Matthew Benkendorf, CIO of Vontobel's Quality Growth Boutique, worries about the state of the overall market. Nevertheless, he finds many attractive stocks. The events in China do not worry him.
The ever higher climbing stock markets urge Matthew Benkendorf to be cautious. In addition to the euphoric investor sentiment, the chief investment officer of Bank Vontobel Asset Management's Quality Growth Boutique is primarily concerned about the rich valuation of the overall market and the high level of debt of many companies.
In addition, he worries that the market is only driven by momentum and no longer has any patience. It is completely open whether inflation is temporary or permanent. But instead of waiting to see how things develop, the stock market just keeps going up every day.
But impatience also has its good sides. Thanks to it, high-quality growth stocks, which Benkendorf and his team prefer, are fairly valued. Despite good prospects, many stocks do not move because investors don't want to wait for the normalisation of profits that will follow after the economy reopens.
In an in-depth conversation with The Market, Benkendorf reveals which stocks are currently underappreciated. He also explains how he deals with increasing regulation and events in China and why airline stocks are out of the question for him despite good prospects.
Mr Benkendorf, equity markets are climbing higher and higher. Does that worry you?
It feels uncomfortable. There are a lot of worrying signs. One of them are moves in stocks like Tesla which just do not make any sense. In two years, Tesla might earn an operating profit like Ford which has been in business for 100 years and has a market cap that much smaller than Tesla’s. Or let’s take the inflation question. The outcome is completely unknown, so you need time and patience to see how things unfold. But the stock market does not have any time, it just moves up every day. It seems to be endemic in the time right now that there is no patience, it is all action.
It looks like TINA-investing – There Is No Alternative – is still the name of the game.
There will be an alternative at one point. Cash has a cost to it, but being patient and have some firepower is also valuable.
Do you own some cash in your funds right now?
2 or 3% – not much. We are not having a problem finding attractive companies thanks to this massive dislocation and narrowness in the market. About half of our stocks went nowhere despite their very healthy underlying earnings trends. Our stocks are not hitting 52 week highs, half of them are actually far from it. This is why I do not need cash. I own a number of names that have yet to do their job.
What are these names?
There are a couple of different buckets. In the consumer staples space, there are vastly underappreciated names like Coca Cola, Pepsi or Heineken. These stocks have not done much because the market is waiting for an economic reopening after Covid. As I said, there is no patience to buy a stock and wait for earnings to normalise right now.
What is the second bucket?
There are some names in healthcare, especially in the Medtech space, which have underperformed because some of these businesses have been shut down during Covid. They will normalise as procedures like implanting pacemakers or stents have to come back. But even in the technology sector which has been booming you find names like Visa and Mastercard which have not done anything because the crossborder travel business is just about to come back.
But are Visa and Mastercard not disrupted by Paypal which you own as well?
This is one of the bigger misconceptions. The big disruption is electronic payment to cash. But even newer areas of disruption such as «buy now pay later» are not such a threat. First, Visa and Mastercard are launching their own platforms. And second, when people are going to pay back their loan, this happens over Visa’s and Mastercard’s rails in most instances. In Crypto they could be playing a role if they want to. 40% of Mastercard’s revenues come from services such as data analysis. Hence, these businesses are evolving too, they are not just simple payment processing firms.
Are there other buckets of underappreciated stocks?
There are buckets even within consumer discretionary. Some of the retailing space in the US is still yet to recover. We own companies such as Ross Stores which has been an underperformer despite all this euphoria around consumer spending coming back thanks to the flush of savings. The stock is a direct beneficiary of wages going up. This is clearly a recovery play with people moving back to the stores. Inventory issues because of supply chain disruptions will normalise as well.
Isn’t there a more structural reason behind the weakness in Coca Cola and Pepsi which is the move to healthier consumer habits?
Coke and Coke Zero are still a material part of Coca Cola's business, but they diversified meaningfully away from carbonated beverages. They are just about to complete a transaction to buy sports drink maker Bodyarmor. Coke has also gone through a major restructuring. Under their new CEO James Quincey they accelerated innovation and time to market. If they develop a healthy new drink, they can move from inception to the market within a couple of weeks. And even in the core business, there are trends which support them such as the move to smaller packaging sizes which is high margin.
Pepsi is more of a snack business which is unhealthy in a different way. Is snacking going away? I don't think so. A lot of habits are here to stay.
Haven’t some of these names loaded up on debt to repurchase shares?
No, these companies sit on quite strong balance sheets, so they have the capacity to continue to buy back shares and pay dividends. Some of our businesses had severe shutdowns during Covid and a severe contraction in revenues, but they had no issue with balance sheet strength. Additionally, they generate very healthy cashflows. But I agree, there is a growing problem in the market from the magnitude of zombie companies and companies that have been leveraging up paying ever higher prices for acquisitions. The leverage problem is one of the many reasons I would worry about the overall market.
Are Coke and Pepsi really cheap or are they just cheap relative to the market or competitors?
These companies are trading at roughly 22 times earnings, they are growing earnings at high single to low double digits and offer a couple of percent of dividend yield. Those are good returns. Everybody is so used to the type of returns we have right now that they forget that a normalised long term equity return is in the middle single digit space. If we can deliver such returns over the next couple of years, we are quite happy. I think the market is going to be shocked that it can’t.
Your return assumption is based on earnings growth but no valuation change?
These names are not overpriced and they are going do deliver growth while everybody else will have massive multiple compression at some point. Multiple compression is the biggest risk to the overall market.
A PE ratio of 22 is rather on the high side, don't you think?
Not if you look at the long-term PE ratio of these businesses. There will be a little room for multiple compression, but they are not trading meaningfully above long-term averages such as a number of other companies especially in the low-quality growth space do. The rich valuation and the extrapolation of the recent high earnings growth rates into the future are the biggest risks to the market. Low quality growth companies – that means companies with low capital returns, low levels of profitability, weak balance sheets etc. – can very rarely maintain double digit earnings growth for five years and then repeat that for another five years. Yet the market is extrapolating exactly this for many companies.
The biggest risk is probably rising interest rates?
I think the Fed has done a reasonable job based on the reality that what is going to unfold in terms of inflation is totally unknowable. The Fed is carefully waiting, and I think when we get through these inflationary headwinds, the backdrop is still deflationary. It might take another year until the inflationary forces will have been worked out of the system, but one of the biggest forces of deflation, which is indebtedness, is higher than it was. One variable I would acknowledge on the inflation side is the excitement about ESG which is creating inflationary pressures particularly in the energy space. We are killing production while demand is still normalising – which is inflationary, but the deflationary forces are counterbalancing that.
What if inflation remains higher for longer?
We are not particularly worried because we avoid labour-intensive businesses which are prone to wage growth. On the revenue side, we focus on companies which have pricing power. The staples companies are the ones to see cost pressures first which worries the market for a while, but these companies can absorb and pass through these pressures.
You still own stocks like Alphabet which might be exposed to regulatory risks. Do you worry about that?
In M&A, increased regulation has already happened. The Federal Trade Commission which evaluates acquisitions has changed its tune. It is not possible any longer that companies strengthen their position by just buying up any new threat and every incumbent along the way. This is a risk for a business that needs to evolve. Facebook had to move out of their core business by building a consumer platform, so they need to evolve which is a risk as they are not able to plan acquisitions from a regulatory point of view. I do not think Google needs to do acquisitions anymore, Amazon neither – so the new regime will not affect them.
What about the legislation side?
There was a bipartisan bill introduced in the US two weeks ago. It is the first bill to point towards the tax base, and it wants to force internet companies to open up their data to competitors. But the bill has a very low chance of succeeding. Forcing these companies by law to adjust their business models is even further down the track. China can do that, and what China did particularly in the area of e-commerce is something the legislator would like to do in the US as well. So yes, the regulatory risks are there, they are building and continue to be there, but the political system makes it difficult to enact them. If you want to see change, it has to happen on the consumer side. The consumer needs to change its pattern, that is where change comes from.
China regulated various areas of the market. Have the ensuing sell-offs in stocks like Alibaba or Tencent opened up a buying opportunity?
We saw three movements in China. First, they shut down the for-profit education space which we do not own. Second, China took action on e-commerce which affected names like Alibaba. Basically, they reminded these companies what the rules on anti-competitive behaviour were and enforced them. But that happened, and it is not a bad thing for the business models longer term. They still have an enormous scale advantage. Will they be able to compete unfairly as they have done for a while now? No, but they can still compete very well.
What is the third movement?
Gaming is a mix of both. We do not own many of these names because there is not a lot of certainty that the Chinese government is done in this area yet. It addressed the most acute issue right away with gaming for children, but in the end, the gaming space could still be construed by the government as a pretty non-productive high profitability space where they want to make some further changes.
Are you still waiting for more clarity before adding to Chinese shares?
No, we have been buying again. We added some e-commerce companies as the visibility is better than in gaming. Not so much Alibaba, but JD.com. In our emerging markets fund, we have also been active in the staples area where there has been some weakness. We are not scared by what happened in China, quite the opposite as the market came closer to our view. We have been sceptical and chronically underweight China for years as the government can touch anything, and the market finally woke up to that. We like an environment in which investors appreciate risks.
Are there companies where you had to change the business case because of Covid?
Not really. People tend to overextrapolate the current situation. You live in the moment, and it was right to do so because there was a lack of visibility. But with time evolving, things will normalise again. People want to go back to bars and restaurants, and they want to meet in person and not through Zoom. That is why I also believe business travel will come back. If you have one person who goes and meets customers and one who isn’t – who will have the advantage?
But you still would not buy airline shares?
The problem with airlines is twofold. These businesses are very capital intensive, and they went into Covid with high leverage because they had been buying back shares foolishly. Then they were hit by the Covid shutdown which was worse than a normal economic slowdown, and now they need the help from the government to save them once again. Warren Buffett sold his airline stocks in the height of the crisis not because he is impatient. He did not want to be involved in a sector which takes a lot of capital from the government and be a profiteering investor alongside them. You look bad, and the interests are very differently aligned. For that reason, it’s difficult to be in airlines, even though the business is certainly coming back. Energy is quite unique in this regard too.
Energy is attractive?
Oil companies have been pressured to not invest in what is historically a capital intensive industry. They had to constrain capital spending which is usually the problem, and they are experiencing high prices because demand remains strong as the world is still carbon based. We will not buy these shares because of our investment style which favours high quality companies, but the scenario looks pretty good for them for a while.
What about the cruise liners?
They had two issues – one was the shutdown of their business and the other was the question how to restore safe operations as there is such a mass amount of people constrained in a small space, and then they are moving in and out of international boundaries too. In addition, they had to take on more debt as they were not eligible for government support because they are structured offshore. But demand is coming back. Cruise liners have a very dedicated customer base as the value for money vacation proposition is attractive.