Equity Investing: A Strategic Mindset For A Changing World

By Nelson Yu

With inflation and interest rates in transition, it’s time to take a fresh look at the forces driving business models, profitability and equity returns.

Equity investors are struggling to adapt to evolving market and macroeconomic conditions after years of low inflation and zero interest rate policies. Overcoming higher hurdles to long-term financial goals will require a new mindset and a strategic application of lessons derived from decades of active investing.

Three primary challenges investors face in the years ahead. First, generating returns above inflation will be vital to preventing wealth erosion. Second, assessing the inflationary risks and opportunities of business models for individual companies must be front and center on the research agenda. And third, technological disruption is shaking up business models and market dynamics. We believe these challenges reinforce the importance of disciplined active investing strategies to successfully steer equity allocations through conditions that we haven’t seen for over a decade.

Inflation Environments in Historical Perspective

Realized inflation has been on a declining trajectory since 1990 (Display). Following the global financial crisis (GFC), a low-growth environment took hold globally and inflation in global developed economies consistently fell below 2% between 2013 and 2020. Central bank efforts to prevent deflation featured quantitative easing and zero interest rate policies. Persistently low rates helped boost corporate earnings while fueling steady market gains that made passive investing appealing.

Recent Period of Ultra-Low Inflation Was Very Unusual

In 2021, as markets recovered from the COVID lockdowns, supply chain disruptions and labor shortages triggered an inflationary spike. US inflation peaked at 9.1% – the highest since the 1970s. The US Federal Reserve and other major central banks started to raise rates aggressively in 2022, causing significant losses in both equity and bond markets.

In recent months, inflation began to subside from the post-COVID spike. However, given the megaforces at play – from deglobalization to demographics to climate change – inflation could settle at higher levels than we’ve been used to over the previous decade.

Equities and Real Returns: A Higher Hurdle

What does this mean for equities? The historical record provides important perspective. While today’s higher levels of inflation may feel unfamiliar compared with the recent history, in fact, the last decade stands out as abnormal. Over the last century, inflation exceeded the low levels of the past decade most of the time.

Higher inflation puts a premium on real returns – the amount of return investors can generate above current levels of inflation. Our research suggests that equities have generally provided those real returns in diverse inflation environments.

When inflation was low, between 0% and 2%, equities generated real annualized returns of 11.7%, a meaningful premium over long-term bonds (Display). In these environments, equities outperformed bonds 92% of the time.

Similar patterns were seen in more normal inflationary environments. When inflation ranged from 2% to 4%, the spread between stocks and bonds narrowed, but equities returned 8.1% a year and beat bonds 73% of the time.

Equities Have Consistently Outpaced Inflation over 100 Years

Based on these observations, we believe equities will continue to play a crucial role in asset allocation. But it will be somewhat harder to generate real returns because higher levels of inflation make for a higher hurdle to clear while also likely leading to higher nominal interest rates than we saw in the past decade. As a result, we believe that the skillful selection of companies that can thrive in the evolving inflationary environment will be especially important for investment success in the future.

To invest effectively as inflation reverts to more typical levels, we first need to understand how the environment has impacted interest rates and shaped equity returns since the GFC.

Cost of Capital: A Key Driver of Growth Stock Volatility

From 2009 to 2021, growth stocks outperformed dramatically. Part of the explanation is rooted in basic finance theory, which stipulates that a company’s long-term value is determined by its future cash flows, discounted back to the present. Falling interest rates since the GFC drove down the discount rate that is used as a firm’s cost of capital (CoC). Generally speaking, growth-oriented companies, whose cash flows are further in the future, benefit disproportionately from falling discount rates, which augment the present value of their future cash flows. This is commonly known as the “duration effect” for equities. For ease of reference, we will refer to the discount rate as a company’s CoC throughout this article.

Ultra-low interest rates did more than just propel growth stocks. This mechanism also distorted some of the basic distinctions between stronger and weaker businesses by masking the difference between companies that could sustainably create returns on their investments over their CoC. With the CoC so low, companies weren’t penalized if they needed many years to deliver growth; shares of companies with tangible, imminent growth drivers and those with more speculative outlooks both performed well.

Conventional wisdom suggests that the duration effect was the catalyst. That is, all growth stocks benefited from their greater price sensitivity to changes in discount rates.

That wisdom has been put to the test. Now, higher interest rates have led to clearer distinctions between business profitability profiles. The profitability ratio, which measures a company’s return on invested capital over CoC, is a telling indicator of vulnerability to rising rates. When the CoC is higher, profitability ratios get squeezed. Our research suggests that since 1982 only about 50% of US companies generated returns above their CoC, and only about 10% of companies exceeded their CoC by more than two times (Display). As the CoC rises, even fewer companies will be able to accomplish this.

Companies that Can Reinvest Above Their Cost of Capital Will Be Prized

So when rates rose in 2022 and stock markets declined, the companies with the lowest CoC at the beginning of the year – mostly growth companies – were the worst performers (Display above). That’s because rising interest rates prompted a proportionally larger increase to a lower CoC than to higher ones (e.g., a 1 percentage point rate increase for a company with a 4% discount rate = a 25% jump in the CoC; the same increase for a company with a 10% discount rate = 10%). The following year, as markets recovered, companies with high-quality attributes such as pricing power, differentiated business models and a clear path to earnings growth, were able to continue to boost profitability and recover their losses. Some of the companies in the Magnificent Seven fit this characterization, helping to explain their significant outperformance – even as interest rates increased.

These trends also reinforce an enduring lesson for active investors. Companies with true quality are more likely to be better positioned for a world of higher rates – and more discerning markets.

Quality: Healthy Businesses with Ample Cash

Quality businesses are a lynchpin of prudent active equity investing, in our view. In a world of higher inflation, investors must sharpen the tools used to evaluate quality and pinpoint companies that are better positioned to surmount a higher CoC.

There are many measures of fundamental business quality. Free cash flow (FCF) is especially important, since it encompasses several dimensions of quality. Companies with high FCF typically have healthier balance sheets, which reduces risk. They need less borrowed capital to grow and have more flexibility to allocate capital and take advantage of growth opportunities. Early-stage growth companies require extra scrutiny when interest rates are higher, since they may struggle to grow rapidly without easy access to capital.

The ratio of FCF to a company’s market value is known as FCF yield. Companies with low FCF yield will have lower FCF relative to their market values and will be at a disadvantage. That’s because they are investing heavily for future growth and future cash flows and will suffer from duration effects. In contrast, high FCF yields create a shorter-duration advantage.

Will Value Stocks Return to Favor?

Value stocks are a case in point. During the low interest rate years, value stocks underperformed growth stocks by a wide margin (Display). Value stocks did offer earnings growth, but falling rates fueled multiples of growth stocks – which accounted for most of the performance gap – while compressing those of value stocks.

Growth-Value Performance Gap Has Been Driven Mostly by Multiple Expansion

So why did US value stocks underperform in 2023 when inflation and interest rates were still high? The main reason was because investors flocked to a small group of megacap stocks seen as the big beneficiaries from AI. Concerns about economic growth magnified the megacaps’ drawing power. Outside the US, value stocks in Japan and emerging markets outperformed in 2023, while in Europe, value returns were in line with growth.

We think investors haven’t fully internalized the long-term trajectory of interest rates. As investors realize that rates are unlikely to go back to zero, we believe the duration effect could reignite value stocks that have lagged in recent years and broaden the sources of return potential for equity investors. Gauging valuation in the new environment must incorporate a view of FCF yields, in our view. This can lead investors to a wider array of companies that can cope with inflation. For example, far from the technology sector, energy stocks generally trade at much higher FCF yields than the market and typically have low debt. Select companies with these features should be able to withstand moderate declines in oil prices while providing a hedge against inflation when commodity prices rise. Across sectors, we believe stable FCF is a good guide to finding companies with pricing power that can offset inflationary pressures.

Business Models Under the Microscope

Beyond pricing power, the uncertainty that comes with inflation should increase the value of robust business models and management teams.

Why are these qualities so important today? Because a changing regime forces companies to adapt nimbly and execute new strategies. Companies with formidable competitive moats typically command pricing power. This enhances their ability to manage margins and return on invested capital amid higher inflation. Balance sheet health and capital intensity will come under increasing scrutiny.

Management quality is particularly valuable. Talented management teams are more proficient at tightly managing costs and efficiency. For investors, actively engaging with management teams is the best way to assess whether they have the right skills to strategically steer a business through changing conditions.

AI and the Technology Test

Technology is another powerful force to reckon with. Excitement over AI in 2023 drove home the risks and opportunities of disruptive technology for businesses and investors alike. In our view, the dominance of the Magnificent Seven stocks adds urgency for investors to take a long-term approach to transformational change rather than jumping on the bandwagon to the most popular stocks.

That might sound counterintuitive given the strong performance of the Magnificent Seven, some of which have great businesses that will reap real benefits from the proliferation of generative AI (GAI). However, we think investing passively in a small group of stocks with such a heavy market weight is risky.

GAI is a generational disruption that will leave no industry or company untouched. Over the next decade, companies that get it right should enjoy a productivity windfall. Yet GAI also adds uncertainty to earnings outlooks. We still don’t know exactly which applications of AI will be the next big thing for businesses and consumers, or which companies will be more effective at unlocking efficiencies from AI. As investors grapple with these changes, we expect more earnings surprises, more idiosyncratic volatility – and a wider dispersion of stock returns.

That should increase the opportunity for active investors to generate alpha. Yet it will take deep fundamental expertise – industry by industry and company by company – to sort winners from losers as these disruptions unfold.

Unlocking Real Return Potential with Conviction

Technological disruption and macroeconomic winds are just two dimensions of change in markets today. Regulatory action and geopolitical tensions, along with industry and company-specific dynamics form a multidimensional matrix of variables that must be synthesized into a risk/reward profile for every company.

Developing conviction amid rapid change is the essence of active management in equities today – and it requires a coherent frame of reference. Understanding the interplay between business models, profitability and valuation in a higher-rate world is the key to unlocking the real return potential needed for investment success in the next chapter of the 21st century.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.