Uncovering Long-term Opportunity in a Short-sighted Market
As the worst sell-off in our 30-year history ensues, we are reflecting on our investment cases and the expected returns of our businesses, which we believe are more attractive than they have been in years.
It’s been a difficult year. Concerns about recession, rising interest rates, inflation, and ongoing geopolitical conflict have collided to spark one of the worst sell-offs in our 30-year history. These are extreme times, and in extreme times, markets tend to shorten their focus. They stand like deer transfixed by headlights, unable to look past the macroeconomic gyrations to see the road ahead.
When markets fixate on the shorter term, everything considered risky gets sold en masse. Good businesses get dumped with the bad; unfortunately for us, long-duration growth assets make up a significant portion of what many participants in today’s market associate with risk. Indeed, over the past six months we have seen a rotation out of high-valuation growth stocks, which led the MSCI ACWI Growth Index to lag the MSCI ACWI Value Index by the widest margin since 2001.1 Moreover, the MSCI ACWI Growth Index has fallen over 30 percent from its October 2021 peak, and our portfolios have fallen further.
This selling, which began in earnest last October, has seemed indiscriminate. The collision of worries has led to a severe valuation compression for the highest growth companies, particularly those that invested heavily in their expansion at the expense of near-term profitability. This category of stocks has suffered some of the sharpest declines, led by unprofitable technology companies, which have fallen 65 percent from their 2021 high as measured by the Goldman Sachs Non-Profitable Technology index.2
As an active manager in innovative growth companies, we are well aware of how sensitive valuations of high-growth stocks are to changes in macroeconomic conditions. We are willing to accept the resultant short-term share price volatility in exchange for potential long-term wealth creation. However, as we reflect on the past year, we recognize we had not appropriately considered the speed and magnitude of the declines that would be sparked by the toxic mix of rising rates and inflationary pressures.
As we move forward, we must look critically at our investment decisions—both in terms of what we did and didn’t do—and our results. We must learn from the experiences created by this extreme market environment. In doing so, we must seek to understand whether our investment results were driven by macroeconomic shifts or by changes in the long-term fundamental outlook for our businesses.
The market selloff has been fast and severe, and we don’t know if a recovery will be as forceful. We claim no expertise in macroeconomic forecasting or market timing. We believe, however, that over our time horizon, business fundamentals will matter most for our results. Therefore, we continue to search for the select companies that we expect can achieve superior growth over many years. It is more critical than ever to ruthlessly apply our six investment criteria in our research process.
Stress-testing the System
Over our long-term investment horizon, it is inevitable that we will face some macroeconomic challenges. The key is to always aim to be a better investor so that we can identify the businesses that have the financial strength not only to survive these periods but also to thrive and become stronger by expanding their addressable markets and taking market share from their competitors.
If we go back to basics, our goal is to add value by generating excess returns over rolling three-and five-year periods. To do so, we believe we must own companies with durable, above-average earnings growth. While price-to-earnings multiples can help or hurt in any given year or environment, over the long run fundamentals tend to drive the bulk of our results.
We remain confident that the majority of our portfolio businesses will become much larger over the next five years as their growth compounds. But we would be remiss if we did not take the opportunity to review our assumptions to determine how the strength of our businesses’ fundamentals aligns with current prices. For this reason, since the market peaked last year, we have systematically reassessed all our investment cases to ensure that their underlying fundamentals have not adversely changed and that they continue to fit our six criteria. As part of this exercise, we have updated our expected returns, looking at the conditions needed for best- and worst-case scenarios. We acknowledge that we have no idea if we have seen the end of the selling, and we are committed to an ongoing process of testing our assumptions as we endeavor to learn from the past and chart a better path toward the future.
Drawing on our findings, we have sorted our businesses into four buckets: 1. those whose investment cases remain intact; 2. businesses whose revenue and profit potential are larger now than pre-pandemic; 3. businesses that we expect have a larger top-line growth opportunity but that will require heavier investment to capture it, making their profit trajectory less clear; 4. businesses on which we are conducting additional research to determine if the opportunity and/or path to opportunity has changed, especially in relation to other businesses we could own.
In some cases, this reassessment has led us to replace certain portfolio holdings with new opportunities. In others, it has led us to add to existing businesses in which current prices have diverged from our assessment of long-term value.
Nothing that we have learned, however, derails our belief that business model strength is paramount to generating excess returns. Businesses that can absorb margin compression, exert pricing power, invest in future growth, and don’t rely on capital markets for funding tend to fare better in periods of uncertainty. Typically, these are businesses led by management with track records of resiliency and adaptability amid volatility and unforeseen changes. We believe that all these factors matter in a downturn and can enable a company not only to endure a difficult period but also to grow stronger throughout it. We believe select businesses that are creating or benefiting from technological advances that enable better, faster, and less expensive access to commerce, financial services, healthcare, and off-premises work remain attractive.
Based on this ongoing review, we believe that expected returns for many of our businesses are more attractive than they’ve been in years and don’t require heroic assumptions about earnings growth or terminal multiples. However, current market action has underscored the dichotomy between the strength of businesses today and relative to long-term expectations. That is where our views diverge from much of the market, which tends to look at valuations in terms of the next 12 months.
We prefer to assess a company’s value using an expected returns framework that forecasts a stock price five years from today, based on our estimate of the business’ earnings and earnings multiple. We then annualize the change between that year-five price and today’s price to arrive at an expected return. This figure isn’t meant to be a precise estimate, but rather a directional tool to help us assess relative opportunity. In fact, for most of our portfolios, we expect price-to-earnings multiples to be lower in five years than they are today, meaning that most of our expected return is derived from earnings growth.
Opportunity in the Disconnect
We acknowledge that a meaningful valuation reset was justified given the market environment, but we believe the sell-off has been overdone. Let’s look at the case of one of our ecommerce companies. Using our estimates as of September 30, 2021, a 300 basis-point increase in the discount rate would have resulted in a 13 percent decline in the stock price. A scenario with higher rates—and earnings that were 20 percent lower—would have resulted in a 30 percent decline.
What happened? From its November 2021 peak through June 30, 2022, the stock fell 82 percent. We estimate that a decline of 80 percent to 85 percent assumes significant earnings impairment for the business, with longer-term estimates and terminal values at a fraction of what we think they will be. In doing the math, a decline of this magnitude assumes that the discount rate is 300 basis points higher and that earnings estimates and earnings growth is 50 percent lower—or it assumes that there is no future growth in earnings at all.
This is a simplified example, relying to a certain degree on assumptions. Nevertheless, we use it to illustrate our belief that the market has fallen too far; and that there is a significant disconnect between our valuations estimates and stock prices.
The Benefits of a Longer Time Horizon
When the market shortens its time horizon, it can create opportunities for active managers who invest with a longer-term view.
The sell-off has pushed our expected returns of many of our companies to their most attractive levels in years, presenting us an opportunity to increase positions in our highest conviction names. In fact, history suggests equity markets tend to bottom before economic cycles, providing potentially good entry points for investors who can look past the panic and toward the future.
And to us, it appears that many of our businesses are in position to move into a future in which investors are more skeptical of valuations, earnings, and end markets. We believe the fundamental outlook of these businesses is strong—in many cases, stronger than it was before the sell-off began last October.
As we’ve seen following previous bear markets, businesses with strong fundamentals will likely lead the way higher. As active managers, our job is to use the market’s indiscriminate selling as an opportunity to identify high-quality assets at discounts to their long-term potential value.
When everyone is running for the exit, it takes courage to walk into the fire. However, we have long believed that we need to be there, not getting there. Rather than wait for the all-clear signal to re-embrace risk, we believe it more prudent to move boldly into what some may regard as the unknown but which we view as a future replete with opportunities to create wealth for our clients.
1 The MSCI ACWI Growth Index captures large and mid-cap securities exhibiting overall growth style characteristics across 23 developed markets (DM) countries and 24 emerging markets (EM) countries. The MSCI ACWI Value Index captures large and mid-cap securities exhibiting overall value style characteristics across 23 DM countries and 24 EM countries. DM countries include Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the UK, and the United States. EM countries include Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Kuwait, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates. 2 The Goldman Sachs Non-Profitable Tech basket consists of non-profitable U.S.- listed companies in innovative industries. Tech is defined quite broadly to include new economy companies across GICS industry groupings.
2 The Goldman Sachs Non-Profitable Tech basket consists of non-profitable U.S.- listed companies in innovative industries. Tech is defined quite broadly to include new economy companies across GICS industry groupings.
The views expressed are the opinion of Sands Capital and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed were current as of the date indicated and are subject to change. This material may contain forward-looking statements, which are subject to uncertainty and contingencies outside of Sands Capital’s control. Readers should not place undue reliance upon these forward-looking statements. There is no guarantee that Sands Capital will meet its stated goals. Past performance is not indicative of future results. All investments are subject to market risk, including the possible loss of principal. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. You should not assume that any investment is or will be profitable. GIPS® reports and additional disclosures for the related composites may be found in the Sands Capital GIPS Report. PT# 20220243