As a difficult earnings season approaches, we still see opportunities to seek out long-term structural growth.
Key Points
- While stock prices have fallen, earnings estimate cuts are likely to be ahead of us.
- Further downgrades may be realized before the backdrop improves.
- Despite our current caution, falling back on our themes and fundamental research is still helping us to identify areas of the market where we see opportunities.
- In the health-care sector, we believe that many elements are now aligned for structural growth.
It is no secret that the current financial-market backdrop is a challenging one. Investors are concerned about high and stubborn inflation, rapid changes in the US Federal Reserve’s rate cycle and fears of looming recession, while geopolitical tensions remain at heightened levels as the conflict in Ukraine and concerns over China rumble on.
While the US economy may be comparatively better placed than some of its European peers in terms of having a greater degree of energy and food self-sufficiency, it is far from immune from the headwinds that are buffeting global economies.
Yet to Experience Earnings Downgrades
Perhaps our biggest current concern for small and mid-cap companies is that, while market sentiment has soured significantly and equity markets have endured the worst first half of a year for almost four decades, we have yet to see any meaningful sense of earnings downgrades fully filtering through in forecasts. While stock prices have fallen, earnings estimate cuts are likely to be ahead of us, and, in some cases, have already started.
For this reason, we remain in a cautious mindset. While it is probably true that, following the market falls of the last few months, much of the bad news has been priced in, we still envisage a scenario where equity investors may have to endure more pain over the coming months before things start to get better.
Our position as investors today feels like one in which we are sailing into increasingly choppy waters as we seek to navigate the next corporate earnings season, and we need to ensure that our ‘radar’ is picking up any further potential ‘storms’ before they hit. We are mindful that, broadly, there is still a relatively positive outlook for earnings, but we fear this may prove excessively optimistic, and further downgrades may be realized before the backdrop improves.
Our investment themes provide us with a ‘chart’ to help navigate these potentially treacherous waters and allow us to think about where we can allocate capital to try to unearth future structural growth. Despite our current caution, falling back on our themes and fundamental research is still helping us to identify areas of the market where we see opportunities.
Opportunities in Health Care
One area where we are unearthing compelling longer-term potential for structural growth is the health-care sector, in areas such as data-driven health care and gene technology. In terms of the former, we are focused on the shift in the US towards value-based health-care payment models, which is receiving a good degree of support from both Democrat and Republican parties.
Since the Affordable Care Act in 2010, there has been a concerted effort to transform the US health-care sector from a system that incentivizes volume to one that rewards value, and we have seen a building out and testing of new health-care payment and service-delivery models.
Our view is that while the last decade of experimentation with value-based payment models has not driven a large-scale systematic change, the next decade looks set to deliver on that promise. We expect to see opportunities arising from a greater adoption of value-based care (VBC) and the shifting of health providers to risk-based contracts. This shift should occur across far-ranging areas of health care, from behavioral and mental health to fertility and oncology. We also expect to see greater adoption of such models in the public space which should, in turn, encourage a greater shift to VBC in the commercial insurance space. Furthermore, we anticipate that health-care systems and providers will build their infrastructure out as they embrace more risk-based models.
In the health-care sector, we believe that many elements are now aligned for structural growth. The federal government and payers (whether they be insurers or self-funded employers) are becoming attuned to how delivery of care is changing, and we believe that change can offer up rewards to investors looking for differentiated returns.
Authors
John R Porter III
Chief investment officer, head of equity
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