Welcome to Soundbites, weekly insights on market trends and investment strategies, brought to you by Investment Executive and powered by Canada Life. For today’s Soundbites, we’re talking about the changing economy with Kathrin Forrest, equity investment specialist with Capital Group. We examined the turbulence of the past few years, and we started by asking what investment parameters are rising in significance.

Kathrin Forrest (KF): We see a number of structural shifts that really have disrupted the investment environment of the past decade. We see trends from multiple expansion to earnings growth, and from narrow to broader market leadership. We also see a shift from digital to physical assets, and from efficiency to resilience. It really does look like a new reality that’s a little bit more nuanced than just a differentiation between growth and value.

What the end of cheap money spells for highly leveraged companies.

KF: Ultimately, what it means is a larger portion of earnings will go to debt service, and that puts pressure on profitability. Capital is not as readily available. So, companies may have less flexibility to refinance or fund future growth, and at the extreme, may struggle to remain viable. On the other side to that, companies with strong pricing power and dependable cash flows may look attractive in a higher-inflation, higher-cost-of-capital world, as may companies that have the ability to fund their own future growth. So, it’s really a differentiation across the opportunity set. So, thinking about strong balance sheets, financial flexibility, sound capital allocation, free cash flow generation, and then structurally, looking for resilient and growing end markets, inelastic demand, pricing power, secular tailwinds that support future demand, all of those look really important.

The changing nature of market influence.

KF: Yes, it does look like there’s an opportunity to move from the narrow leadership of U.S. growth that we saw over the past 10 years to broader market leadership. Interest rates are no longer declining. So return will not so much come from P/E but from “E” or earnings expansion. There’s some businesses that have been incredibly successful. But now they are increasingly competing against each other so, it’s a lot more tricky for those companies. And in this environment, we may see different leaders emerge.

The new challenge for e-tailers.

KF: It’s interesting, E-commerce companies really have gone from being the disrupters to now being challenged themselves. Cyclically, a number of them saw really strong growth during lockdowns. It was an environment where many of them added capacity. And now with demand normalizing, it may take a while to work through this higher capacity and higher cost structure. From a structural perspective, they are often very low margin and they are expensive to scale, with difficult delivery logistics to manage, and very few have done it well. These companies are also seeing increased competition from traditional retailers that combine brick and mortar stores with much more compelling online shopping experiences. And they’re starting to take share from some of the other pure e-commerce companies.

Are lofty multiples a thing of the past?

KF: You know, many investors have gotten comfortable with stocks being very expensive over the past five or 10 years or so. When I look at the S&P 500, the price-earnings ratio has moved up from around 11 times, or so, in 2011 to over 22 times in 2020. It’s tempting to assume that stocks will return to those levels during the next bull market. But that may not be the case if we see interest rates steady or up from current levels. So, if multiple expansion is limited in the next bull market, stocks will have to be supported by earnings growth. And that means the market may be less likely to reward less-profitable or unprofitable companies, and companies with business models that depend on cheap money. So, those companies look to be more challenged as we look ahead. Now, the market once paid up substantially for future growth but now with higher interest rates, it seems less likely that we might see that continue.

And finally, what’s the bottom line on these economic shifts?

KF: So, with capital more expensive and constrained, and less support from multiple expansion, there’s more emphasis put on earnings growth. And the good news here, really, it opens up a much broader opportunity set. And we can find companies that have an opportunity to grow earnings across industries and geographies. It’s really not a matter of style or geography, or sector. It’s about earnings. And we can find that abroad but we have to look a little bit more closely.

Well, those are today’s Soundbites, brought you by Investment Executive and powered by Canada Life. Our thanks again to Kathrin Forrest of Capital Group. Visit us at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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