Our team recently had the pleasure of travelling to Latin America to meet with clients and partners we work with in the region. Our colleagues in Uruguay showed us the meaning of ‘asado’, while our friends from Argentina, Brazil, Chile, Peru, Ecuador, and many other countries were as kind and hospitable as anyone could ask for.
During our presentations and conversations, one topic came up again and again. What is the investment outlook for the rest of 2023?
Last year was a tough year for investors with equity and bond markets declining significantly. High inflation and rising interest rates in 2022 have set us up this year for the prospect of a slowing economy and even a possible recession. Recent bank failures in the United States and Europe further adds to the uncertainty facing asset allocators and individual investors.
So the question so many of our colleagues in Latin America were asking us was exactly what they should have been asking. The current situation facing investors is highly uncertain and very challenging. What’s going to happen and how do we invest? Quite right.
Our response to this question was as follows.
We cannot, in fact nobody can, accurately predict what the global economy is going to do in 3 months, 6 months, 1 year, etc. Trying to predict the future revenues of an individual company is highly complex and even with the best analysis your prediction is most likely to be wrong. Scale up this problem of unpredictability to the whole economy, and the project becomes pointless. The starting point for any and all investors, in our view, should be to not bother trying to predict the future of the macro-economy.
This is especially important in times of great uncertainty, as we find ourselves in today in financial markets. Taking strong views either way (either bullish or bearish) poses great risks to investors. Too aggressive / optimistic a position in your portfolio risks significant losses if the economy is weaker than expected. Too bearish / pessimistic a view risks missing out on strong positive returns from risk assets if the economy is stronger than expected.
Rather than focussing our attention as investors on factors we cannot control or predict (e.g., the macro economy), we think the correct strategy for investors today is to focus on factors you can understand and which are under your control.
The current market price of an asset relative to the cash income it produces is a very useful measure of its valuation. For example, imagine a business with a market value of $100 million, with 10 million shares listed on a stock exchange. This equates to a price per share (the stock price) of $10. This same company generated $20 million of free cash flow last year, equivalent to $2 per share of free cash flow. If we divide the market value of the company by the cash profits generated by the company last year, we get what is known as a ‘valuation multiple’. In this case, the free cash flow multiple is 5x. In other words, the company is currently trading on a valuation of 5x historic cash flows.
This methodology allows us to compare investment opportunities. Imagine now another company in the same industry as our previous example. Let’s say it generated $30 million of free cash flows last year, and trades on the stock market for a total company valuation of $360 million. The free cash flow multiple for this company would be 12x.
We can now compare the two investment opportunities based on valuation. One company trades on a 5x multiple, the other a 12x. As a prospective investor, you are paying much more for the second example than the first example, the first example is ‘cheaper’ and the second is more ‘expensive’. All else equal, you should buy the first stock trading on the lower valuation multiple.
There are dozens of different valuation multiples and other methodologies we can bring to the table when making investment decisions. The importance of doing this and focussing on investments trading on attractively low valuations is that you are reducing the downside risk to your portfolio. To go back to our example, two businesses trading in the same industry, one trading on 5x its cash flow generation, the other on 12x, all else equal in a recession the more expensive stock will fall much more in % terms than the cheaper stock.
This brings us back to the initial question. What is the outlook for 2023 and how should we invest?
We do not know what the economic outcome will be, but what we can do is invest in assets trading on attractive valuation multiples. The cheaper the better, if the asset is of a good quality. If we can build a portfolio of high quality assets trading on low valuation multiples, this sets up the strategy to: (i) be a recession beater and outperform in the event of a weaker economy, and (ii) perform very well if the economy is stronger than expected, because we still own risk assets and did not hide in cash or money market funds!
Our advice in this difficult time, don’t panic, get the strategy right, and invest in strategies with a focus on offering quality at an attractive price.
Disclaimer: The views expressed in this article are those of the author at the date of publication and not necessarily those of Dominion Capital Strategies Limited or its related companies. The content of this article is not intended as investment advice and will not be updated after publication. Images, video, quotations from literature and any such material which may be subject to copyright is reproduced in whole or in part in this article on the basis of Fair use as applied to news reporting and journalistic comment on events.
