Premier Miton UK Value Opportunities Fund Manager
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
- One of the most striking aspects of 2022 was the underperformance of cyclical stocks, particularly in the consumer sector, which was driven by a deterioration of the economic outlook.
- During recessions themselves, cyclical stocks often perform better than expected. Looking into 2023 and beyond, there are some good reasons to believe that the performance of cyclical stocks may improve.
- Two interesting areas are “early-cycle” consumer discretionary stocks, where much of the de-rating may have already happened, and pandemic afflicted industries where activity is still well below peak cyclical levels of activity.
- In this environment, the most promising investment ideas are likely to be found amongst high quality growth cyclicals, where short term cyclical concerns have created long-term valuation opportunities.
A darkening outlook
“It is largely the fluctuations which throw up bargains and the uncertainty due to the fluctuations which prevents other people from taking advantage of them.”
John Maynard Keynes
“Rule number one: Most things are cyclical. Rule number two: some of the greatest opportunities for gain and loss come when other people forget rule number one.”
With major asset classes all posting negative returns, for most investors 2022 will be a year to forget. For stock pickers, the pain was felt most acutely amongst cyclical stocks, particularly in the consumer discretionary sector. According to Bloomberg, the FTSE 350 General Retail Index lost 32% during 2022, significantly worse than the broader indices, and it was a similar story for most other economically cyclical sectors. These moves reflect the deterioration in the near-term economic outlook, as cost of living pressures and rising interest rates have darkened the outlook for consumer spending and the broader economy.
The more recent performance of cyclical stocks has, however, been better. Again, referencing Bloomberg data, the FTSE 350 General Retail Index rose 18% during the last three months of 2022, significantly ahead of the FTSE All Share, and has continued its gains into early 2023.
What explains these moves and what are the prospects for economically cyclical stocks during 2023 and beyond? Despite the challenging macroeconomic backdrop, there is a case to be made that certain cyclical stocks and sectors may perform relatively well. This note looks at two specific examples: ‘early-cycle’ consumer stocks and pandemic afflicted industries.
Fundamentals versus expectations
Stock markets act like giant discounting machines. Information about the future is reflected into today’s share prices. Risks factors are therefore most dangerous when they are not widely known or understood. But the opposite is also true, when everyone is aware of a negative, the chances are it is already discounted into share prices. The old investing adage “markets climb a wall of worry” encapsulates this phenomenon. To see this process in action, let’s examine the UK retail company Next Plc.
The chart below shows the share price total return of Next versus the FTSE All Share over the period 2006-2011. The period captures the end of the mid 2000’s, a period termed ‘the great moderation’, the global financial crisis (GFC) and subsequent recovery period.
Two things stand out from this chart. Firstly, the substantial underperformance of Next Plc shares relative to the FTSE All Share Index started towards the end of 2007, a long time before the recession caused by the GFC started. Secondly, the trough in absolute and relative terms occurred in mid-2008, after which Next Plc outperformed the market during the GFC itself and throughout the subsequent recovery period.
Next Plc versus FTSE All Share Index: 2007-2011 (Rebased to 100)
Source: Bloomberg data to 31.12.2011
Thinking about change catalysts
This result might be surprising to many considering how challenging this period was for the economy, with rising unemployment and a deep contraction in GDP. Two factors explain why this happened.
- Cyclical consumer retail companies are amongst the earliest and modest obvious losers from a recession. Because of this, Next Plc shares de-rated well before the rest of the market, so much so that a great deal of bad news was already discounted long before the recession itself hit.
- Secondly, the severity of the recession dramatically changed the outlook for inflation and interest rates, both of which had previously been relatively high. A lower inflation and interest rate environment provided a boost to consumers’ incomes relative to what had previously been expected. At the same time, other sectors of the market that had previously been expected to hold up better saw earnings downgrades and valuation de-ratings.
This experience illustrates a crucial point about investing: taking decisions based on how the world looks today is not enough on its own; it is necessary to think also about what could change.
Let us turn to the situation today
The chart below shows the share price total return of Next Plc versus the FTSE All Share for the period 2020 to the end of 2022. Once again, the Next Plc shares have fallen significantly ahead of an expected recession, whilst the wider market, represented by the FTSE All-Share Index has done much better.
Can we expect a repeat of the GFC experience into 2023 and beyond? There are certainly some similarities. Rising inflation, followed by rising interest rates and fears of a downturn are what have caused most of the underperformance. Meanwhile there are signs that supply side inflation pressures are easing, which when combined with weaker demand as the global economy itself weakens, may serve to bring down inflation in 2023. This in turn may take the pressure off central banks to increase interest rates.
If this does happen, cyclical consumer shares are likely to respond well. It is probably too early to say whether the recent recovery is the start of a sustained trend, but for investors with a long-term time horizon, this area of the market represents an opportunity.
Next Plc versus FTSE All Share Index: 2020 – 2022 (Rebased to 100)
Source: Bloomberg data to 30.12.2022
Pandemic afflicted industries
The previous example showed how it is possible to glean insights from past cycles as to what may happen in the present. As investors we also need to recognize when something about the current situation really is fundamentally different. Great care must be taken in this exercise. Very often plausible sounding arguments turn out to be nothing more than wishful thinking. It is with good reason that the words “this time it’s different” are the four most dangerous in investing!
That said, few would disagree with the notion that the Covid-19 pandemic has been genuinely unprecedented in the effects it has had on the global economy. Although day-to-day life may feel back to normal for most people, the truth is for many industries the impact is far from over. As an example, consider the automotive industry, historically one of the most economically cyclical sub sectors within industrials.
The chart below shows the historical global industry volumes of cars and light commercial vehicles. Over the long term, there has been a clear upward trajectory driven by increased motorization rates, particularly in developing countries. The cyclical nature of the industry can also be seen clearly in the 16% peak to trough decline during the GFC period. What is particularly interesting is the decline in volumes that has occurred since the pandemic is similar in magnitude to the GFC. Yet unlike other cyclical industries there has been barely any recovery. This is not due to a lack of demand. It is due to supply chain constraints (semi-conductors and certain other materials), the causes of which date back to the pandemic and subsequent lockdowns.
Auto industry: total industry volumes (millions of vehicles)
Source: International Organization of Motor Vehicle Manufacturers (OICA)
What could happen to the auto industry during a 2023 recession?
New demand for high ticket consumer purchases such as cars may decline as consumers retrench, but whether this translates into a volume contraction for the industry is far from clear. With supply already so constrained, lead times far longer than normal, as well as a stock of pent-up and replacement demand that is still yet to be satisfied, overall industry volumes may be more resilient than expected.
Nor is it only the automotive industry where we see these dynamics at play. The travel, leisure, and aerospace industries are also, to varying degrees, exhibiting unusual supply and demand dynamics dating back to the pandemic which may result in them behaving in a less cyclical manner. For investors, the opportunity here lies in finding high quality business models where valuations are heavily discounted due to cyclical fears that may turn out to be unfounded.
Conclusion – stay selective and focus on the long-term
This note has focused on the economic cycle as a source of potential mispricing at the individual stock and sector level. But the ups and downs of the economic cycle are relatively short term in nature. They come and they go, even if they may feel very intense at the time.
For long term investors, cyclically driven mispricing can be seen as an opportunity to invest in financially robust, high quality growth companies on discounted valuations. There should be no need to compromise on quality and growth, even if this might come with the appeal of an optically lower valuation.
To illustrate the dangers of getting such judgements wrong, compare the experiences shareholders have had over the entire period 2006-2022 in Next Plc, a highly profitable and well managed business, with its close peer Marks & Spencer, a company that has been unable to achieve the same level of dynamism and profitability. The former has returned just over 470% whereas the latter has lost investors almost 70%!