A broad ranging and perhaps controversial question, but a timely one, as we’re knee deep in the middle of the corporate earnings season. Textbooks suggest that the price of an equity, for example, is driven by company fundamentals, such as cashflow, return on assets, gearing, etc.
Indeed, analysts spend their time pouring over accounts, reading company research, visiting companies and listening to company calls, with the ultimate aim of assessing whether a company is correctly priced or not.
Company fundamentals are indeed one of the main drivers, especially during a quarterly corporate earnings season. Here, companies get a reality check, with management announcing their results and revisiting their guidance (not that management know what’s around the corner much more than anyone else).
Indeed, many fund managers invest using a stockpicking/bottom up approach, and many have been very successful. However, what drives the price of an investment, whether it’s equities, bonds, currencies, property or commodities, isn’t always the fundamentals. For example, the price of financial assets is also always driven by human psychology such as greed, fear, complacency, etc., to some degree or another.
There are also extended periods when the Fed is the main driver of assets; it might not even be through actions, it might just be words, and often nuances. Of course, this is less binary than it might seem, as the discount rate, and borrowing costs, are also very important for the fundamental outlook of an investment.
Another recent example is geopolitics, though, again, some of the Russia/Ukraine conflict can be brought back to fundamentals, such as lower volumes (supply chain disruption) and margin pressure (higher input costs). Nevertheless, the analysis of the geopolitical environment can be invaluable, certainly more than a narrow assessment of the investment fundamentals.
Of course, some of it is down to definition. Many stock pickers will argue that their analysis includes an assessment of the broader environment, and few seasoned and successful investors believe that it is all just about the theory.
At the minimum though, there’s more than one way to skin a cat. Our approach, for example, is to invest in a range of macro and thematic ideas, getting exposure by holding small individual positions in a larger number of investments which all link back to that idea. This limits risk to the individual positions but increases factor risk, in this case to macro or thematic ideas.
Take resources as an example, an area we like as we believe inflation will be more persistent (see later). We have exposure to baskets of mining and oil equities, and also more directly to the price of agricultural commodities, gold and industrial metals via ETCs. The equity baskets spread risk by company, whereas the ETCs reduce exposure to the volume constraints and margin pressures felt by many commodity businesses, as the exposure here is simply to the commodity price.
This approach has implications for how we spend our time. As a result of materially reducing company specific risk, we don’t visit companies, helping us to remain objective. Meanwhile, our assessment of company fundamentals is more due diligence than forensic in nature. We appreciate that this is tantamount to heresy in some investors’ minds. Instead, though, we focus our time on analysing macroeconomic trends, as well as understanding how resilient some of the long-term themes will be, such as renewables and health tech. In short, we focus on the ideas, more than company fundamentals, as that’s where we are taking more risk.
More generally, we look at the hierarchy of risk across assets from the top-down, rather than bottom up. Currently, our base case is for an inflationary environment and hawkish central banks, particularly the Fed, which leads us to believe that stagflation risks are on the rise. In practice, we believe that this will be the defining environment for investments in aggregate over coming months, overshadowing investment fundamentals, such as a company’s underlying progress. For us, this base case explains clearly the material moves higher in government bond yields, the stronger US dollar and the less favourable environment for technology companies.
That’s not to say that fundamentals won’t have periods where they reassert themselves, just that the nature of the dominant risk is ever changing. There will be extended periods when fundamentals will be less powerful, as they are now, with economic and policy risk so elevated.