Investing in Uncertain Times: Dealing with Volatility

The world is currently experiencing profound transformation: the war in Ukraine is testing geopolitical alliances, inflation is running high, the Fed's reactive monetary policy is creating market volatility, and the prolonged Covid-19 lockdowns in China are slowing the global supply chains’ return to normalcy.

The situation is chaotic and difficult to navigate, even for the most seasoned investors.

Thankfully, our trusted analysts rely on historical data to make sense of the situation, scrutinize portfolios to consider whether the companies we invest in are suffering permanent damage, and anticipate the future to provide guidance as to how we should proceed going forward.

1. The Federal Reserve’s Fight Against Inflation

In most of the developed world, inflation is reaching record highs. This is obviously top of mind for individuals and businesses alike, as rising prices reduce purchasing power and, consequently, corporate profits.

As a result, central banks are being pressured to raise interest rates to levels that would curb inflationary pressures. This is not an easy task, as they must raise rates without causing a full-blown recession.

Since January, the Fed has declared its intention of progressively tightening its monetary policy over the coming years.

In its most recent meeting, the Fed raised the discount rate by 50 basis points, the biggest single increase since 2000. In addition, the Fed has pledged to remove the emergency accommodation that was put in place to stimulate the COVID-ravaged economy.

Not only are rates increasing, but the Fed will also stop buying bonds on the open market. This should put downwards pressure on long-term bond prices, which will increase yields.

Of course, the consequence of rising interest rates is that credit becomes more expensive. In the short term, this means that consumers and businesses may have to scale back on high-ticket purchases and costly investments. In the worst-case scenario, the Fed will raise rates too quickly and cause a recession.

However, the Fed is confident it can achieve its objectives in a responsible way.

While the recent rate hike was wholly insufficient to control inflationary pressures, this second increase since the start of 2022 suggests the Fed is doing its best to avoid an economic meltdown. Indeed, many domestic economic indicators are strong: household debt levels are relatively sound, corporate balance sheets are healthy, and the labor market has recovered from the pandemic shock.

It appears that the Fed has deemed the US economy fully capable of weathering incremental rate increases. For investors, it is important to look at the data to gain some insights as to how the markets could perform in this environment.

Historically, equities have delivered strong performance and positive returns most of the time.

Will this time be different?

Nobody knows, but we share Warren Buffet’s belief that investors should “never bet against America”.

2. Rising Rates are (Usually) Good for Stocks

The past two years saw incredible monetary expansion that fueled a phenomenal stock market rally. In truth, the rally was fueled by extreme optimism and the belief that “stocks can only go up”.

Unfortunately, the euphoria was short lived.

The combination of rising rates and extreme geopolitical turmoil has encouraged investors to sell speculative growth stocks and seek refuge in safe assets such as gold, commodities, and large-cap value-stocks.

This is not all bad for equities.

In fact, the S&P 500 has delivered double-digit returns in each of the six past interest rate increase periods.

However, in this context, big idea, and long-duration assets, such as disruptive but unprofitable technology companies, will see their earnings multiples contract. Indeed, investors will scrutinize assets and analyze fundamentals such as business models, competitive advantages, debt ratios, free cash flows, dividend history and net profits.

We expect the rotation from growth to value to accelerate over the coming months, as rate increases further reduce the risk-premium of investing in speculative assets.

3. We Remain Focused on the Long-Term

Stock market crashes are always sobering events.

However, rather than panicking, we should see them as an opportunity to assess the coherence of our long-term investment strategy.

After carefully reviewing our portfolios, our investment managers are confident that the factors rocking the world economy have not caused structural damage to the businesses we own. In fact, many of our holdings have higher intrinsic values today than they had at the end of 2021.

Here are 3 examples of quality growth companies whose stock price declines are simply collateral damage of the overall stock market selloff:

• Adyen, a Dutch payment company, grew revenues 46% last year with a 64% profit margin. The stock was down 25% in the first quarter.
• Zscaler, a cloud security company designed to help enterprise customers secure their employees, applications, and data, grew revenues 60% with a 23% profit margin. The stock was down 25% in the first quarter.
• Datadog, an observability service for cloud-scale applications, saw its stock price decline 15% during Q1 2022, despite reporting revenue growth of 84% year-over-year.

Clearly, there is no reason to panic-sell. Cycles will come and go, but quality businesses with forward-thinking and visionary management, growing client bases, rising revenues and high profit margins will always emerge as winners.

As Benjamin Graham famously said, "in the short run, the market is a voting machine but in the long run, it is a weighing machine”.

Key Takeaways

Investors are clinging to human emotions of fear, myopic focus of "right now" and joining the herd mentality by rushing to safe assets. As always, it is impossible to accurately predict market sentiment and short-term volatility and trying to time the market is a losing proposition.

We remain convinced that trust, quality portfolio structure, and a long-term philosophy, will help us not only navigate these troubled times with relative peace of mind, but also remain rational and clear-minded when the bulls retake control of capital markets.

Ultimately, we are fundamental, bottom-up investors with a long-term ownership mindset. We are optimistic about the companies in which we are invested, and we strongly believe that equities will continue to provide the attractive returns and solid inflation protection they have delivered in the past.

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