Insights: Looking back and forward

2021 was another rewarding year for investors, with particularly strong returns for euro-based investors, thanks to the decline in the value of the single currency relative to other major currencies during the year. Of course, currency driven gains can be illusory, but they feel good, and we all like feeling good. However, even without the tailwind of the euro decline, returns were still well above long term averages.

So where does this leave us now? I think some candour is required. Returns have been very strong for a number of years now, which is all the more remarkable given the circumstances we have found ourselves in over the past two years. Returns have been ahead of what we would have reasonably expected over this period, and it is important that you hear that from us.

Over the very long term, equity markets have delivered after-inflation returns of c.6% per annum, so whenever you see returns above this you should ask whether we are ‘borrowing’ returns from the future.

Indeed, based on today’s valuations it is reasonable to conclude that returns will be a little below the longterm average. Of course, they may not be, and we are optimistic about the potential for productivity gains and future earnings growth, but it is important to have realistic expectations. It is all the more important when we reflect on the fact that investors seem to have quite high expectations today, with some surveys suggesting investors expect double digit returns in the years ahead.

This may seem like an odd thing to say but we absolutely do not want to see double digit returns in the years ahead for broad market indices. We do not want valuations to expand, we do not want unsustainable gains. Slow and steady wins the race.

Indeed, some investors today are drawing parallels with the tech bubble of the past when valuations really did expand and future returns over the next decade were very low as a result. To be clear, this is not what we believe today. We don’t believe valuations are unreasonable at overall index level and we continue to believe investors can look forward to reasonable returns over and above inflation, but we feel it is important to temper expectations, after a very rewarding period.

A review of the performance of our direct equity portfolios in 2021 serves to reaffirm this view. Whilst many of our companies performed very strongly operationally, we also saw a notable re-rating (i.e., valuation multiple expansion) of a number of our holdings, with the market clearly developing a greater appreciation of the value of some of the unique businesses we own. We will continue to hold these companies, but we fully expect a period of consolidation, allowing time for earnings to catch up with valuation expansion. In saying this, it is important to remember that whilst valuation is an essential part of investment analysis, over the very long term the return on capital that our investments can generate, and the ability to re-invest capital, will be the most important determinants of return.

Speaking of valuation, perhaps one of the most fascinating aspects of equity market performance over the past year has been the remarkable ‘round-trip’ we have seen in many of the perceived Covid-19 winners.

As regular readers know, we absolutely believe that the pandemic has catalysed an acceleration of digitalisation and we believe investors need to deeply reflect on the coming changes in the economy over the next decade. We also believe we need to strategically allocate to strategies that will allow our clients to capture some of the value that will likely be created by companies at the vanguard of change.

However, we are prudent in how we do so. We allocate to managers that have expertise in this area and companies that we have conviction in, with more established track records. The merits of this approach have certainly been vindicated over the past year.

An alternative approach of stock picking and attempting to pick the winners of innovation and disruption over the past year would have been deeply damaging, with many of the perceived winners falling by more than 50% over this period. What’s so interesting is that whilst many of these companies have continued to deliver good growth, it has become clear that they were priced for much higher growth, and right now the market is clearly grappling with the durability and duration of their growth.

Naturally the strategies that we have allocated to in this area have also suffered declines in recent months and a small number of our higher growth direct equity holdings have also experienced a de-rating.

However, we remain very comfortable with the portfolio approach we have taken, allocating to managers who spend all their time thinking about innovation and disruption. Our odds of success with this approach are clearly much higher and the volatility is much more tolerable than trying to pick the winners ourselves.

Turning to another of our core views, on interest rates, it is interesting to see the changing stance of central banks over recent months, with the market now very focussed on the pace of interest rate increases in the US. There has been plenty written on this topic, and we are not inclined to weigh in with our view, mindful that nearly everyone has been wrong on interest rates and bond yields for at least 10 years now.

However, we do retain conviction in our view that interest rates will remain below inflation for a very long time, and this is much more important than the level of nominal rates. We believe it is entirely sensible to expect interest rates to increase as the economy recovers and expands, but we do not believe interest rates can materially go above inflation without slowing the economy, potentially causing the next recession.

This view, of course, informs our view on equity assets. Whilst it is likely, in our view, that 2022 will prove to be a bumpier year, we don’t see the grounds for a sustained equity market de-rating, given cash and bond assets will likely continue to deliver sub-inflation returns.

At the time of writing, the forward earnings yield for the world equity market is c.5.5%, which is a reasonable proxy for after-inflation returns, which seems more than acceptable relative to other alternatives today. Perhaps an inflation overshoot and fears of a faster pace of interest rate increases could cause a temporary de-rating of markets (i.e., decline) but if this happens it will likely prove an opportunity.

It is also important to remember, that the big declines in equity markets only really occur when we have a recession and a decline in earnings, which we view as unlikely today. The long-term evidence also shows that markets perform reasonably well during the earlier phase of interest rate increases, albeit with heightened volatility, because interest rates are going up for the right reasons.

So where does this bring us? Well, we have always described ourselves as pragmatic optimists and we fully believe that optimism is rewarded over time. We also believe that investing in high quality assets is the right approach, aligning to our clients’ long term investment horizons. In addition, we have strong conviction that we need to position for innovation, and that interest rates, whilst increasing, will remain below inflation.

These views leave us overweight equities as we enter into 2022, but we also wish to temper expectations and remind investors that volatility is part of the journey and should we see heightened volatility in 2022, don’t be surprised. To be forewarned is to be forearmed.

As always, please do not hesitate to contact us to discuss our views further.

Ian Quigley
T: +353 1 2600080
E: ian.quigley@brewin.ie

www.brewin.ie

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