We have reached the final stretch of an extremely difficult year for investments and financial markets. In recent months, market sentiment has been dominated by four, closely-related factors: the war between Russia and Ukraine, inflationary trends, interest-rate hikes by the central banks, and the severity of the impending slowdown. These factors have triggered extreme volatility, setting the standard since the beginning of the year. In October, however, we managed to take a breath and recover a portion of the year’s losses. The month’s gains attest to the dismal market sentiment at the September close and the fact that prices already reflected a very negative scenario. Still, there are reasons to be optimistic:
- Global supply chain pressures continue to improve;
- The price of raw materials (metal and food) and oil are near pre-war levels;
- Gas prices have corrected sharply in recent weeks, dropping from nearly 350 euros in late August to just under 100 euros (30-day benchmark). We can discard the worst predictions as regards supply cuts, thanks to the swift accumulation of reserves by European countries, a substantial drop in consumption, and better weather.
In addition, the publication of third-quarter earnings reports shows that trends in economic activity remain positive. The results for most of the companies in our portfolio surpassed estimates and messages from the various management teams convey confidence and are far from focused on a severe economic slowdown. In fact, 27 of the 31 portfolio companies are carrying out share buyback plans and management teams are even increasing their personal holdings in these companies. For the moment, all companies have maintained their short- and medium-term guidances, with some even opting to increase them.
In this environment, EDM Strategy closed the month of October with a cumulative return of -19% YTD, vs. the -12.2% obtained by the MSCI Europe NR. Much of the negative spread relative to the index is attributable to our lack of exposure to the energy sector, especially oil companies. In the first half of the year, as a result of the war between Russia and Ukraine, the European energy sector rose +12.5%, while the market’s other sectors plummeted -20% on average. It is therefore understandable that the fund’s spread relative to the index, where the energy sector accounts for 7%, reached its widest point in late June. Since then, the market’s evolution has been slightly more homogenous among the sectors, though equally volatile, and we have managed to contract the spread somewhat. It is worth noting that, in this period, the energy sector experienced favourable trends, clocking the second-best performance by sector, which we were able to offset through stock picking.
In a market climate as complicated as the one we have witnessed this year, effective stock picking is essential. In this respect, we have walked the line, avoiding profit warnings, selecting the finest quality companies in each sector, and seeing profit estimates revised upward across two-thirds of the portfolio in 2022. Below we explore three clear examples of successful stock picking by sector. It is interesting to note that, in these examples, the upward revision of profit estimates (red line) is not accompanied—as history and logic would indicate—by a rise in share price (white line):
The companies on the left belong to the EDM Strategy fund, while those on the right are sector comparables not included in the fund.
In light of the current scenario, where we continue to face uncertainty given the war and the effects of inflation and interest rates on economic activity, the best investment strategy is to remain steadfast in our belief and philosophy: to find top quality companies and focus on the long term. Many factors define a quality company. We would like to highlight a few that are of particular importance in the current climate.
1. Pricing power: leading companies in their sectors, whose strategies focus on providing value distinct from that of their competitors, usually accompanied by a powerful brand. These companies are able to pass on inflated costs to their customers and thus safeguard their margins.
2. Sales visibility: in an economic slowdown scenario, it is vitally important to invest in companies capable of providing predictability in the behaviour of results. We are not only referring to companies in defensive industries, like healthcare or consumer staples, but to companies exposed to clear megatrends in sectors like tech, logistics, specialised industry, etc.
3. Minimal debt: in general, the companies in our portfolio maintain very low levels of financial leverage (net debt/EBITDA ratio of ≈ 0.5x, vs. an average of 1.8x in the European market). As such, they are protected from rising finance costs and can capitalise on acquisition opportunities when the valuations of potential target candidates are low.
We at EDM Strategy have capitalised on the excessive compression of multiples among top-quality companies to add names like Straumann, L’Oreal, and Atlas Copco at valuations far below their historical average, and strengthen positions like ASML, Sika, EssilorLuxottica, Accenture, and LVMH.
After the de-rating of our portfolio in light of sensitivity to higher interest rates, EDM Strategy trades at a P/E ratio of 18x, markedly below the average of the last 10 (20x) and 5 years (22x). As is evident in the following table, rarely have we seen such a favourable combination of risk and return. Taking the current P/E ratio of 18x into account and using as a reference our 5-year profit estimate for the whole portfolio (+12.5% annual growth), we obtain a cumulative return of +80% at the end of those five years. It would be logical to consider a scenario of higher profitability given the likelihood of expanding multiples once the rate scenario returns to normal. In terms of quality, we believe the current portfolio is the best of the last five years, so the present P/E ratio is not entirely comparable to its historical counterpart.
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.
Carlos Palau and Guillermo Fernández-Gao,
EDM Strategy Fund Analysts
