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Categories
Global Equities
When volatility is rising, boring is beautiful
Jonathan Knowles
Equity Portfolio Manager
Andrew Suzman
Portfolio Manager
Diana Wagner
Equity Portfolio Manager

Fast-growing digital and tech companies generated a lot of investor excitement over the past decade, not to mention an outsized share of market returns.


Since the start of 2022, however, many of these market darlings have taken a beating. Amid slowing economic growth, soaring inflation and the fear of rising interest rates, investors may be taking a second look at the high valuations many digital platform and software stocks command.


“This is one of the most complex environments for investing we have seen in years,” says equity portfolio manager Jonathan Knowles. “With questions lingering over the persistence of inflation and shifts in the geopolitical landscape, I am looking to invest in an ‘all weather portfolio’ with the potential to withstand a variety of potential risks.”


That’s why boring is beautiful according to Knowles. “I'm looking to invest in dull and dependable companies with the potential to generate solid cash flows and continue growing regardless of the direction of the economic cycle or macroeconomic developments.”


Here are some investment themes that cautious investors may want to consider.


Railroads are riding a commodities boom


You can’t build the new economy without old industries.


Long-term shifts toward a digital future, the rollout of electric vehicles and the transition to clean energy will likely continue to drive opportunity for innovators in those areas. But these trends are also providing tailwinds for old industries like mining and railroads.


Nickel, for example, is a key component in electric vehicle batteries. So is copper, which is necessary for updating the electric grid. And while software is becoming an increasingly essential player in the production of modern cars, steel remains a required component. Indeed, prices for select commodities have skyrocketed in recent months, a trend amplified by the war between Russia and Ukraine — major producers of nickel, copper and grains.


“People have underappreciated how much copper is needed to rewire and modernize the electric grid as demand rises,” says equity portfolio manager Andrew Suzman. “Businesses like Canadian metals and mining company First Quantum Minerals, which focuses on copper, and Brazil’s Vale, a producer of iron ore, could benefit.”


Rising demand for commodities and energy could also boost demand for North America’s railroads, which are the most cost-effective way to transport heavy materials. Railroads have pricing power potential as well, which is important in today’s inflationary environment. They typically base their pricing on the cost of the underlying commodities they are hauling, so revenues rise with commodity prices.


Rising fuel costs also prove beneficial, as the difference between the cost of trucking and rails is at its widest gap in years. “A railroad like Canadian Pacific, which has the only tri-coastal Canada-U.S.-Mexico network, could do well under a variety of economic circumstances,” Suzman adds.


Railroads have room to increase pricing amid a commodities boom

The chart shows the widening gap in pricing in USD between trucking and rail from 1990 through 2018. In 1990, trucking pricing was $0.08 per ton-mile and railroad pricing was $0.03 per ton-mile. The gap generally expanded, with trucking pricing climbing to $0.20 per ton-mile and railroad pricing rising to $0.04 per ton-mile by 2018.

Source: Capital Group, Association of American Railroads, U.S. Bureau of Transportation. Data shown from January 1990 through December 2018. The rail category refers to Class 1 rail, or carriers earning more than $505 million in annual revenue. Pricing per ton-mile refers to the pricing charged for transporting one ton of freight across one mile. Values are in USD

Industrials help power an energy-efficient future


The global push to reduce carbon emissions and improve energy efficiency is often associated with electric vehicles or utilities harnessing solar and wind power. At first blush, traditional industrial companies making machinery, chemicals and other construction materials might be construed as part of the problem, not the solution.


But HVAC companies like Carrier and Daikin are developing air conditioning and heating systems that could help reduce global greenhouse gas emissions. Regulations in Europe and elsewhere that require the replacement of older systems with more energy-efficient products could drive long-term opportunity for both companies.


Tighter carbon emissions regulations and infrastructure spending across major economies could also provide tailwinds for Swiss specialty chemical maker Sika, Knowles says. “The company makes cement additives that can reduce carbon emissions and increase durability,” Knowles says. “This may sound like a boring business, but its growth potential is pretty compelling as global emissions standards tighten.”


Tightening emissions regulations are generating opportunity for select industrials

The chart provides information for three companies focused on energy efficiency. Founded in 1915, U.S. HVAC manufacturer Carrier has a current market capitalization of US$39.8 billion. Carrier’s sustainability goals and progress include: the aim to achieve carbon neutral operations by 2030, reduce hazardous waste production by 23% from 2015 to 2020, and reduce greenhouse gas emissions by 17% from 2015 to 2020. Japanese HVAC manufacturer Daikin was founded in 1924 and has a current market capitalization of US$54.1 billion. Its sustainability goals and progress include: the aim to achieve carbon neutral operations by 2050, growing its sales mix categorized as “environmentally conscious” from 83% in 2017 to 98%, and reducing greenhouse gas emissions by 31% from 2016 to 2020. Sika Group is a Swiss building materials supplier founded in 1910 with a current market cap of US$47.4 billion. Its sustainability goals and progress include: the aim to achieve carbon neutral operations by 2050, 52% of electricity used for operations comes from renewable sources as of 2021, and its proprietary concrete recycling process reduces carbon emissions of new concrete by 40%.

Sources: Capital Group, company reports, Refinitiv Datastream. Company market capitalizations are in USD as of 3/31/22.

Bargain hunters find “treasure” at dollar stores


When economic conditions become challenging, consumers may naturally become more careful about spending. Many shoppers shift their spending to discount merchants known as treasure hunt retailers. These stores offer clothing, personal care items and household products at relatively low prices, as well as some higher quality products at bargain prices.


“In a slowing economic environment, many people will be trading down to dollar stores,” says portfolio manager Diana Wagner. “Such stores have held up well in past recessions.”


Treasure hunt retailers have outpaced the market in recessions

The chart shows average returns relative to the S&P 500 over the three most recent recessions during the recessions themselves, six months after the recessions and 12 months after the recessions. Returns shown are for the S&P 500 consumer discretionary sector and three treasure hunt retailers: Dollar Tree, TJ Maxx and Ross Stores. Average relative returns are as follows: for Dollar tree, 29% during recessions, 17% six months after recessions and 17% 12 months after recessions; for TJ Maxx, 23% during recessions, 6% six months after recessions and 16% 12 months after recessions; for Ross Stores, 49% during recessions, down 1% six months after recessions and 15% 12 months after recessions; and for consumer discretionary, 1% during recessions, 12% six months after recessions and 13% 12 months after recessions. Returns are in USD.

Source: Capital Group, National Bureau of Economic Research, Refinitiv Datastream, Standard & Poor’s. Reference periods for recessions are March 2001 to October 2001, December 2007 to May 2009, and February 2020 to March 2020. Consumer discretionary category refers to the S&P 500 Consumer Discretionary Index. Returns are in USD.

What might be less intuitive is that well-run treasure hunt retailers often have pricing power potential when inflation is rising.


For example, Dollar Tree, which offers a wide variety of items for US$1, recently launched their “breaking the buck” strategy. The company initially offered a US$5 category of goods, followed by a category for US$1.25. “This same approach has helped other treasure hunt retailers generate multiple years of strong same-store sales growth and margin expansion,” Wagner says.


A change in senior management at the company could prove to be another tailwind. “Dollar Tree has been undermanaged relative to its competitor Dollar General,” Wagner observes. “But recently Rick Dreiling, the former CEO of Dollar General, was named chairman of Dollar Tree. I think this could be an important turning point for the company.


“In today’s environment, I look for companies that can improve their businesses and make their own growth happen regardless of what the economy does,” Wagner explains. “Dollar Tree could be one of those self-help stories.”


The bottom line


Investors may be wondering if the digital transformation has run its course. “Not at all,” Knowles says. “Leading digital platform companies, cloud software and autonomous vehicle technology continue to reshape the way we work, live and shop. But many of these companies may have gotten ahead of themselves.”


With inflation rising and the earnings potential for many of these companies still years away, valuations may be extended. “Leading technology companies continue to look promising over the long term,” Knowles says. “But in this environment, I am shifting my focus a bit toward companies that actually make stuff and tend to hold their ground during all types of market weather.”



Jonathan Knowles is an equity portfolio manager with 30 years of investment experience. He has an MBA from INSEAD, France, as well as a PhD in immunovirology and a bachelor's in veterinary science from the University of Liverpool, U.K.

Andrew Suzman is an equity portfolio manager with 28 years of investment experience(as of 12/31/2021). He holds an MBA from Harvard and a bachelor's in political economy from Tulane.

Diana Wagner is an equity portfolio manager with 25 years of investment experience (as of 12/31/2021). She holds an MBA from Columbia Business School and a bachelor’s degree in art history from Yale University.


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