The first quarter of 2022 will go down in the history of markets for its tremendous volatility. Initially, concerns about sharp interest-rate hikes, monetary policy “mistakes”, and rising energy prices triggered a violent sector rotation that may have gone beyond what could be justified from a fundamental standpoint. The outbreak of war in Ukraine, in addition to the human drama, prompted a radical change in economic expectations and a geopolitical shift with various implications that imply a new scenario in the medium and long term.
In this environment of extreme volatility, EDM Strategy L Class closed Q1 2022 with a decline of -10.15%, relative to a -5.32% drop for the MSCI Europe NR.
As of this writing, the horror of the war continues. However, we think that the moment of maximum risk—i.e., an expansion of the conflict leading to an even greater disaster—is behind us. Naturally we have no crystal ball, but the unfolding of events on the ground and the statements from the warring parties regarding cease-fire negotiations may be narrowing the range of uncertainty in some respects.
As for the scenario that the companies in our portfolio will have to face, we must assume major changes are in store as a result of the conflict:
- Given Russia’s crucial role as an exporter of oil and natural gas, the most likely scenario is one in which companies will have to assume higher energy costs for a time, until Europe can establish supply alternatives.
- Hopes of lower inflation in the second half of the year are declining significantly.
- Downward revisions in economic growth expectations in the US and Europe have already begun, though we do not share the fears of the most pessimistic analysts.
- The increase of defence budgets in Europe will have consequences in the redistribution of long-term spending priorities.
- Central banks may have to tread more carefully before taking monetary measures to curb inflation that could negatively affect growth expectations.
There are also positive aspects that the best-managed European companies will undoubtedly make the most of.
- The unity of Europe in particular, and of the Western world in general, has been one positive upshot of the war. The unity of action in Europe and the swiftness of the reaction (also economically) compare very well to previous crises.
- Some major global megatrends, like digitisation in the broad sense and the energy transition, are still fully in force.
- We believe that consumers’ “zest for life” post-COVID has not changed as a result of the war, and will likely mitigate the negative impact on travel, tourism, and leisure in general.
Once again, the leading companies will find opportunities to emerge from the crisis stronger by participating in the reconstruction effort that will foreseeably follow the end of the conflict.
From this perspective, our investment strategy in response to the uncertainties of the war and the subsequent shift in the macroeconomic scenarios can be summarised in the following points, invariably with a medium- and long-term vision:
- Once again, quality will be key. With milder tailwinds, the attractiveness of companies in highly cyclical sectors will decline, in a movement counter to what we saw in the first few weeks of 2022. Still, the main “quality” attribute in this scenario will be, in our view, pricing power and the ability to defend margins in an inflationary environment.
- The attractiveness of those companies capable of offering predictability in their results, regardless of the cyclical moment, will increase. This appreciation will encompass companies in sectors traditionally considered defensive, such as health, as well as other sectors that benefit from specific megatrends in technology, logistics, specialised industry, etc.
- The attractiveness of those companies that, thanks to reasonably cautious management, face new challenges from a position of strength, particularly in terms of debt on their balance sheets, will also increase.
Our confidence in quality, through selecting the companies in our portfolio from a micro, bottom-up approach, is reaffirmed in crisis situations. It is worth noting that in the last month, in the midst of the war, five important companies in our portfolio—EssilorLuxottica, Deutsche Post DHL, Accenture, Brenntag, and Air Liquide—published new guidances as part of their 2021 earnings reports or CMDs. In these cases, despite the latest uncertainties and negative factors, there were no cuts in the market consensus’ profit expectations. On the contrary, specific positive trends favouring these companies in their respective sectors have provided sufficient room to manoeuver, at least for the time being.
The good news from an investor’s point of view is that the sharp drop in share prices in the initial weeks of the war, which spared only energy and commodities, provided outstanding entry points to acquire top-quality companies at very attractive levels with a medium- and long-term perspective. In recent months, we have been able to capitalise on these opportunities and add new names, like L’Oréal and Straumann, to the portfolio, and strengthen our position in others, like ASML, EssilorLuxottica, and DSV.
The portfolio’s average P/E ratio of 19x, 15% below the historical average, for companies that we expect will obtain annualised profit growth of 13% in the next five years, with low levels of debt and an average ROE of 24%, in our opinion, represents an excellent investment opportunity.
In our view, we maintain a well-balanced portfolio of quality companies, leaders in sectors with long-term growth, attractive valuations, and all the ingredients necessary to obtain good returns in the years to come, in absolute terms and relative to the market, consistent with what we have achieved in the last three years.
José Francisco Ruiz and Beatriz López,
co-managers EDM Strategy fund
