Around the world, there are concerns given rising inflation, supply chain issues, and higher energy prices coupled with an ongoing war in Ukraine. In trying to combat inflation, central bankers globally are raising interest rates which in turn are pushing up the risk of a recession. Economic headwinds are being felt, especially in the equity markets, where growth stocks have suffered significantly on aggregate given the interest rate hikes. The following chart compares the total return of the style indices relative to the Core benchmark, based to 100, over the last 25 years. Value recovery is evident following the bursting of the tech bubble in 2002. Post the Global Financial Crisis, growth outperformed during a sustained period of low-interest rates. With inflation unchecked and ever-rising rates, the current market environment suggests a continued backdrop for rotation into value-oriented stocks.
Quality Expectations – Index Composition
This current value rotation is narrow, driven in particular by the financial sector. The following chart provides sector allocations for the portfolio versus the core and value indices.
Given our focus on quality, the portfolio has less exposure than the index to what we deem to be lower-quality financial holdings (generally characterized by low P/B and elevated financial leverage). While the value index is much more heavily concentrated in financial companies, the portfolio is more heavily weighted to higher-quality diversified industrials and materials companies. These companies tend to have strong, and often net cash balance sheets, with higher margins and consistent free cash flow generation. In a rising interest rate environment, companies that rely heavily on debt become increasingly burdened by having to refinance their debt at higher and higher levels. The companies we look to invest in can internally fund their operations, R&D initiatives, bolt-on acquisitions and long-term growth plans from their strong balance sheets and consistent cash flows. These types of companies are better aligned with our long-term-oriented investment approach.
The difference in index composition, as noted above, has been a key contributor to Sprucegrove’s underperformance versus the value index in the current environment. At the onset of a market sell-off, there is typically a flight to liquidity as many investors choose to exit the market as irrational exuberance wanes. Greed starts turning into fear and investors start a flight to quality to ascertain a wider margin of safety. At Sprucegrove, we invest in a portfolio of high-quality companies that we believe have demonstrated their ability to perform through a full market cycle. In looking at previous down markets, as shown below, we have tended to participate more when a downturn worsens and markets start favoring higher-quality companies. This has typically occurred several quarters following the start of a downturn. We believe our high-quality companies with an emphasis on strong balance sheets will come into favor as the cycle continues to progress. That said, this is not an indelible rule, and we cannot guarantee that this will occur again in the future.
JAPANESE ASSET BUBBLE
PANDEMIC BUBBLE – INFLATION AND RISING RATES
* The Portfolio is the Sprucegrove International Equity Master Fund and is intended to serve as a representative example across all portfolios for the purpose of this historical illustration. Actual data points across characteristics will differ by portfolio. Returns are gross of fees in U.S. dollars.
Our portfolio companies have shown their ability to adapt over time. The aftermath of an environment characterized by high inflation and rising rates has historically been favorable to our style, given our focus on quality combined just as importantly with a discipline on valuation. We remain steadfast in our approach and look forward to the future with cautious optimism.
The market events illustrations in the portfolio perspectives section (Flight to Quality) are defined as the following: (1) Japanese Asset Bubble (December 1986 – February 1991) Source: Britannica, (2) Dot-Com Bubble (March 2000 – October 2002) Source: International Banker, and (3) Pandemic Bubble – Inflation and Rising Rates (March 2020 – Ongoing) Source: Centers for Disease Control and Prevention. This information is for illustrative purposes only and may not necessarily reflect actual performance and is not indicative of future results.