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Staying On Theme

When inflation, interest rates and global economic uncertainty are rising, cash today can seem more urgent than exposure to the markets of tomorrow—but could that mean investors risk missing out on the potential of thematic strategies?

Article also available in : English EN | français FR

We think that investing with a thematic research framework is a compelling way to approach the market. We believe it helps us to identify some of the younger companies that are about to disrupt an industry or create a new market, but also some of the established companies whose sector-leading products are about to find unexpected new applications.

We also recognize that, at times, investors will have other priorities for their portfolios. When inflation, interest rates and global economic uncertainty are rising, cash today can seem more urgent than exposure to the markets of tomorrow.

But investors who take that view could risk missing out. Here’s why we think it still makes sense to have some exposure to thematic strategies.

Duration

When investors think about thematic investing, they tend to think about information technology and growth stocks, and about the long duration of a growing earnings stream. There is a lot of truth in this, which is why so many stocks in thematic portfolios have sold off so sharply since the start of this year.

But it’s not the whole story.

When themes are defined sufficiently broadly, we believe portfolios can not only be constructed with diverse exposures, but those exposures can be actively managed in response to changes in the macroeconomic outlook. There is no rule that says thematic strategies must go into a rising-rate environment with super-long duration, because not all companies geared to interesting themes are speculative growth stocks.

As we mentioned, many are established companies whose sector-leading products are finding new applications: We think their earnings will grow, but their valuations are not necessarily predicated on that growth.

Others might be slow-growing companies with fast-growing businesses tucked away inside them. These may be their primary source of revenue one day, or spun off as separate entities, but today these companies could be trading on moderate multiples and generating abundant free cash flow from more established products or services.

In addition, some technology sectors are positively exposed to some of the dynamics that are leading to higher rates. Semiconductor and semiconductor capital companies are likely to benefit from ongoing chip shortages and supply-chain disruption, for example; cybersecurity is getting renewed interest due to Russia’s invasion of Ukraine.

New and Old Industries

Some investment themes are barely technological at all.

For example, we are interested in the way that data science can take the digital footprint left by increasingly connected Generation Y and Z consumers, who are about to enter their prime spending years, and reveal emerging themes on Main Street and the online marketplace.

For sure, those themes may include rising demand for digital finance or metaverse-related products, but they equally uncover themes around home improvement, travel, fashion or ethical consumption—themes that may benefit well-established companies in the consumer discretionary and staples sectors with already robust pricing power and cash flow generation.

Other themes involve an interesting blend of new and old industries, high technology and real assets.

Indeed, this is exemplified by one of the strongest and most prominent investment themes of our time—the transition to a low-carbon economy.

The stocks in a thematic carbon-transition portfolio are likely to be selected because they get a high proportion of their revenues from products or services linked to clean energy or electrification infrastructure. They may include utilities, solar panel and wind turbine manufacturers, and energy companies. These investments could serve not only as a hedge against inflation today, but as part of the solution to the threat of rising energy-related inflation over the long term.

Fundamental Growth Stories

Ultimately, despite these important exceptions, there’s no getting away from the fact that thematic investing is likely to be growth-oriented, and that performance is likely to lag when the market prioritizes value, defensiveness and cash.

But the thing about well-thought-out investment themes is that they should not simply evaporate at the first sight of inflation or a recession. While some of the more speculative companies geared to these themes may struggle, we believe well-selected businesses with robust fundamentals should be able to tell the same growth story in two years’ time that they are telling today—indeed, if the investment theme is valid, they should be able to tell a better fundamental growth story.

That means these same thematic growth opportunities are more attractively valued than they were five months ago. Does market sentiment have further to fall? We think it’s quite possible. But we already see Nasdaq 100 Index valuation metrics, including price-to-earnings and enterprise value-to-sales ratios, back at pre-pandemic levels. An equally weighted basket of software-as-a-service stocks—where fast-growing, high-quality names have tended to sell off dramatically on slowdown concerns before rebounding strongly—now trades with an EV-to-sales ratio consistent with prior equity market downturns, such as March 2020 and December 2018, according to Bloomberg data.

Far from turning your back on thematic investment, the next few months could be just the time to give them your closest attention.

Hari Ramanan 24 May

Article also available in : English EN | français FR

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