What Costco has that Peloton does not

Earnings come in cycles but rarely do those numbers come into the post-maturity stage of a business cycle like the one we are witnessing right now. As 2021 turned to 2022, investors sold off baskets of assets as they prepared for rising rates to disrupt valuation bubbles that have been brewing over the last two years. 

When earnings for the major global names hit the trading desks in March, the last people who weren't selling off in January got the memo and reacted accordingly - leading some to ask whether this year will be a turning point for groups of companies like the FAANG names. 

In the latest of our Expert Insights, Ned Bell of Bell Asset Management discusses the precarious stage of the earnings cycle we are in. Ned says earnings volatility is on the way with the next few months vital for some companies who listed but may not have delivered yet on their outlooks. He also nominates three companies that could perform well at this stage of the game while noting some notable avoids. 

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Watch the full chat here or read our edited transcript below:

• Consumer names have been very oversold - MSCI World consumer discretionary index -17% this year but earnings estimates haven't changed;
  
• Best opportunities in global small and mid-caps but be warned of earnings downgrades going forward;
  
• Supply chains have thrown a massive spanner in the works - the  most vulnerable companies are those in the "value" camp (eg Volkswagen, Ukraine impact);
  
• Magnitude and breadth of inflation is nothing we've seen since the 1970s - and will probably be with us for a while;
  
• Earnings volatility is coming - with quality names reigning over value... this is the true test for a company;
  
• FAANG stocks - material slowdown in growth - businesses are not in trouble but the market has been wrong footed on the slowdown.
  
• Quality names will break away from the pack courtesy of good  

Edited transcript

Consumer sentiment is on the move

Consumer sentiment, it's definitely changed in the very short term. We're coming off basically the back of two and a half years of incredibly strong consumer spending, particularly in the US, post COVID. The initial gut reaction, I think has been that with inflation spiking as it is, that's going to materially dampen, obviously, consumer behaviour.

Having said that, I think the two points I'd make is that the consumers came into this period in a very strong position. So they've essentially spent next to nothing in the last two years. So there's a lot of the strong balance sheets. There's a bit of catch up to play out.

A lot of the consumer names themselves have been very oversold. So you've actually seen, say for example the MSCI World Consumer Discretionary Index, it's down about 17% this year, but the earnings estimates have barely changed. So there's arguably some quite good opportunity in some of those names that do get a bit oversold.

Best ideas reside among small and midcaps

Where we're finding the best ideas is in the global small midcap space, more generally. So those stocks as a whole are today trading at a 40% discount to large cap growth, which is the biggest discount in 10 years. Versus their own average, or sorry, I should say, versus MSCI World Index, they trade about 8% discount versus a 12% premium over the last 10 years. 

They've become dislocated from a valuation perspective, and the valuations have come back much, much more than the earnings estimate. So that's looking like pretty good value.

Then from the sector perspective, we still, again, I think the consumer sector is probably getting a bit oversold. Also I think the healthcare sector is interesting in that it's got obviously far less cyclical risk. It's got far less risk to do with inflation, because Big Pharma and these types of names, they don't have the bottleneck risk that is affecting, for example, tech. So those are some of the sectors where we are finding pretty good value for money without that risk of big earnings downgraded. That's the big issue this year, is going to be earnings downgrades.

Quality is all about profitability

Well, there's a few common denominators. 

When it comes to quality, it's all about profitability. So your starting point is return on capital. You're looking for companies that consistently generate very high levels of return on capital. 

Obviously, really strong management across all business, but particularly in small midcap part of the market and strong balance sheets. The balance sheet strength is, again, that's going to be watered by the market, much more so in a rising trade environment.

At the big end of town, you're looking at names like Costco, just a fantastic business. 

generate about 88% return on capital. They've grown revenue in 19 of the last 20 years. In the one negative year, they were down 1%. 

LVMH is another fantastic large cap quality name. It's the the best of the best when it comes to a luxury portfolio.

Then when you move down the spectrum, you're still looking for similar things. So a company like Pall Corp, which is the leader in the pool industry in the US, it's a bit of a niche, but they really they've got the highest market share. Again, very high levels of return on capital, great management. So you're looking for similar things. Some of those things have really been put at the test during COVID, where you saw earnings estimate get beaten up pretty heavily, but it was a good test to really demonstrate what the truly high quality companies were.

Supply chain problems hitting value names hardest

So when it comes to the supply chain issue that's come out more recently as a result of COVID, the recent lockdowns in China, that has thrown a massive spare in the works for a lot of companies. I think the companies that tend to be more vulnerable are actually the ones that are probably a bit more in the value cap.

Switching gears, but if you think about what's happening in Russia and Ukraine.

Volkswagen had to close down their biggest plant because of the wiring was all manufactured within the Ukraine. So that just stops. That doesn't slow down, it stops. 

So there's a lot of those, a lot of low margin type businesses, the ones that are probably the most vulnerable. Then when you switch gears to, I guess China, a lot of the tech companies...

Obviously, companies like Apple over many years, they've had a big part of the supply chain in China, and they're not the only ones. I think to some degree as labour costs have increased in China in the last couple of years, they've been diversifying their supply chain, but I think a lot of companies have been caught off guard as we speak. There's still quite a bit to play out there, I think.

In many ways, it's the quality companies that should really benefit because they're not necessarily the ones that have been a hundred percent reliant on just using, having all of their supply chain purely focusing on China or any other geography. 

They've been a bit more diversified and had some of their supply chain within developed markets. So somewhat, it might sound a little bit ironic, but it's actually the quality companies, they should actually benefit and have less risk.

How dangerous is inflation?

The short answer is it is dangerous because we've been through a period where, if you think about the last five years, you've had very low interest rates, not much inflation. So what companies have tended to do, and again, this tends to be a bit more at the value end, is they borrow money, buy back shares, borrow money, buy back shares, and that's how they grow their earnings. So that works really well until interests rates go up.

So that party's coming to an end and a lot of the, what would typically be regarded as, probably more value stocks. 

The companies that are capital intensive don't have great pricing power, pretty lousy margins, those are the ones are most vulnerable, because they cop it from the perspective of they can't pass through inflation. 

Because they might have net EBITDA of three times or more, their interest costs go up. So when that's happening simultaneously, that's not great. That's a difficult situation.

Obviously the magnitude and breadth of inflation now is like nothing we've seen, since probably since the seventies. It'll probably be with us for a while, so I think you're going to see a lot of earnings volatility as this year plays out. In our view, you'll see almost like a mushrooming of earnings results. So the quality companies will hold up much better than a lot of the more value orientated names.

Can long duration stocks survive?

That's really the test of a true franchise, is do you have longevity? There's been a lot of fly by night franchises that have been demonstrating they don't have much longevity. So a lot of the Pelotons of the world. There's been a lot of companies that have benefited maybe from COVID and then hit the wall pretty suddenly. You only look at, we were talking about Costco and LVMH and Pall Corp before, those companies held up incredibly well. So that's really the test.

So if you are screening for companies that have got consistently high levels of return on capital, they do tend to hold up really well. 

So the short answer is, yes, that there is high quality. There is longevity in these companies. The one other point I would make is that amongst the much larger companies, the bigger FANG stocks, what you are seeing this year, it really is, it's a material slow down in growth. So the businesses aren't necessarily in trouble, but the growth has slowed very dramatically. I think that's where the market's been wrong footed. They've just completely underestimated the slow down in growth.

Learn more about Bell Asset Management

Bell Asset Management is a global equities specialist who focuses on small to mid-cap companies. Stay up to date with Ned's latest insights by following him here, or visit their website for more information.   

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