Why it's all about Earnings Growth

Insync Fund Managers

May 2022

Why it's all about Earnings Growth

Companies that sustainably grow their earnings at high rates over the long term are called Compounders.

Investing in a portfolio of Compounders is an ideal way to generate wealth for longer-term oriented investors that tend to also beat market averages with less risk. This chart shows the tight correlation between returns of the S&P 500 (orange line) and earnings growth (blue line) since 1926. NB: Grey bars are US recessions

Insync's focus is on investing in the most profitable businesses with long runways of growth resulting in a portfolio full of Compounders.

Inflation & interest rate impacts

By focusing on identifying businesses benefitting from megatrends with sustainable earnings growth, means we do not need to concern ourselves with market timing, economic growth forecasts, inflation, or the future of interest rates.

Throughout the last 100 years we've experienced periods of high economic growth, recessions, different inflation and interest rate settings, wars, pandemics, crisis and on it goes, but the one thing that has remained consistent... Over the long term, share prices follow the growth in their earnings.

Media and many market 'experts' continue to be concerned about the risk of a sustained period of higher inflation. They worry over a short-term 'rotation' from quality growth stocks of the type Insync seek to own to value stocks. The latter in many cases is simply taken as equating to lowly rated companies and reopening stocks, such as airlines, energy, and transport. There are 3 problems with this view that can trap investors:

1. Timing - no one has a crystal ball for consistently predicting changes to economic growth and inflation rates nor the pathway for the virus.
2. Share prices have already built in the upside. The value/re-opening stocks have already likely anticipated the potential for higher inflation and the opening up of the economy ahead.
3. All boats rise on an incoming tide. The major problem with low quality businesses that are prevalent in the latter category (so-called value/cyclical stocks) is that most remain low quality and continue with low returns on capital.

In sharp contrast good businesses remain strong at this stage of the cycle. They continue delivering the earnings growth that propel share prices over the long term. This is what makes their share price progress both sustainable and well founded.

High margins and superior pricing power from Insync's portfolio of 29 highly profitable companies across 18 global Megatrends offers "the holy grail" of inflation-busting companies. Pricing power, sound debt management and margin control allow great companies to handle inflation and interest rates well.

LVMH and Microsoft (featured in October update) are portfolio examples that recently increased prices of their products with no impact on their sales growth.

Profitability + Revenue Growth

Short term, investors typically fret over interest rate rises and all growth stocks suffer initially, as they adopt an indiscriminate machine-gun approach to selling.

Over time however, the more profitable businesses with strong revenue growth start to reassert their upward trajectory in their share prices, as investors appreciate their long-term consistent earnings power.

Stocks with "quality growth" attributes, such as high returns on capital, strong balance sheets, and consistent earnings growth, have typically outperformed in past situations similar to what we face today (Mid-2014 through early 2016 and from 2017 through mid-2019. Source- Goldman Sachs).

This is in sharp contrast to stocks with strong revenue growth projections that also have negative margins or low current profitability. They are highly sensitive to changes in interest rates (These stocks propelled the short-term returns of many of the Growth funds in 2021). Many of them lack profit and cash flow, which doesn't give you much downside protection if they don't deliver. Many rely on the constant supply of new capital to fund their operations.

These types of companies have very long durations because their present values are driven primarily by expectations of positive cash flows at a distant point in the future. We call this HOPE. As the saying goes; we don't rely on hope as a sound strategy. Stocks with valuations entirely dependent on future growth in the distant future are vulnerable to a dramatic drop in price if rates rise sharply or revenue growth expectations are reduced.

This chart (performance of the Goldman Sachs Non-Profitable Tech Basket) shows the downside risk to this sector of unprofitable high revenue growth companies. The index has fallen by close to 40% from its peak in February 2021. The index consists of non-profitable US listed companies in innovative industries.

Unsurprisingly, popular "new era" stocks held by high  growth managers have also suffered a similar fate with examples noted below.

Funds operated by this manager:

Insync Global Capital Aware Fund, Insync Global Quality Equity Fund

Disclaimer
Equity Trustees Limited ("EQT") (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Insync Global Quality Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) ("Insync"), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.