Forget traditional hedges, think equities

Investors traditionally flock to defensive asset classes like fixed interest in volatile and inflationary markets, but equities might offer a better defence. It just comes down to focusing on cashflow and being selective in your stocks according to Paul Loudon, portfolio manager at Walter Scott.

While investing in growth assets like equities might seem in conflict with many investors’ goal of wealth preservation in current markets, Loudon suggests that growth and capital preservation are not always mutually exclusive.

“The key defence in an inflationary environment is your ability to grow your cashflows with inflation and if you’re invested in a fixed interest security like a bond, clearly that’s not the case. If you are sitting in cash, clearly the value, the purchasing power of that cash will diminish over time as inflation takes hold. So equities tends to be the place where you can find you can preserve wealth but you have to be selective,” he says.

In this interview, Loudon discusses the sectors Walter Scott & Partners have typically identified resilient companies over market cycles and quality factors like pricing power used for selection as part of a strategy for capital preservation in the current market environment.

Key takeaways:

• The key to wealth preservation in inflationary markets is a focus on cashflow growth. This tends to be easier to find in equities.
• Stock selection matters. Walter Scott & Partners look for established, quality businesses with pricing power, strong returns on capital and high levels of profitability.
• Investors can also look for megatrends and themes in sectors like technology and healthcare to help propel growth and offer resilience in market cycles.

Edited transcript

Where are you finding opportunities?

We've done quite a bit of digging to understand which asset classes tend to do best in higher periods of inflation going back through history. You tend to find that equities are a pretty good place to preserve and grow your wealth even in inflationary times. Now there is this notion that inflation is bad for stocks, it erodes the purchasing power of consumers, it might lead to higher rates that bring down discount rates and valuations, and that might be true to an extent, but the key defence in an inflationary environment is your ability to grow your cash flows with inflation. If you're invested in a fixed interest security, like a bond, clearly that's not the case. If you are sitting in cash, clearly the value, the purchasing power of that cash will diminish over time as inflation takes hold. So equities tends to be the place where you can find you can preserve wealth, but you have to be selective. You have to invest in the right sorts of quality equities where they have the pricing power to grow with inflation, otherwise you will see that valuation come under pressure.

Which sectors are best placed to weather the storm?

Historically Walter Scott has tended to find a lot of great companies in the technology space and in healthcare, so this isn't a top-down call. We just find the kind of high quality compounders with rock-solid balance sheets and high barriers to entry in those spaces. We're generally looking for companies that are benefiting from secular tailwinds, so things like ageing demographics, or industrial automation, societies digitising. There are lots of great mega trends in these sectors which really helps to propel that compounds growth over time, so that's the kind of areas that we're focusing on. We really think that lots of businesses in the tech and healthcare space (yes, there is a lot of noise around higher rates bringing down valuations), if you focus on the small set of companies that are already generating loads of cash today, they're not reliant on profits in 20 years to deliver their value, if you find these quality businesses that are very established and already generating loads of cash today, then they can still absolutely do the job over the short, medium, and long term.

How do you decide when it's the right time to buy?

We definitely want to be careful and sensible when we are building a new position and a new name, especially in such volatile choppy markets like we've seen. So when you do have some very high quality growth stocks that are selling off 30-40%, there's every chance that there's still going to be another leg down. We don't know, but we need to be cognisant of the fact that things are still pretty volatile out there. We might not be too gung-ho about entering in a new position, but we want to be opportunistic. We are very excited as a team because when you have a situation where a great companies selling off 30-40%, some of these companies are fundamentally not going to be challenged by inflation or higher rates. If anything they could flourish, so if we're getting a much better entry point then we'll try to be opportunistic and build positions over time.

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