By Andrew Macken
Today’s set of economic parameters is enough to puzzle even the most seasoned observers. We have a strange combination of strong labor markets, high inflation and tightening monetary policies, and apparent recessions in the US and EU.
But despite the uncertainty, the recent earning season highlighted one clear trend for investors: these difficult economic times are accelerating the bifurcation of the market into ‘advantaged’ and ‘disadvantaged’ businesses.
As we enter turbulent times, avoiding ‘disadvantaged’ businesses, and aligning your portfolio to ‘advantaged’ businesses, is becoming much more important than picking sectors or style and will be vital to long-term compounding and wealth building in coming years.
A tale of two businesses
An advantaged business has characteristics that put them in a powerful position to keep driving growth, no matter what the economic conditions. Their products and services are mission-critical to customers’ businesses. That protects them from competitors and delivers reliably growing (recurring) revenues that aren’t tied to the economic cycle. These businesses are the ‘all-weather’ engines of the global economy: they perform in any environment.
They can also generate big profits through things like scale advantages, pricing power and network effects (particularly data network effects). And, importantly, they can use their strength and profits to take advantage of big long-term trends by investing in new businesses and opportunities that have a high probability of success, turbocharging new rounds of growth.
By contrast, a disadvantaged business generates revenues that are far less durable across business cycles and their customers can more easily switch to competitors. Their pricing power is limited, and their profitability more volatile and largely out of the control of management.
Disadvantaged businesses struggle in tough times
Disadvantaged businesses are now showing investors how unreliable they are when facing an unexpected economic ‘googly’. This has been the case for some time but has become particularly obvious during the recent earnings season amidst the ongoing economic turbulence. A number of disadvantaged businesses and sectors are suffering from volatile economic conditions:
1. Subscale advertisers
Subscale advertisers that don’t have sophisticated targeting and measurement capabilities, such as Snap, are seeing just how susceptible their revenue is to macroeconomic headwinds. Snap’s CFO rightly observed that: “Advertising is among the very few line items in a company’s cost structure that they can reduce immediately in response to pressure on their topline or their input costs.”
Banks are also not well suited to the current macroeconomy. They traditionally make money by borrowing money from savers at short maturities, then lending to longer-term borrowers at higher interest rates. But this arrangement is now under pressure because the yield curve has inverted: short-term interest rates are now higher than long-term interest rates. The inversion, by the way, reflects the fact that short-term interest rates are being raised by policymakers to combat inflation, while longer-term rates have weakened as recession probabilities have increased. And recessions are also anathema to banks because they result in lower demand for loans and higher risks of default.
3. Chip designers
Chip designers, such as Intel, and memory manufacturers such as Micron Technology, are bearing the brunt of a sudden cyclical downturn, particularly in consumer computing products such as PCs. Prices are falling as original equipment manufacturers (OEMs) liquidate inventories as customer demand softens, in what Intel’s CEO described as a “once in 10 year” inventory adjustment. Even chip giant Nvidia proactively cut prices of its gaming chips in recent weeks and wrote down nearly $US2 billion in inventory as it responded to rapidly weakening demand.
Consumer-facing retailers also have their hands full. In recent days, Target (the US retailer) reported a significant second-quarter gross margin reduction from 30.4% one year prior, to just 21.5% this year. This large contraction in profitability substantially stemmed from inventory mark-downs in core merchandise categories such as apparel, home and hardlines. And these, in turn, were the result of a sharp slowdown in customer demand as high food and fuel inflation impaired customers’ willingness and ability to spend on general merchandise.
5. Consumer service stocks
On the consumer service side, challenges are also plentiful. For example, cruise lines, including Carnival and Royal Caribbean Cruises, present a fascinating case study today in the challenges of managing through industry overcapacity, high fixed (and inflating) costs, little pricing power and highly levered balance sheets in a rising interest rate environment. And unfortunately, the remedy for these elevated costs is likely a deeper recession – which would be detrimental to customer revenues.
But the world’s advantaged businesses continue to deliver
But the world’s advantaged businesses are continuing to show strength. The contrast between these challenged businesses and those with strong business advantages is stark. There are at least three areas where advantaged businesses are showing they can continue to deliver strong growth and profits, despite difficult economic conditions.
1. Platform businesses
Industry-leading platform businesses, such as UnitedHealth’s Optum in healthcare, and Visa and Mastercard in payments data, are thriving today. Their services are mission-critical for customers, their value-add far outweighs their cost, and they have very limited competition. As a result, revenues are growing reliably, profit margins remain healthy, and their clean balance sheets are naturally immune to increased interest rates.
2. Alternative asset managers
As are the world’s leading alternative asset management platforms, especially Blackstone. In a depressed fundraising environment during an asset price downturn, it is nothing short of extraordinary that Blackstone generated an additional US$88 billion in capital inflow during the June quarter – the second highest in its history – bringing total assets under management to US$941 billion. Their fundraising success reflects their world-leading brand in alternative asset management, which makes Blackstone the obvious, lowest-risk choice for adoption by a wide range of capital allocators around the world.
3. Cloud and distributed computing
In cloud and distributed computing, the three oligopolistic leaders, Amazon’s AWS, Microsoft’s Azure and Alphabet’s GCP, continue to generate very high and reliable rates of revenue growth. These businesses provide some of the most mission-critical technology services to the world’s corporate and government sectors – and with economics that cannot be recreated by customers or competitors. In the June quarter, AWS grew revenues by 33% per annum, a very modest slowdown from the 37% rate of growth generated in the prior quarter. Similarly, Azure grew by 46%, a slight moderation from the 49% growth rate delivered in the prior quarter.
After the recent correction, when even strong businesses were sold off indiscriminately, many of these advantaged businesses remain substantially undervalued today.
In challenging times, stick with advantaged businesses
The economic times of the day are particularly challenging to decode. But the truth is, markets are never easy for investors. Investing great Charlie Munger pointed this out rather directly when he said:
“It’s not supposed to be easy. Anyone who finds it easy is stupid.”
But a valuable step in making investing just a little less difficult is to focus on businesses with strong advantages. These are businesses that provide mission-critical value to customers with limited competition. Businesses with reliably growing non-cyclical revenue streams. Businesses with expanding profitability as scale, pricing and networking advantages translate into higher profits over time. And businesses with large growth options of which they remain the high-probability long-term owners.
As a result of these valuable characteristics, investors in advantaged businesses can be less concerned with the daily ups and downs of the macroenvironment. Owners of these kinds of businesses can look through the short-term noise and instead remain focused on the long-term growth potential of company earnings power.
Montaka continues to own the businesses we assess as being highly advantaged that will perform well over the long-term, irrespective of the short-term business cycles, while they remain undervalued.
Andrew Macken is the Chief Investment Officer at Montaka Global Investments.
To learn more about Montaka, please call +612 7202 0100 or contact us on https://montaka.com/
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