Investors from Evenlode, Gresham House, Sarasin and Syz Bank reveal the parts of the market that they will be avoiding in 2023.
Last year was a rocky one for markets, with all major assets classes selling off because of soaring inflation and rising interest rates, but there are warnings that 2023 will bring further volatility with it.
This week might be an apt time for investors to mull over the assets that could struggle over the coming 12 months, as it includes ‘Blue Monday’ – said to be the most depressing day of the year. Blue Monday is down to a number of factors, including grim weather conditions, Christmas being firmly in the rearview mirror and low motivational levels, although those with a portfolio also have any losses incurred in 2022 to add to their worries.
With this in mind, four professional investors highlight the parts of the market that they are feeling particularly downbeat on this Blue Monday.
Stretched balance sheets
As rising interest rates and dampened equity valuations cause the cost of raising external capital to increase, companies that lack the ability to self-fund their growth are likely to slash investment over the coming 12 months. Chris Elliott, co-manager of the Evenlode Global Equity fund, warned that this could be a problem across the board and not confined to specific sectors or geographies.
“One red flag we look for is a business model dependent on a debt-fuelled, roll-up acquisitions, where organic investment is eschewed and the balance sheet is stretched,” he explained. “While these businesses can generate returns for investors in the ‘good times’, their additional financial leverage increases their risk in recessionary market conditions.”
While avoiding companies with stretched balance sheets, Elliott looks for asset-light companies with resilient competitive advantages as they tend to be cash generative and require little capital reinvestment to maintain their existing operations. As this leaves them with excess cash, they can invest in activities such as research or advertising even in a downturn and put themselves ahead of less-profitable peers, who are often forced to slash spending.
While inflation caused many parts of the market to sell off in 2022, resources companies benefitted from the rising price of raw materials and were able to boost dividends. As a result, many investors pivoted into these previously unloved sectors in a short-term bid to make their money work harder.
However, LF Gresham House UK Multi Cap Income co-manager Ken Wotton said this was “a very imprudent course of action”.
“These cyclical sectors are prone to volatility, as evidenced by dividend cuts during Covid-19 and the future of fossil fuels is a foregone conclusion,” he explained. “Instead, investors should look to other areas that can consistently deliver robust dividends.”
Wotton’s approach is to invest in stocks that operate in structurally growing sectors and have a competitive advantage which gives them pricing power, as he has more confidence they will be able to maintain healthier dividends and dividend cover than more cyclical businesses.
European and emerging market stocks
Ben Gilbert, model portfolio manager at Sarasin & Partners, warned high inflation, interest rate hikes and increased recession worries that caused 2022’s sell-off has left the market at risk of more turbulence this year.
Given this backdrop, he said it is prudent to take a cautious approach at the moment, with portfolios adopting taking minimal risk exposure and increasing weightings towards defensive assets. As a result, he is underweight global, European and emerging market equities.
“While equity valuations have returned to much more compelling levels in recent weeks, the accelerated tightening of monetary policy across Western economies risks further compression of equity valuations” Gilbert noted. “The expectation that global growth will slow materially over the coming years also poses a considerable threat to the outlook for corporate earnings.”
Passive investors may struggle
Antoine Denis, head of advisory at Syz Bank, agrees that uncertainty is likely to persist in the market for some time as interest rates remain elevated and the economic cycle deteriorates, which strengthens the case for active management.
“We thus believe the current conditions call for the knowledge and experience of active investment managers, as opposed to the use of passive investments,” he argued. “Passive investments greatly benefited from the low interest rate environment and subsequent bull market of the past 13 years, which lent wings to often profitless, speculative ‘concept’ stocks.”
However, heightened volatility and a more realistic pricing of risk by the market makes Denis think that active managers who can adjust the portfolio’s exposure in response to changing market conditions. “We therefore expect active managers to be better drivers of investors’ returns going forward,” he finished.