26 Apr 2022
Having recently gone through a successful 10 years at the helm of Fidelity Global Situations, portfolio manager Jeremy Podger looks ahead to what the next decade could have in store for investors. In particular, he identifies 10 trends that are set to increasingly influence returns and discusses what this means for stock selection and portfolio construction.
In the last 10 years, equity investors have enjoyed returns that would have looked rather ambitious back in 2012. But the investment landscape has shifted in this period. There are new themes and new challenges emerging. What worked well in the past decade may not work so well in the next.
It has been a good decade for our funds. The framework we set up for stock selection some 10 years ago has served us well – focusing on corporate change, exceptional value and unique (growth) businesses. Each of these has shown strong performance, even though the value category has been more challenging in the past five years or so. The performance contribution relative to benchmark has been broad based in most sectors and regions and across size strata, vindicating our diversified, bottom-up driven approach to portfolio construction.
Five years ago, we put out a piece reflecting on the challenges of active management and the myths and prejudices around it. At that time, it appeared that active management was under brutal attack from passive strategies. We maintained that good management can clearly add value relative to passive strategies. For fund selectors, it is then a question of judging which managers do have that potential and which have strategies that are best suited for the prevailing investment climate. In the past five years, judging true performance potential may have been more challenging, since managers with a permanent “growth” bias have not had to try too hard to outperform the broad index.
What the past few years has clearly brought in favour of active management is a greater appreciation of stewardship responsibilities. Our investors increasingly expect us to engage with companies on their behalf to encourage actions that will not only directly benefit shareholders but also be a benefit to wider society.
There has been a huge increase in focus on Environmental, Social and Governance (ESG) factors. We are currently in the early stages of addressing the climate crisis. So far, the fund management community has played a constructive part in deploying funds to encourage beneficial investment and discourage harmful investment by companies (through changing their market-implied cost of capital). There are enough professionals who recognise that this is a real emergency, and we are anxious to help as far as we can.
This is not going to be an easy or straight road. There will be times when there is over-exuberance which gives way to periods of underperformance – as we saw for example in renewable energy stocks in late 2020. Our approach is to incorporate ESG factors into each stock investment decision and to avoid companies that have high ESG-related risks. Those risks will result in bad performance when governments penalise or sanction bad actors – as they surely must if we are to realise our collective long-term environmental and social goals.
We need to think about how to benefit from the investment needed to take carbon out of the system. Within power generation, Fidelity projects that renewables will go from around 40% in Europe in 2020 to around 90% in 2040 (20% to 75% in the US). Investors will not necessarily profit most from exposure to suppliers to renewable generators - this will continue to be cyclical. We should also look at those who see cumulative benefits such as wind farm operators and transmission grids.
But the opportunities go far further than that - from suppliers to electric vehicles to oil service companies that are turning their focus to carbon capture technologies. And while electrification of energy consumption is the most efficient solution in most cases, green hydrogen is likely to play an increasing part. We will continue to seek investments in companies that will benefit from these sustained changes whilst being (as ever) extremely valuation sensitive.
Whilst utilities have been closely regulated for decades, we can reasonably expect further government direction designed to reduce emissions. Exactly what forms this may take is still a moot point, but it is surely coming. Companies that have recently committed to aligning with the UN goals for greenhouse gas emissions (as set out in the Paris COP21 conference in 2015) have done so not only to help play a part in achieving these objectives but also to mitigate the financial risks from carbon taxation and other penalties.
But there are other dimensions to regulation. As a result of the global financial crisis in 2008, the last decade has seen progressively tighter regulation and supervision of banks in order to protect consumers and avoid another systemic failure. Arguably, the banking industry is now more resilient than at any time in living memory. Other industries will surely come under scrutiny in the coming 10 years.
Notably, there is now more regulatory focus on technology market power and the dominance of “platform” companies that benefit from “winner-takes-all” scale economies, particularly from the point of view of harmful content and data privacy. While the EU has been leading on this for a while, the US is likely to follow. The US appears to be shifting from a laissez-faire approach, only acting where consumers were demonstrably worse-off due to corporate actions, to a wider and more proactive approach.
While the last 10 years has been about the expansion of scope and profit margins of technology companies (“tech eats everything”), with some regulatory nudging, the next 10 years may see more focus on internalisation of technology by companies in all industries (“everything eats tech”).
It is interesting to note that the massive monetary stimulus in the late 1990s brought about the 2000 tech “bubble” and something similar happened in 2020 with investors going all out to buy “growth at any price”, forgetting the risks of future competition and obsolescence. Much of what was happening in the markets through the Covid pandemic period has looked and felt a lot like it had 20 years earlier, despite the more recent correction in some of the more speculative names. Although we see great potential in technology and have always found many interesting opportunities here, it will surely be a more difficult and dangerous area over the next 10 years.
For most of the past 20 years, most investors have largely ignored geopolitics which rarely had a significant impact on the progress of companies. The post-World War II “rules-based international order” underwrote the free expansion of companies around the world. It meant that global investors were essentially able to apply the same metrics to assessing publicly listed companies wherever they might be.
From 2016, however, this has come into question. The previous administration in the US did much to try to undermine the standing of the UN which had played a pivotal role in maintaining this order. Now investors have to contend with the risks of tariffs and sanctions and must also follow through the consequences of disrupted international supply chains. The tragic situation in Ukraine reinforces these concerns.
With more local political risks and countries and companies now seeking to build local self-sufficiency, we are likely to see lower correlation between markets. As global investors, in a sense we should welcome this since it provides a clear argument for diversification benefits in order to improve risk-adjusted returns. This would lead us to favour opportunities in less correlated markets such as Japan, which has an attractive combination of low valuation and stable legislative framework.
This all goes to remind us that emerging market equities are not a separate asset class. Emerging markets are essentially a sub-set of global equities and consist of countries that have the potential to converge with the richest nations over the coming decades. They are a hunting ground for companies with strong growth and profit potential, but typically carry more governance and political risk. Our investors have become more sensitised to these issues. Arguably, they are easier to deal with in a responsive and dynamic way within the context of a global portfolio, rather than through a separate allocation to emerging markets.
Like most observers, in 2021 we saw the brewing inflationary pressures in developed economies as being largely a function of Covid-related supply chain bottlenecks and distortions in the labour market. We thought that most effects would be temporary and would therefore have limited chance of becoming embedded or of triggering a wage-price spiral effect. But these inflationary causes have gone on longer than expected and have been exacerbated by higher commodity prices resulting from the Ukraine situation. We still expect inflation to ease, but now more slowly and from higher levels.
How do we take this into account when selecting investments? We have to assess the inflationary risks to profit margins on a case-by-case basis. But there are some common threads. Companies with strong pricing power (in relatively concentrated and disciplined industries) should cope well. Companies with high gross margins (e.g. software) or cost pass-through models (e.g. distributors, parts of insurance and healthcare) or inflation indexing (e.g. telecommunications towers) should also feel minimal pressure.
The last few years have been great for growth investors and a real struggle for value investors. Certainly, this has been partly about the rise and rise of technology, but we have also seen widening valuations within sectors. In recent months, the gap between the two has narrowed somewhat, but growth stocks still appear expensive against their own history and value stocks do not.
Typically, value tends to do better in higher inflation environments when bond yields are high or rising. In the past decade, many fund managers have become systematically more growth-biased and this may be something they find difficult to reverse. In contrast, we generally have a balanced and flexible approach to style and have actually found it more difficult to source attractive growth stock opportunities on sustainable valuations in the recent past. It is worth recalling that two decades ago it took six years for the growth index to bottom against value.
We are now at valuation levels for equity markets that are mostly higher than they were 10 years ago when people were still reeling from the financial crisis and feared there would be another meltdown around the corner. This is particularly true for the US. It is not too difficult to justify current valuations given they appear relatively attractive against bonds. The bigger question is around the potential for profits in the coming years.
In most markets, prevailing profits are higher relative to the size of the economy than long run historical averages, and they are around record levels in the US. Some of this can be explained as a direct consequence of lower interest costs and lower taxes. Some can be explained by better company management and a focus on excellence within industry niches (rather than wasteful diversification). In addition, labour has taken a smaller share of GDP in most economies in the past decade (while company profits have risen) and it is quite conceivable that this may reverse somewhat. Finally, if internationalisation helped companies reduce costs and increase scale benefits, “de-globalisation” may add to inflationary pressures and reduce returns on capital. On a more positive note, it is of course possible that the progress of technology leads to higher economic growth rates in coming years.
But considering all factors, it seems likely that real profit growth (above inflation) will not match the rates seen in the past 10 years. Nevertheless, equities remain a good hedge against long-term inflation and, from where we are now, equities should continue to reward patient investors.
So, with all this in mind, how are we thinking about constructing global funds for the future? In general, we are looking for attractively valued stocks in companies with good pricing power. We expect to give more attention to companies that are part of the solution to the climate crisis. At current valuations, we are somewhat more cautious on technology in general. But we are enthusiastic about a number of the tech titans which have global reach and massive cash generation potential and expect to find many emerging new opportunities in technology in the coming years.
Finally, while we think about macro factors as highlighting areas of potential risk and opportunity, our portfolios will continue to be built from the bottom-up using the stock selection methodology that has been in place for the past 10 years. We continue to look for opportunities in corporate change, exceptional value and unique (growth) businesses and to blend these to give a diversified and balanced global portfolio.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of an investment in overseas markets. Investments in emerging markets can also be more volatile than other more developed markets. The Fidelity Global Special Situations Fund has the potential of having high volatility either due to its composition or portfolio management techniques. It can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. A focus on securities of companies which maintain strong environmental, social and governance (“ESG”) credentials may result in a return that at times compares unfavourably to similar products without such focus. No representation nor warranty is made with respect to the fairness, accuracy or completeness of such credentials. The status of a security’s ESG credentials can change over time. Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.