Some retailers said they might never offer discounts again. Yet, by mid 2021, demand started to shift from goods to services, such as leisure and travel. Fast forward to 2022, and those retailers that had overestimated demand sustainability needed to clear inventory and were forced to lower prices, which typically hurts margins. And that was before central banks started raising interest rates.
Similar situations unfolded in many sectors, impacting both growthy and mature companies, regardless of their business quality. In many cases, companies with one-time windfalls were priced to assume a permanent step up in growth, in contrast with historical performance. This created an increasingly unattractive risk/reward profile.
Finding Consistent Profitability Amid Uncertainty
Investors are understandably confused by this landscape. But we believe there is a clear prescription for choosing stocks despite the uncertainty.
Avoid companies that show suspiciously strong profitability. Warning signs include unusually strong gross margins and sales growth relative to history, and unusually strong returns on investment.
Instead, identify companies with consistently high return on assets and return on invested capital over longer periods of time. These profitability measures are good signs of quality, especially if a company is reinvesting profits back into the business. We aim to verify that profitability or valuations are high for reasons that can be explained—not because of transitory impacts.
The moral of this story? Beware of companies that are being rewarded for untenable business results. This creates higher risk relative to the potential reward (and vice-versa). In other words, being in the right place at the right time doesn’t warrant a sustainably high multiple. Think of a bank, considering lending to a borrower who just won $1 million in the lottery. That windfall wouldn’t be seen as sustainable annual income for the borrower.
Apply the same principle when evaluating post-COVID corporate performance and valuations. With a disciplined, bottom-up fundamental research process, investors can establish the appropriate context for each company and develop a dispassionate assessment of risk and reward. This is the best way for equity investors to successfully navigate uncertainty ahead as the impacts of central bank tightening become clearer, and position a portfolio for a future recovery.