CIO Doug Foreman, CFA, discusses how quality companies offer sustainable competitive advantages amid the current market environment marked by rising inflation and recession concerns.

At KAR we believe investing in high-quality businesses enables investors to increase their chances of capturing what have been historically stronger risk-adjusted returns.  Read more about our approach to investing in quality companies: The Case for Quality

For additional information about quality investing, get in touch with our investment team today. 

TRANSCRIPT

Today I thought I’d talk a little bit about the macro environment that we’re all currently operating in, what the problems are, and then a little bit about what an investor should do in this type of environment given how difficult it’s been over the last 12 months or so. 

First of all, the environment on a macro basis has been totally driven by inflation and disappointing inflation numbers, which have proven to be much stickier than any of us thought over the last 12-24 months. The Federal Reserve has gotten increasingly hawkish in response to this, and it’s remained fully committed to getting inflation under control. 

We’ve had an enormous backup in interest rates, and investors have become increasingly concerned, not just about the inflation outlook, but also about the Fed’s ability to overdo it and send us into a more meaningful global recession. 

Risks continue to rise, and I think even before the Fed’s hawkishness broke out since, really, last November, investors were concerned about slowing growth rates to begin with, so this has only exacerbated the earnings outlook for corporate America. It’s only made things tougher as we go forward. 

So, we think we’re in a tough environment, we’ve been in one, we think we’re likely to stay in one over the next 6-12 months. Earnings growth is going to be exceptionally difficult to come by.

What should an investor do with this type of environment? We think you really want to stick with quality investments. It’s not time to buy businesses that have a lot of leverage or have a weak competitive position. This is the type of environment like ‘08 and 2000 where the strong get stronger and the weak get weaker and ultimately disappear.

The only good news, I think, out of this environment is quality companies and companies that have sustainable competitive advantages are actually able to get market share and grow now that their competitors can’t get free money to fund business models that really aren’t sustainable and won’t be sustainable over any reasonable time period.

So, the fundamentals that we think are going to matter going forward…things like good cash flow, sound balance sheets, strong competitive position, and pricing power.

Many of our companies have been hurt by the rise in inflation because they’re price takers in many commodity products, and as those commodity products have soared over the last 12-18 months that our companies haven’t been able to fully recoup the price that they need to absorb those price increases. You simply can’t run to a customer and tell them you’re going to double their prices overnight because your aluminum and transportation costs have gone up.

Now the good news is, I think, is that many of these input costs that we’re seeing, whether it’s transportation, raw material prices, etc., these things are now heading in the right direction, they are declining on a sequential basis, so the input costs to many of our companies have started to subside, and our companies are implementing price increases to recover the margins that they had previously enjoyed.

So, we think quality businesses that have pricing power will ultimately get their margins back to where they were before this bout of inflation really hit their P&L’s, and we think that’s a good place for investors to look for some earnings momentum in an environment where it’s going to be very difficult to find any type of earnings momentum as we go forward because of the increased bite of monetary policy, which is clearly already impacting negatively areas like housing, and autos, and even semiconductors here recently.

It’s important to keep your long-term investment goals in mind, and we thank you for your trust and confidence in managing your assets, and we will continue to be quality investors as we always have at Kayne Anderson Rudnick. Thank you.