Fund is up +24.7% as compared to the +19.8% increase of the European index.
Looking ahead to the coming quarters, there is a fair amount of consensus that we are likely to move into an environment of higher inflation, especially compared to the recent past. Where the debate becomes more intense is regarding the type of inflation we should expect. Some see a moderate and even “healthy” rise in inflation in the short to medium term, a logical consequence of economic growth. Others, however, warn of the risk of out-of-control inflation due to structural imbalances that could become the catalyst for an unexpectedly abrupt change in central bank policies.
Our view at EDM Strategy is closer to the former, but we believe that the best protection for the investor, in either scenario, is again to invest in quality, growth companies. And in this environment, quality translates into pricing power.
In the coming quarters, companies are going to face a general increase in production costs, something that has already been seen in many of the results published in the second quarter of this year. Companies will have to be able to increase, at least proportionately, the prices of their goods and services to avoid a contraction in profit margins. Some will be able to do this thanks to factors such as market structure, product differentiation, brand strength, the absence of substitute products, a good offering of supplementary services, innovation or, simply, their leadership in the market that will allow them to make decisions that will be followed by their competitors.
For other companies, however, raising prices to defend their margins can be a much more complicated mission. For those operating in fiercely competitive, highly fragmented markets, with little or no product differentiation, without leadership positions or in sectors where customer decision-making is essentially based on the search for the lowest price, we believe they may be faced with a difficult situation.
At EDM Strategy we invest in quality companies, where one of their attributes is pricing power, which allows us to have confidence in their performance in this scenario. For example, for technology companies such as ASML or ASM International, the absence of realistic alternatives to their product creates a market situation in which their ability to reasonably and justifiably raise prices seems beyond doubt. L’Oréal, Sika and Michelin have a global market leadership position, strong brands and loyal consumers. One extreme within consumption is luxury, with even negative elasticity, where the more expensive a Gucci or Louis Vuitton handbag is, the more exclusive it is perceived to be, attracting even more potential buyers. The pharmaceutical companies Novo Nordisk or Roche have the most diversified and innovative product portfolio in the industry protected by their patents.
With regard to valuation, it is true that in an environment of higher inflation, an increase in interest rates could have a negative impact: higher discount rates. However, we believe that quality companies with the ability to raise prices will be able to generate higher growth in their future cash flows, which in many cases will more than offset the negative valuation impact of higher discount rates.
Another important point to bear in mind in an environment of higher interest rates is the possible increase in finance costs. In this regard, EDM Strategy’s portfolio is also very well protected. The fund’s companies have a net debt to EBITDA ratio of 0.75x, well below the index average of around 1.8x, and a quarter of the fund’s companies even have a net cash position.
In conclusion, we believe EDM Strategy remains very well positioned to continue outperforming the market over the coming quarters, and in an inflationary environment. Despite the fund’s excellent performance since the beginning of the year, this is mainly explained by upward revisions to earnings forecasts rather than a rise in multipliers. We hold a well-balanced portfolio of quality companies, long-term leaders in attractive sectors and interesting valuations that has all the ingredients for good returns in the years ahead.
José Francisco Ruiz and Beatriz López,
co-managers of the EDM Strategy fund