The spectre of ‘stagflation’

The start of May has seen some investors’ fears over the outlook for corporate earnings growth crystallized. One day included profit warnings from Boohoo and Joules, the clothes retailers, as well as Victorian Plumbing, the online bathroom retailer.

While none are portfolio holdings, they are a prescient reminder of the current risks faced by investors and reflective of the extremely challenging economic environment in which they operate. Boohoo posted slower revenue growth and pandemic related cost pressures, Joules blamed weaker margins on a very promotional retail market (the CEO is also departing), and Victoria Plumbing pointed to a normalisation of the DIY market and cost inflationary pressures.

What does stagflation mean for equity markets?

The spectre of ‘stagflation’ – slowing growth and sustained inflation – has had significant ramifications for the performance of consumer related stocks and led to a severe ‘derating’ of cyclically exposed companies in general. This, in combination with the outbreak of war in Ukraine, has elevated risk aversion to the extent that price formation in public markets appears increasingly inefficient. Valuations (Price Earnings multiples) have rapidly compressed across the market, with the consequence that some stock prices do not appear to realistically reflect the true underlying quality, or long-term earnings growth prospects, of those particular companies.

There is a striking lack of differentiation between those companies capable of growing through economic cycles (due to self-help or secular opportunities such as digitization, supply chain security, life science spending, regulation or content creation for example), and those where earnings are more economically sensitive. Increasingly companies are lumped together according to sectors (e.g. retail), styles (e.g. growth) or themes (e.g. RMI) and traded as ‘buckets’ irrespective of their individual attributes, and this amplifies market inefficiencies, particularly in smaller companies. It is during times like these, with heightened risk aversion and economic uncertainty, that it pays to hold cash generative companies with strong balance sheets, and self-help or secular growth opportunities, in a diversified and liquid portfolio. Downside protection is an important part of generating long term risk adjusted returns.

Not all bad news!

While we always focus on picking good companies and desist from attempting to predict the macroeconomics, it seems there are four significant positives to take from our current economic predicament. The first is that labour markets remain strong as at the end of April, and demand for labour has not slowed. The second is that consumer and corporate balance sheets are in good shape after a period of significant deleveraging during and post pandemic. Ordinarily, one might expect a fragile labour market and distressed balance sheets towards the end of a typical economic cycle. Thirdly, sentiment and positioning indicators on risk assets are already very depressed. Some of the most damaging recessions have historically followed on the heels of investor exuberance, rather than widespread concern. Finally, in a reversal, public market valuations increasingly appear to be at a discount to private market valuations and this is stimulating private equity bids for public markets assets. Recently in the UK small and mid-cap market we have seen RWS, Ideagen, Homeserve, Brewin Dolphin, Johnson Matthey and others attracting private equity bid interest or stake building, often at significant premiums to current share prices.

This month has been an excellent opportunity to get out of the city and visit some of our portfolio holdings, including Focusrite, the audio technology company, Stelrad, the UK radiator manufacturer, and Spectris, the specialist engineering group. Both Stelrad and Spectris are more recent additions to the Small and Mid-cap portfolios respectively. We visited Spectris’ Malvern Panalytical business, where the company designs and manufactures electronic sensors/products and analytical instruments. Malvern Panalytical is already a high returns business, with operating margins of 18%, but management expect to drive these higher through lean production methods. Major end markets advanced materials, pharmaceuticals and primary materials are sustainably growing well above ordinary GDP and management have increased investment in research and development to 7% of sales to drive revenues further. Following their aborted bid for Oxford Instruments (another fund holding) this year, Spectris’ shares were trading on an undemanding valuation multiple of 10x 2022 EV/EBITDA, despite having divested of non-core and arguably lower quality businesses in the portfolio for over 17x EV/EBITDA through recent years (including Omega just recently). This is a stark reminder of the current disparity between public and private market valuations.

The outlook for UK equities is bright

We believe that there are several companies where the pandemic has created the opportunity to accelerate growth, and this is most obvious in the technology sector. There are a multitude of reasons for this, including a fundamental shift in customer demand (a larger addressable market in the case of Bytes Technology or Auction Technology) or because technology adoption is improving companies’ ability to scale (i.e. Alpha FMC supporting customers’ digital transformation projects) and allows them to grow while requiring lower levels of capital (i.e. FDM, the IT training recruitment company, requiring less permanent real estate requirements). The challenge for investors now is to distinguish between whether these accelerated growth opportunities are long lasting, or whether the demand pick up post pandemic was simply a short-term phenomenon - a pull forward or temporary acceleration - after a Covid induced vacuum. The current state of extreme risk aversion in equity markets, and heightened market inefficiencies, mean that we believe attractive UK equity returns are on offer for those investors who can make this distinction.

Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.

The Royal London UK Smaller Companies Fund and Royal London UK Mid Cap Growth Fund are sub-funds of Royal London Equity Funds ICVC, an open-ended investment company with variable capital with segregated liability between sub-funds, incorporated in England and Wales under registered number IC000807. The Authorised Corporate Director (ACD) is Royal London Unit Trust Managers Limited, authorised and regulated by the Financial Conduct Authority, with firm reference number 144037. For more information on the fund or the risks of investing, please refer to the Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Information page on www.rlam.co.uk.

Royal London UK Smaller Companies:
Investment Risk The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested.
EPM Techniques The Fund may engage in EPM techniques including holdings of derivative instruments. Whilst intended to reduce risk, the use of these instruments may expose the Fund to increased price volatility.
Liquidity Risk In difficult market conditions the value of certain fund investments may be difficult to value and harder to sell, or sell at a fair price, resulting in unpredictable falls in the value of your holding.
Counterparty Risk The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose the Fund to financial loss.
Smaller Company Risk The Fund invests in smaller companies, the prices for which can be less liquid and be more volatile than those of larger companies and therefore may have a greater impact on the value of the Fund.

Royal London UK Mid-Cap Growth:
Investment Risk The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested.
EPM Techniques The Fund may engage in EPM techniques including holdings of derivative instruments. Whilst intended to reduce risk, the use of these instruments may expose the Fund to increased price volatility.
Counterparty Risk The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose the Fund to financial loss.