If it was ever necessary, the last few weeks have provided an object lesson as to why quality does not matter until it does. Over the past year, the US Federal Reserve raised the Fed Funds Rate from close to 0% to almost 5% in response to high inflation. These moves have led to a number of intended and unintended consequences. One of these consequences was the sharpest sell-offs of quality stocks we have seen for as long as there have been markets. We invest in quality and value for the long-term and the shares of many of the globally leading companies we own did poorly because they are in businesses that have strong prospects for sustained growth and value creation and they are perceived as longer duration or more highly valued compared to other businesses. Among the best-performing sectors last year were energy, commodities and financials.
But this year has shown that quality matters. The best-performing sectors are the worst of last year and the worst-performing are last year’s best. Our approach is entirely driven by fundamentals and we have kept working to ensure that the fundamentals of the companies we invest in are sound and fulfil our criteria for quality and value. Quality for us is a gating condition: a company can be as cheap as chips but if it does not have the quality we look for we will not invest.
Our four criteria are a strong and sustainable competitive position, in a good and growing market, a management team with a record of value creation and a balance sheet so strong as to weather any kind of adversity. These criteria take us into companies that are involved in digital transformation, consumer products, healthcare and life sciences, and industrials. It takes us away from balance sheet-driven financials, capital and resource-intensive companies, and regulated businesses that rely on licenses or concessions for their returns.
Another of the consequences of the sharp rise in interest rates is the banking crisis that has been gripping markets for the past several weeks. We think that balance sheet-driven financials struggle to fulfil our criteria because they are difficult for outsiders to analyze for three key reasons. First, as we have just seen again in the case of Silicon Valley Bank, First Republic or Credit Suisse, it is impossible to know what the assets or liabilities are given the complexity of the businesses. Secondly, the balance sheet of any bank is inherently unstable because a bank’s core business is maturity transformation in which short-term deposits are used to make loans that are often not repaid for years. This means that any bank no matter how large is potentially vulnerable to a sudden outflow of short-term deposits. Third, one of the few certainties is that regulators want to increase the amount of equity required to support the assets on the balance sheet. Therefore the return on equity (ROE) of a bank is highly leveraged and at risk from externalities. The mark-to-market losses from long-dated government and corporate bonds and loans that are at the core of the current crisis result from the rate rises last year. That is why this crisis may be the first to have been caused directly by central banks themselves and we expect there to be further impacts before it is resolved.
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