Now is the time to own compounders: Morgan Stanley

Oksana Patron

18 January 2023

As compression in the valuation has turned away asset owners from higher-growth stocks, they should shift their focus towards high-quality compounders which offer recurring revenues and pricing power protecting margins in a downturn.

Given the opportunity to add new names to investors’ portfolios, Morgan Stanley’s analysis pointed to a number of sectors such as consumer brands, mission-critical software services and quality health care companies as their currently favourite compounders.

At the same time, the investment bank warned of one of the risks investors should pay closer attention to going forward was earnings.

“There are two ways of losing money in equity investing: either the earnings go away or the multiple goes away. The main risk we see ahead is earnings,” William Lock, head of international equity and Bruno Paulson, portfolio manager international equity at Morgan Stanley, said.

“High-quality compounder companies that can grow their earnings steadily in real terms, across cycles, are likely to outearn the market, just as they have done over the last few decades. When supply normalises (or possibly even overbalances into excess supply), true pricing power comes into its own.”

The major threat to earnings in the short term was the prospect of an economic slowdown as central banks continued to counter inflation through higher rates.

“The pace may differ by region. Longer term, there could be further pressures on earnings, such as the need to build more resilient supply chains or potentially higher corporate tax rates as governments look to repair their finances,” the noted.

“Given the uncertain macroeconomic landscape and the room for policy errors, we continue to advocate for a portfolio of high-quality compounders. The combination of these companies’ recurring revenues and pricing power should protect revenues and margins in a downturn, providing asset owners with earnings resilience and relative predictability through tougher, more volatile times.”