Investing in a Recession

Tommy Dai, Investment Director

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The Last Few Years Have Been Great For Markets

The last few years have been phenomenal for both private and public markets. Against the backdrop of a global pandemic, investor optimism became fuelled by continued loose monetary policy, supportive fiscal stimulus and faster than expected economic re-openings. Net investor inflows in the US were $150B+ in 2021^[8] – an increase of 140%. As a result, the S&P 500 ended 2021 on a +27% gain – making it the third straight year of growth. Similarly, in private markets, over 500+ “unicorns” were minted in 2021; more than the past 5 years combined.^[9]

Number of New Unicorns^[1]

However, this also generated distorted valuations across markets – from the risk-on appetite of investors in search for returns. Trailing Twelve Months P/E reached peaks of 30x+ during 2020-21^[7] created by high levels of optimism whilst earnings are yet to catch up. As per Marketplace Pulse, in the Amazon Seller Ecosystem, private label sellers were achieving 4-8x SDE plus earnouts vs. 2-3x seen in early 2020.^[3]

S & P 500^[2]

Year	Returns
2019	29%
2020	15%
2021	29%
2022 YTD	(21%)

^[4]

Amazon Seller Multiples

^[5]

The Short / Medium Term Demand Outlook is Challenging

As we move through 2022, conditions have become more challenging. Central banks have begun tapering off pandemic-era monetary easing whilst gradually increasing rates to tackle the highest level of inflation recorded in decades. Consumers are getting squeezed by the higher cost of living and rising rates, which makes a consumer-led recession ever more likely.

Public markets have felt the impact dramatically – the S&P is down over 21% from the highs of January; we are now in bear territory. However, the declines have not yet fully diffused down into private markets thanks to active ownership, longer-term focus and the attempts at holding out for 2021 valuation levels.

We at Olsam are not immune to the current environment, nor are our colleagues and competitors. Rising rates also means that we have a higher cost of capital; the acquired earnings has to now cover higher interest charges. At these return hurdles, the industry has been forced to drive down valuations in the space.

If (or when…) we enter into a recessionary environment, future revenue generation is challenged by consumers shifting to cheaper alternatives or stop buying altogether. Expensive discretionary items will be hit the hardest; AO.com, an online seller of electrics and white goods, have issued a string of profit warnings this year and were forced into £40 million in equity to boost liquidity as a result of falling consumer demand. Similarly, Made.com, a British furniture e-commerce business, issued its third profit warning following a -19% decline in H1-22. AO and Made.com will not be the only ones, with many other categories facing similar demand headwinds, thereby increasing the level of acquisition risk.

Now with this background and going into the rest of 2022 and beyond, we see multiples following the classic idiom of reversion to the mean; 2-3x SDE experienced pre-2021.

Why We Are Optimistic

Without beating around the bush as the Brits say, there is clearly a valuation gap currently. However, for the acquirors who are still acquiring (for there are many that are not…), a bridge needs to be made and this takes a certain mindset.

There are many avenues to go down and our colleagues & competitors may choose a different path; but we at Olsam are fundamentally Strategic Investors. This means that we prioritise growth and operational improvements to add value vs. primarily debt and leveraged focus.

With reference to McKinsey & Co, before and after recessionary periods, groups focused on value-creation and those without, performed comparably (~13 / 21% internal rate of return respectively). But during recessionary periods, firms focused on operational value creation meaningfully outperformed the pack.

^[6]

The focus on value creation is core to Olsam’s strategy. What this means in practice is driving profitability growth. A non-exhaustive list of levers includes but not limited to (i) new product development, (ii) new channel launches, (iii) geographical expansion (leveraging UK HQ) and (iv) cost efficiencies driven by economies of scale and consolidation. In this way, we principally grow brands with a now established playbook; to not standstill – to drive higher long-term valuations.

Crossing the Bridge

Driving value is not easy. It is a difficult journey. However, that road is made significantly easier with brands that have real brand equity – by that we mean a brands with an identity, valuable IP, operate in markets with significant barriers to entry and share our growth mindset.

By growing profitability, the higher current cost of capital can be covered by future earnings growth. And that growth, we share with our partners. That is how we bridge the valuation gap – by sharing the upside.

Further Tailwinds Lie Ahead – We Are in The Transition

With the well documented assertion that last year was impacted by COVID surged demand, supply chain constriction and unprofitable cost of advertising, Amazon sellers whose financials had looked rosy and bright eyed, on current trading fell off the proverbial cliff. In tandem, our colleagues and competitors were aggressively acquiring in the pursuit for rapid scale. Acquisitions were akin to catching a falling knife for certain categories.

That is why, throughout 2021 and 2022, we have been prudent but deliberate. Partnering with only the brands and aggregators who have that brand equity and also share our view on the world.

As we move through 2022, the outlook for these factors is beginning to dissipate. The comparison period will gradually revert to normality. Freight and advertising rates are gradually coming down to earth and with some of our colleagues and competitors beginning to retrench, so now are multiples.

Looking Forward

We view the outlook with significant optimism and packed with opportunity. With upfront multiples reverting to 2-3x SDE, our focus remains unchanged, and we continue to partner with the best players in our ecosystem who can in turn share in our growth. Now is the best time.