One of the most elemental questions of fund management is whether to change or to stand still. In the middle of long-term trends, such as the one towards growth and innovation in the 2010s, the skill in fund management is to do very little. Many people will come and present arguments that the world has changed but it rarely has and activity in these periods is usually counterproductive.
Then, one year in ten (on average) the world really does change, and inactivity is the counterproductive choice. Indeed, not changing can undo the good work of previous nine years. Although we are far from certain, there is a chance that 2022 was that one year in ten.
Change is hard. We all have a bias towards the status quo, and failing while being consistent with previous choices is, wrongly, seen as more acceptable than failing though making new choices. This creates an inherent bias against trying new things, even in the face of strong evidence.
The evidence which built up gradually in 2022 is that the investment environment is evolving into something which is quite different from the one of recent times. Not to the extent that everything which worked well in the 2010s must be left behind: innovation, for example, remains the purest driver of investment returns and societal improvement, but one where evolution is required to capture the best investment opportunities.
This evolution is primarily, but not solely, down to the plumbing of financial markets, rather than the real world necessarily being different. Our average holding period in recent years has been somewhere between five and ten years, which fits with the theory that inactivity within a trend is key. This means we have looked at the world as we see it somewhere between 2027 and 2032 and invested accordingly. When we look forward now, we think much will remain the same as we thought before: the world will be more digital, less carbon intensive and healthier.
The key issue that markets had to work though in 2022 was that inflation results in higher interest rates (as central banks are charged with maintaining inflation at low levels) – and assets are worth less in such an environment. It is far from certain, but there is a credible case to be made that on a multi-year horizon inflation and therefore interest rates will be structurally higher than over the last ten years. This isn’t actually a heroic assumption given how low they have been in recent history. More expensive energy, labour and capital (debt and equity) mixed in with observable de-globalisation will remove many of the disinflationary forces that have been acting on the global economy for so long.
It is possible that we are moving from a time when central banks were an investor’s friend, to one where they are his or her foe. Between 2008 and 2021, each fall in asset prices was met with interest rate reductions and significant amounts of quantitative easing. Last year was the first year when the consequences of this began to feed through to higher inflation – and unsustainable asset prices. It may be that rather than providing a floor to asset prices in the coming years, central banks will be the ceiling, having to tighten policy in the face of higher inflation, rather than loosening it into falling inflation as has been the trend.
Another factor to consider is how innovation, at least of late, has become more incremental in certain key parts of the economy. Can anyone really spot the difference, other than price, between the iPhone 14 and iPhone 13? And does e-commerce delivery in two hours really improve society beyond next-day delivery? The days when technology companies were producing genuinely innovative products year on year look, for the time being, to be behind us. Of course, futurologists would profoundly disagree with this, and they are of course correct. But time horizons matter in investing – if they didn’t, we’d invest in one set of companies for the entirety of our careers. It is important to recognise the shifting sands of economies, industries, companies, and markets.
In summary, while we will get the answers in 2023 to the key questions that puzzled markets in 2022, such as where inflation and interest rates will peak, it is the longer-term trends in innovation, inflation and interest rates that really matter to investors. It seems to us they could be pointing in a different direction from recent times. It would be wise for investors to at least consider this as 2023 starts to unfold.
What are we doing?
The issues that we are thinking about at the start of 2023 are quite different from those at the start of 2022. After the rally in asset prices at the end of 2021, valuation was our primary concern in considering our portfolios – although not to the extent it turned out to be. This year, after a significant derating of growth stocks (even after taking higher interest rates into consideration), our portfolios look more fairly valued than highly valued. High-quality companies trade at much lower prices than in recent times and, if interest rates move to where expectations currently are, they look reasonably valued and worth having some exposure to.
Our main question now is which areas will benefit from a different interest rate and inflation environment, and would owning some companies in these areas improve our portfolios? This is an important question. As always sustainability comes first for us, so we need to be convinced of this aspect of anything new that we invest in. In addition, on a financial basis, we want to see value creation and the potential for long-term growth as we think these are the key long-term drivers of investment returns.
When we cast out our investment process, the sector which comes back, which didn’t a year ago, is banks. From a sustainability perspective the banking sector has been on a rehabilitation path for over a decade following the financial crisis. Governance improved first, followed by social aspects as products became simpler and somewhat more aligned with societal needs. Finally, environmental performance is on the cusp of improving as better disclosure on financed emissions and clearer policies on future lending are made. We would certainly score this sector higher from a sustainability perspective than at any time in the last decade.
Financially, the low-interest-rate environment since 2008/9 has been materially detrimental to bank profitability, and most banks have failed to meet their cost of capital in recent years. We think this could change in the potential new world we are entering. Equally banks can price their capital more attractively now as other sources of lending, such as bond markets (and, indirectly, central banks) become less favourable. We also think banks have a fundamental role to play in financing the huge amounts of capital investment needed to transition to a more sustainable society, which can provide interesting avenues for growth. Financially, therefore, the sector looks more attractive than for some time.
We are aware, however, of the perceptions of this sector, which for some years have been somewhat negative from a sustainability perspective. Banks are also exposed to the economic cycle, around which there are some understandable concerns. It is our role, however, to assess and think about change and that is what we are currently doing in this area. Thishas been and will continue to be done in coordination with our external advisory committee. Ultimately, any investment we make must be through our rigorous process, and the banking sector will be no different.
While we consider open-mindedness a virtue, we are conscious that ‘change’ can sometimes appear to involve deviating from your philosophy and the values at the core of your investment process. To be clear, though, we are not changing our investment process: we are simply applying these long-standing principles to a different investment environment.
This year will undoubtedly evolve in ways that we don’t expect, as indeed 2022 did. Overall, though, sustainability continues to grow strongly in business and in society, and we are confident that this will continue to underpin our development.
This is a financial promotion and is not investment advice. 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.