I Feel We May Be in a Combination of the Dotcom and the Nifty Fifty Bubbles

Rajiv Jain sees equity markets in a delicate spot. An environment of entrenched inflation and rising interest rates could hit quality growth stocks, everyb0dy's darling for the past ten plus years, very hard.

The founder, chairman and chief investment officer of Florida-based investment boutique GQG Partners – the company manages almost $90bn in client assets and in October successfully gained a listing at the Sydney Stock Exchange – sees a possible regime shift ahead.

«All in all, I think you need to gradually shift away from the things that worked very well in the last ten years. I feel one should look to buy the sectors and regions that have not worked well in the recent past, which are unloved and where valuations are much more interesting for high quality companies», Jain says.

In an in-depth conversation with The Market NZZ, which has been edited and condensed for clarity, Mr. Jain shares his views of what's ahead for world equity markets and where he currently finds the most attractive investment opportunities.

Mr. Jain, what’s your view on the current market environment?

Over the past twenty months, since Covid hit, we saw a massive amount of stimulus. This obviously caused a big market reaction to the upside. On top of that, especially since the global financial crisis, we have seen a multi-year one-way street of declining interest rates. The single most important question today is how entrenched inflation is and what path interest rates will take going forward. This is a fundamental issue because in developed markets, we haven’t seen significant, lasting inflation in decades. This question has enormous implications for financial markets, because a vast number of money managers have never operated in a rising rate environment due to above trend inflation. It has implications on how we value companies and what corporate earnings are going to be.

What do you think? Will we see entrenched inflation and higher interest rates?

One of my principles in investing is «don’t predict but prepare». So I’m not predicting an environment of rising rates, I’m just saying it would have enormous implications for equity valuations. But based on what I see, I do think what we’re experiencing in terms of inflation will not just be transitory.

What makes you come to that conclusion?

We do a lot of bottom up work with companies, and based on that work we see price pressures getting entrenched. Take energy, for example. There is a lot of pressure from ESG minded investors about reducing supply, but there is not much discussion about reducing energy demand. The results are energy crises and power shortages in a number of countries. You see it in Europe. Because the whole discussion solely circles around supply reduction, what has happened in the energy sector is that capex has dropped by more than half. Yet at the same time, world demand is almost back to pre-Covid levels. That creates shortages. The same logic applies to commodities like cobalt, copper, and nickel. The second aspect is labor: We see tightness in labor markets, which creates upward pressure on wages. The third one is supply issues coming out of China. A big reason why we had a disinflationary world over the last two decades was China’s entry into the WTO. We could outsource everything to China. That reduced the world pricing mechanism in a meaningful way. This seems to be changing. Supply chains are getting disrupted. When you talk to shipping companies or freight forwarders like Kühne+Nagel, the message we get is that this could stay on a bit longer. Over time it will be resolved, for sure. But it will take longer than current consensus expectations.

How long?

I don’t know. People always compare endpoint to endpoint, but in my experience, it’s the journey that matters. Sitting here and now, it feels like we will see inflation above the norm we had in the past 10 to 15 years. Mind you, it doesn’t have to be Seventies-like, I’m not talking about a prolonged period of 7 or 8% in the CPI. But, I believe it will be higher than in the past. And the question is when do central banks start to freak out about that.

The Fed is preparing the grounds for a tightening cycle. What will that mean for equity markets?

If you look at equity markets, you can divide them into two buckets: The Haves and the Have-Nots. The Haves are companies that have seen revenue growth and are less cyclical, often commonly referred to as quality growth companies. The Have-Nots are everything else. If you look at the top quintile of companies by revenue growth, they are selling at higher valuations than during the dotcom bubble. Now, I know that to the vast majority of people currently active in financial markets, the dotcom bubble is merely a distant memory. Many of today’s professionals were in high school back then. They have never lived through something like the dotcom crash. The other aspects I see are similarities to the early Seventies, the Nifty Fifty era. So I feel we may be in a combination of the dotcom and the Nifty Fifty bubbles.

Both those bubbles crashed spectacularly. What’s ahead for us?

If you look at the Haves, in the last few months, air has begun to come out of the bubble, hitting the lower quality names. Stocks like Peloton, Zoom, even Autodesk or Paypal. Why? Because their valuations are simply too stretched. The thing is that - backward looking - quality growth companies have been the right place to be over the last ten plus years. Many fund managers have done very well by simply ignoring valuations. The less you cared about valuations, the better you did. So the valuation of the Haves is very high. It’s very hard today to find any decent company which is not valued at more than 30x earnings.

But aren’t these often the kind of companies that have pricing power, which immunizes them to some extent against inflation?

In my view, people tend to overestimate the pricing power issue. It’s not rising input costs that will hurt them, but their high valuation. That’s a huge vulnerability if interest rates indeed go up. You know, I’ve also been running emerging market funds for almost three decades, and perhaps one of the benefits I have is that I’ve lived through a number of high inflation periods over the last 30 years, think about Turkey, Indonesia, Brazil, India, Russia. The pattern is sometimes similar. There hasn’t been any sustained period of inflation in developed markets since the 1970s.

When you say the pattern is similar, do you mean higher inflation leads to higher interest rates, and higher interest rates cause multiple contractions?

Yes. And at some point the market also starts to question if their growth rates will slow down. Look at Autodesk: This is a fantastic franchise, but the stock dropped by almost 40% in late November when they only slightly missed their numbers. I’m not even talking about slightly lower quality companies with less proven business models like DocuSign. Areas such as SaaS or cloud computing companies could be vulnerable because of their valuations. We know the pattern: When things go up, people always look at relative valuations and they say «Oh, it’s not that bad». I remember during the dotcom bubble people looked at Tiscali in Italy and said it’s attractive, because America Online was so expensive. So things get connected. Today, we are at the tail end of a huge, multi-year valuation expansion. An environment of high inflation and rising interest rates could hit this segment very hard.

Just so we understand you correctly: This is not only a U.S. tech issue, right?

No, it’s an issue about what is commonly called quality growth stocks. Take Hermès, which trades at 65x forward earnings, or LVMH at 32x. These are quality companies, but the problem is that everyone loves them, every fund owns them. Now there is some risk of a Europe-China trade war brewing, because of the Lithuania issue. If that comes to fore, do you think LVMH will be able to continue to grow at more than 10%-12%? If the stock dropped to 22x earnings, it would still not be dirt cheap. Meanwhile, it appears that nobody likes a company like Royal Dutch.

How do you deal with that dilemma? As a fund manager, you can’t entirely steer clear of the Haves. You do own some large cap tech names in your funds, like Alphabet, Microsoft or Nvidia. How do you decide which ones to pick and which ones to avoid?

Again, I don’t want to predict that interest rates will rise, but I want to be prepared if that scenario plays out. Our portfolios have a barbell shape, because I believe it’s time to have bets in a more diversified manner. We currently own some names in the large cap tech space, some of the names you mentioned. Alphabet is trading at 23 to 24x earnings for a business that we believe should continue to grow in the mid to high teens. But what we don’t own are the second tier tech names, like in SaaS, or in cloud computing. What we also don’t have are highly valued growth companies from Europe, like LVMH, where the macro risk is increasing but the consensus believes that they can just continue to grow. We don’t own Hermès anymore, we even sold our Lindt & Sprüngli in Switzerland. It's a fantastic company, but the valuations just got too high.

What’s on the other side of your portfolio barbell?

We like some European banks, and we like some of the energy companies. For ten plus years, I have hardly had much energy exposure, but we have increased it in the past twelve months.

Those are the sectors that you have bought lately, European banks and energy?

Yes. Three or four years ago, we used to have 45% technology in our portfolios. Now we are well below that because the space is getting narrower, and we are mindful of paying reasonable valuations for good growth. The other side of the barbell you find financials and energy. A third group on the Have-Nots side is in some emerging markets. Our global strategy’s exposure to EM is the highest it’s been in a long time. But it’s mainly markets outside China that we like. Once you leave the Tencents and the Alibabas, the kind of stocks that everyone loved and owned until a few months ago, valuations in EM are very attractive. Growth there is picking up. Look at the data from Brazil: Credit growth, cement demand, steel demand, construction activity is rising. India seems to be in the early stages of a real estate cycle. Even for Russian corporates, earnings growth is improving. In some of these markets, we are in early stages of what we think could be a meaningful new capex cycle.

So you would rather own Brazil, Russia and India than China?

Yes. To give you the context: In our global portfolio as of today, we have a very low exposure to China, and we have significantly more in the other three countries you mentioned combined. It used to be the opposite a few years ago. All in all, I think you need to gradually shift away from the things that worked very well in the last ten years. I feel one should look to buy the sectors and regions that have not worked well in the recent past, which are unloved and where valuations are much more interesting for high quality companies.

But if we get a Fed tightening, rising yields and possibly a rising dollar, wouldn’t that hurt many emerging markets?

I think this scenario is already priced in. The dollar has rallied already. The consensus is way too bullish on the dollar now, in my opinion. I would not be surprised if the dollar started to weaken at some point next year.

Large cap Chinese tech names have suffered badly from the regulatory crackdown. Isn’t there a point where they are attractive again?

Yes, I think we are getting there. But you need to appreciate that the cycles in China can be very, very tricky. Policy is very fluid in China. So today, I would agree with you that a lot of the regulatory angst is priced in. However, now the earnings picture begins to matter. Why is Alibaba underperforming JD? Because JD’s earnings outlook is much better. So in China we are now getting into the kind of market where you have to take a deep look into corporate earnings profiles. This is hard work.

Over the past 20 plus years, we have seen big trends ebb and flow: We had the tech boom in the Nineties, then we had an emerging markets and commodity boom, and in the last decade US large cap tech and growth outperformed everything else. What’s in for the next decade?

It’s hard to say. What I do know, however, is that in 2010-2012 everybody was talking about a commodity supercycle. Now everybody talks about a digital transformation supercycle. Whenever these buzzwords come up, historically we tended to be closer to the end than the beginning of the cycle. Nobody talked about a commodity supercycle in 2002. Nobody talked about digital transformation in 2009. In 2009, nobody was interested in software, nobody was interested in Microsoft, even at 10x earnings. These long cycles are hard to predict, but usually you find good quality at sensible valuations in the areas that nobody likes.

Such as energy today?

Yes. The good thing about energy is we think ESG is becoming an alpha proposition. There are so many investors who would just not touch these stocks. Whenever investors make non-commercial decisions, that tends to create an opportunity, because it means people are not behaving rationally. I honestly think it’s wrong to just focus on the supply side of energy and force a company like Royal Dutch to be held accountable for how their customers use oil. Which industry should do that? Should banks be held accountable for how their clients use their money? That’s laughable. But that is an aspect that is creating an opportunity. I believe these energy companies have become very disciplined, they are highly cashflow generative at $65 oil. You don’t need $100 oil for the bull case.

You own Petrobras in your portfolios. Is that a double bet on energy and Brazil?

Yes and no. If you look at Brazil, the underlying economic growth has begun to pick up since summer of last year. There is a political overhang of course, with an election next year. Petrobras, meanwhile, has cut the number of employees by more than 40%, their cost of production has gone down dramatically. They generate more free cashflow at $60 oil than when oil was $110. We are not making a prediction where the price of oil will be in the future. It's simply a case of what the fundamentals are today and what you are paying for it.

What do you like about the European banking sector, then?

European banks are attractive because capital return policies are improving. I have been looking at European banks for 25 plus years; and have never seen them buying back stock like they are today. BNP, UBS, BBVA, Santander, they are all talking about buying back stock.

Which banks do you particularly like?

We quite like two, BNP and BBVA. BNP has grown at 7 to 8% over the last decade, now they have excess capital, the management has begun to come back to their roots and there is a discussion of them selling their U.S. operations, like BBVA did the year before. BBVA has a very strong franchise in several emerging markets, particularly Turkey and Mexico, and that should allow them to grow their earnings at high single digits. On the macro side, Europe in general looks quite attractive, we haven’t been this overweight in Europe in a long time in our global portfolio. Loan demand is picking up, and we believe interest rates will either remain flat or go up, which would create a tailwind for the banks. The ECB recognizes that negative rates are not helping anybody.

How about UBS and Credit Suisse?

I like UBS a lot. The only thing right now is that we like some of the other European banks a little better. Credit Suisse is a much messier situation, and in a field where there are so many good choices, I don’t even need to go there. In the Swiss context, UBS is the single best stock in the banking sector and is in fantastic shape. We like the new management, and as long as they remain disciplined from a capital perspective, I think it’s a very good stock to own.

How about healthcare? I mainly see AstraZeneca and Novo Nordisk in your portfolios. Why those?

We like and own Roche too. AstraZeneca has one of the best drug pipelines in the industry, their business should grow at around 15% over the next five plus years. The stock is selling at 18x forward earnings, which we think is reasonable. Novo Nordisk is the market leader in diabetes, the whole space is growing at double digits, and we believe their development pipeline on obesity and diabetes should allow them to grow at 10 to 12%. Within the pharma space, the three best names today in our view are AstraZeneca, Novo Nordisk and Roche. We believe they can deliver healthy growth and still are sensibly valued. Most of the other companies have some issue or another.

There are hardly any stocks from Switzerland in your global portfolios anymore. Why?

Part of the reason is valuation. Today, we do own Roche and some Nestlé, which is executing remarkably well. However, look at a company like Sika for example, a fantastic company that we have owned when it was trading at 20-30x earnings, but now it’s valued at more than 45 times earnings for essentially the same outlook for growth. Sika is now priced like a software company. That is the problem in Switzerland. Or take Lindt & Sprüngli: A fantastic company, but it is unlikely that they will be able to keep growing at 15 or 16% every year. This is a consistent high single-digit grower, maybe low double digits, but not more. But Lindt & Sprüngli is now trading at a price to earnings multiple north of 55x. We feel there is no margin of safety anymore. Back in 2009, a lot of these businesses were trading at significantly lower valuations. Nobody was interested back then. But today, they are valued as if they were able maintain above average growth rates to infinity. It’s not a business issue, it’s a valuation issue. In investing, you must never forget that any great business can become a bad investment if the price you pay is too high. If people don’t appreciate that, they will likely learn an expensive lesson.

But when do you sell a company like Sika? If you sold a few years ago at 30x earnings, you missed a big upside.

Obviously in hindsight, we sold too early. In investing, things can go to excessive levels and remain there for a long time. Yet at the same time, we all know that trees don’t grow to heaven. You can’t keep extending valuations forever. Why do you think there are not many investment professionals who have decent 25 or 30 year track records? The reason is because regimes change. In the past ten plus years, we have lived in a regime where valuation didn’t matter. People have fallen in love with the business virtues of quality growth stocks. Can Lindt & Sprüngli go to 80x earnings? It could, but remember that if interest rates go up, and the valuation of the stock drops to 25 to 30x earnings, then your return pattern will be very different. This is a key learning from the experience of the dotcom bubble.

How do you mean that?

Let me give you an example: Microsoft is a great business and it was also a great business in December 1999. But if you had bought Microsoft at the dotcom peak, it took you 16 years to breakeven, even though Microsoft is a monopoly and continued to compound over those years. When the dotcom bubble burst, Microsoft fell by 50% in a matter of weeks. So, all I’m saying is there is the risk that the inflation picture is changing the dynamic. There could be a rude awakening for many «quality growth» managers.

So you’d rather miss on the way up than to lead on the way down?

That’s very easily said, and very hard to do. Remember the quote by Chuck Prince, the former CEO of Citigroup, who in 2007 said when the music is playing, you have to keep dancing? He was criticized for that. But how is the narrative we’re seeing today any different from when Prince uttered these words? The party is on, the music is playing, how can you leave the party now? How can you sell your Sika or your LVMH or Paypal or Keyence in Japan now? This is very hard to do for any professional fund manager as long as the music is playing.