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Fundamental Equity

INVEST IN INNOVATION: AN ATTRACTIVE ENTRY POINT

The equity market has pulled back in recent months, driven by fears around inflation, rising rates, and geopolitical uncertainty. In our view, this has created an attractive entry point for long-term investors in innovation equities. Moreover, the current environment may actually provide additional tailwinds to companies that have strong pricing power, offer innovative solutions and are on the right side of long-term secular growth trends, such as technological innovation, environmental sustainability, future health care, and the new-age consumer. One thing is for sure: uncertainty and volatility drive increased differentiation between stocks, making active management even more important.

 

INVEST IN INNOVATION AT A MUCH MORE REASONABLE PRICE

Over the last few months, central banks’ hawkish shifts in policy in response to rising inflation have unsettled investors and triggered a broad-based repricing of equities. Innovation-oriented equities, which outperformed the broad equity market by 132% over the prior five years, have experienced the most severe sell-off, pulling back by 21%. One of the reasons innovation equities have corrected so severely is that they have the highest anticipated growth rates and derive the majority of their value from cash flows extending far into the future. As a result, they have the highest implied duration risk: they are the most sensitive to rising rate expectations. When the market anticipates higher rates, it applies a higher discount rate to those future cash flows, lowering their present value. Valuations of innovation equities have now fallen to below their long-term average, giving investors the opportunity to gain exposure to innovation at a much more reasonable price.

 

Exhibit 1: Innovation Equities Have Experienced the Sharpest Sell-Off Relative to the Broad Equity Market

Innovation Equities Chart

Source: Bloomberg as of 23-Dec-2021. All returns are net.   

FUNDAMENTALS REMAIN STRONG AND INNOVATION EQUITIES ARE WELL-POSITIONED TO OUTPERFORM

 

Although the premium that investors are willing to pay for long-duration growth has moved lower, we have not seen a broad-based deterioration in fundamentals. In fact, we see examples of fundamentals remaining strong and, in many cases, improving. One concern of investors is that we may have seen 2022 spending pulled forward into 2021, and that we may now be heading into a period of deceleration. We believe this is a valid concern for some companies, where the acceleration in demand resulting from the pandemic may be unsustainable, but we remain confident in the sustainability of the demand outlook for the companies we own in our portfolios. In addition, we believe the current environment, characterized by high inflation and geopolitical uncertainty, is likely to provide an additional tailwind to innovation equities for the following reasons: 1) innovation helps to offset inflation 2) geopolitical uncertainty drives the push for energy and technology independence.

 

When inflation is high, businesses will seek to increase revenues and reduce expenses in order to offset rising input costs. As a result, companies that 1) have pricing power, enabling them to pass on higher input costs to consumers via higher prices, and 2) offer innovative solutions that help other businesses improve productivity and reduce costs, will be prized assets. With higher inflation, we expect to see rising demand for many of the innovative solutions in which we invest, including automation software solutions resulting in increased labor productivity and lower overall costs; and tech enabled healthcare that lowers costs and improves outcomes for patients.

 

In a world of increasing geopolitical tension, we expect the trend toward resource nationalism to accelerate as countries look to reduce their reliance on others and establish self-sufficiency, primarily in the form of technology and energy independence. Companies and governments now realize that relying on offshore technological production – such as semiconductor manufacturing – poses significant risks, as they navigate increasingly complex geopolitics, national security concerns, and the supply chain bottlenecks that have paralyzed multiple industries. Meanwhile, recent geopolitical events have drawn global attention to the risk of relying primarily on finite energy resources – namely, oil and gas – from a small subset of countries. To avoid the impact of potential supply disruptions and resulting price shocks, countries are moving to diversify and avoid depending on any single energy source. This push is fueled by regulatory tailwinds that favor the adoption of renewables, particularly in Europe but also increasingly around the world.

ACTIVE MANAGEMENT IS EVEN MORE IMPORTANT

 

We believe the current environment heightens the need for active managers to: 1) be selective, using a disciplined, fundamental approach; and 2) build well-balanced portfolios aligned with durable, secular growth themes.  In our view, taking a disciplined, fundamental approach to stock selection is critical as not all companies – even those aligned with secular growth – are created equal. For example, businesses with robust balance sheets, high profit margins, strong free cash flow, and low leverage tend to be best positioned to withstand higher interest rates and rising cost pressures. One of the metrics we pay close attention to is a company’s gross margin. A higher gross margin provides a greater cushion to absorb inflation, and usually indicates strong pricing power and core unit profitability. It is also important to differentiate between companies that may be unprofitable now but are likely to become profitable in the future, and those that may never become profitable. 

LOOKING AHEAD

 

Going forward, we believe innovation equities continue to be well-positioned to outperform, even in an inflationary, rising rate environment. Ultimately, we believe the long-term growth we are likely to see in these businesses will outweigh the current tension from higher rates and other short-term structural pressures. We foresee demand for the companies in which we are invested, which benefit from strong secular tailwinds – cybersecurity, sustainability, digital transformation, decarbonization, health care innovation, and tech-enabled consumption, to name a few – accelerating rather than slowing. That said, we believe active management is even more important in the current environment, as being selective at the company level and building well-balanced portfolios will likely be key to long-term success. Overall, we retain conviction in the multi-decade secular growth themes on which our portfolios are focused, continue to believe that companies on the right side of these themes may be well-positioned to outperform, and view the market pull-back as offering an attractive entry point for long-term investors.

Have a more detailed look at our Thematic Strategies

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