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For most investors, 2022 is a year to forget.
Of course, if you have a degree in oil like BP and shell – both up more than 35% – then you’re happy.
A high proportion of commodity companies in the UK FTSE 100 index obviously that once our market trounced the world, too – even with barely-there growth for the year.
Flat is pretty good when everything else is down.
But who – outside of Texas – really has all the money in oil stocks?
Hopefully you don’t have all your money in the FTSE 100, as the UK stock market accounts for less than 5% of the total global market capitalisation.
All were punished
No, most of us have a more diversified portfolio. That in 2022 just means that we’re going to have a lot of fun seeing different things crash together.
The losses of disruptive growth companies and tech stocks – the darlings of the pandemic – are certainly the most spectacular. Many former favorites are down 90% or more.
But perhaps of greater interest to Fools – and more to report – is the kick they give to the best ‘quality’ companies of their kind that they want to buy and keep forever.
The same rise in interest rates called time in the speculative frenzy in IPOs and unprofitable cryptocurrencies also hit the price of quality stocks.
Higher rates popped the stock bubble by giving money back its value, after years when borrowing was virtually free.
But with quality companies, the impact is more subtle.
A quality company always has a strong balance sheet, low debt relative to income, and spends cash like it’s printing the stuff. Higher rates don’t see their leaders losing any sleep.
However, higher rates are causing stock market analysts to scratch their foreheads and reexamine their best estimates of what investors should pay for any stock – even the best.
Deep discount
That’s because the most popular way to calculate stocks is by doing what’s known as the discounted cash flow model. And when the interest rate increases, you have to repeat the entire amount.
With a discounted cash flow analysis, you’ll get all the cash you think (/guess!) the company will have forever.
But, you discount the value of season cashflows return for today, before doing the final tally.
Discount refers to the fact that money in the future is cheaper than money you have now.
How much less? Well, it depends on the discount level you choose.
Discount rates vary for many reasons. But they are almost always strongly influenced – raised or lowered – by the prevailing interest rate.
As the discount rate rises, the value of future cash flows will fall. This means that an increase in the discount rate used in your amount by just a few percent can affect the stock price.
You can easily see estimates of the company’s value growing by half compared to last year, before interest rates rose. It’s even worse for very high growth companies. That explains a lot of carnage in the market this year.
Light bulb moment
So much for science. But there is another, more intuitive reason why quality companies are not valued enough today.
You may have heard these companies described as ‘bonding proxies’ in the past. The idea is reliable profits and dividends – relative to other stocks – so that money-hungry investors can have money instead of bonds.
The logic behind this trade is questionable in my view. However, that is common – and indeed one of the reasons why central banks are taking rates so low. He actively wants to encourage investors to take more risks, to grow the economy after the financial crisis.
But everything changes in 2022.
After being wrong-footed by runaway inflation, the central banker set hiking rates faster than you can say “How many economists does it take to change a light bulb?” *.
That doesn’t just hurt the stock market. It also led to a rout in the bond market.
The result now that the smoke has settled is that you can buy high-quality government bonds with yields of 3-4%.
That means no one talks much about bond proxies anymore. There is little appeal for safety-first investors when they can buy real things for income, without messy uncertainty even high quality shares.
It thus has a double whammy. Rising rates have boosted the valuations of quality companies, but at the same time, many investors who were reluctant to buy in the past decade may be retreating back to boring old bonds.
Hey ho. Nobody says that you won’t lose money by investing in quality companies.
(Actually, someone said that. I hope you don’t mind!)
A trio of quality companies
So much for medicine – let’s stop using sugar to wash it.
De-rating of quality stocks has been painful for investors. But it is in the past.
The stock price has dropped significantly, but the business prospects for me look bright.
That means you can now aim to buy better companies – and all of your fantastic future earnings – for less than ever before!
Here are three to start your research:
Halma (LSE:HLMA). An engineering conglomerate consisting of more than 40 different subsidiaries does not seem like a recipe for quality. But Halma has been steadily increasing its profits for decades. Halma produces mission-critical components, often for regulated industries, which provide key market strength and pricing power. Return on equity usually hovers around 20% – a sign of quality. And with Halma shares down 37% in 2022, trading at a P/E (price-to-earnings) ratio in the mid-20s, instead of 40 a few years ago.
Move right (LSE: RMV). Everyone knows Rightmove, the online property portal. But if you think your property porn addiction is bad, consider the real estate agents who can’t stop spending money on this important platform. Earnings, profits, and dividends have been steadily increasing for ten years. Yes, the housing market is slowing down – but Rightmove is also making money from letting agents. Rightmove’s P/E has fallen from 30 before the pandemic to around 20 today as the share price is down 35% in 2022. A lower P/E rating is only a shortcut when valuing a company, but, given the company’s more stable earnings, A lower P/E tends to indicate better value.
Unilever (LSE: ULVR). My last suggestion is to actually increase the stock price in 2022, even if only by 5%. But it was a welcome tonic for Unilever shareholders frustrated by the consumer giant’s share price which has been spinning its wheels for half a decade. Indeed, Unilever’s shares have only recently regained their first level when competing in the US Kraft Heinz offer for the company in 2017. Fortunately, business is better. The £105bn behemoth continues, reaching deeper into emerging markets, raising prices to counter inflation, and increasing its dividend offering more than 3.5% yield. With well-known activist investor Nelson Peltz on board and the CEO now retired, 2023 could be exciting. And a P/E below 20 can tempt bargain hunters, again because of the stability of earnings here.
Feel the quality
Most economies around the world are forecast to slow over the next 6-12 months, as the delayed impact of these interest rate hikes hits home. Recession predictions are everywhere.
But quality companies are known for their stronger business models. They can soldier on through slowdowns compared to other economically sensitive or cyclical stocks. And its strong market position gives it the power to keep inflation high.
So, quality stocks are better than most to weather the storm ahead. But you can buy it cheaper now than last year, when everything still looked rosy in the global garden.
I told you there is a bright side to falling stock prices!
*“There is none. If the light bulb really needs to be replaced, market forces have caused it to happen!
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