Against a backdrop of economic and geopolitical uncertainty, rising inflation and rate hikes, Australian investors are searching for investments that can benefit from these evolving market conditions.

With credit spreads at attractive levels, now might be the opportune time to have exposure to hybrids and credit.

With minimal returns on cash continuing to underpin strong demand for hybrid securities, we anticipate demand for yield to remain robust throughout 2022, resulting in strong returns over the year for this asset class.

The upside of rising interest rates

Rising inflation, above average GDP growth and the unwinding of quantitative easing (QE) in 2022 has seen financial markets reprice interest rate expectations.

The rising rate environment will push the outright return on hybrid securities higher, without having a material impact on spreads given the strong economic backdrop. Given most hybrids are floating rate, investors will benefit via higher income from these rising short-term rates.

Strong balance sheets you can bank on

Australian banks are the largest issuers of hybrids domestically and their balance sheets are in fantastic shape, with capital ratios at historical high levels. COVID-19 provided Australian banks with access to cheap funding via the Term Funding Facility (TFF), which provided them with a degree of funding certainty and lower funding costs.

Following the withdrawal of the TFF in 2021, new bank issuance is coming to market at attractive credit margins, providing the ideal environment for active credit managers to identify the most positive risk adjusted opportunities.

For instance, bank senior credit margins are significantly off their TFF lows, which is leading to an attractive re-pricing across all bank capital issuance (refer to Chart 1). Overvalued growth sectors are likely to lead an equity market sell off similar to 2000 - 02, but are unlikely to impact credit market returns.

Chart 1: Bank senior credit margins - Well-Off their TFF 2021 lows

The higher the carry (running yield of an investment), the greater the protection it offers investors from adverse movements in credit margins. The carry for the Yarra Enhanced Income Fund is currently sitting at ~3.0% above cash.

Based on an average portfolio maturity of ~3 years, we'd need to see an extreme 1.0% move wider in credit margins to wipe-out the carry. However, given the robust economic backdrop in 2022, we expect credit margins to remain relatively stable throughout, adding to floating rate credit's income generating credentials.

This benign outlook is in contrast to the capital losses currently being observed in traditional fixed income due to the reset in interest rates and real yields. Usually, a rise in real yields will impact the value of everything long interest rate duration, from traditional fixed income to most equities. That's not the case with floating rate credit, since its short duration offers protection to portfolio valuations from rising interest rates. This is observable in EIF's outperformance compared to traditional fixed income (Bloomberg Composite Index) since February 2020 (see Chart 2).

Chart 2: Floating rate credit with carry continues to outperform fixed rate with little carry

Making the grade

In a world that seems to be getting riskier by the minute, investment grade hybrids look to be a safe haven for investors. Here's why:

• Investment grade hybrids appear to be fairly priced in an environment appearing increasingly more expensive, especially if real yields rise or normalise in a post QE world.
• Investment grade issuers remain well capitalised, making them more likely to be able to service their interest payments and repay debt.

• Most Australian investment grade hybrids are floating rate securities, which tend to pay higher yields if prevailing rates go up because they are based on a variable interest rate, rather than fixed. Not only does this mean more income when rates rise, but there is also no loss of capital.

Getting exposure to hybrids and credit

Being able to access fixed rate securities for floating rate portfolios remains a key competitive advantage for Yarra's clients. The Yarra Enhanced Income Fund invests in high yielding, floating rate credit and hybrid securities to deliver better returns than traditional cash management and fixed income investments.

Lifting of pandemic restrictions has generated an overly enthusiastic view that economically sensitive companies will rebound quickly across many business sectors. Insync deliberately has no exposure to stocks of this ilk. We favour companies that are not only are some of the most profitable companies in the world but are also expected to consistently grow their earnings at high rates regardless of how the global economy performs. 

As the earnings growth across our portfolio continues to compound at high-rates, the gap grows ever wider between their stock price and their valuations (currently circa 50%+ below valuations). In these shorter periods of relative underperformance, a tension permeates in markets. This creates ideal conditions for entry as a sudden 'snap-back' in stock prices can occur very quickly. Snap backs are triggered by a change in market conditions, an event or simply the market recognizing the big disparities between the companies promising to deliver to the ones actually delivering.

We liken it to an elastic band. The more you stretch it (the widening of the gap between valuation and share price), the greater the likelihood of a rapid 'snap-back'. Whilst it's impossible to time exactly when the snap back will occur, when it does do so, it delivers strong outperformance to those stocks with the real underlying earnings and profits to support a sustainable uptick in their price. At the same time, the reverse occurs for those presently leading this latest bout of exuberant price growth.

We like value but we are not value Investors.

We recently had an extensive meeting with a fund researcher where we took him through our valuation approach. One of his key conclusions was that Insync is a 'value investor'.

Whilst we would not describe ourselves as value investors based on conventional metrics (just buying companies based on low Price/Earnings ratios), an important part of Insync's process includes building a high degree of confidence in understanding the worth of a company's future cashflows beyond its present state.

To make money involves finding companies where the value we see is significantly greater than the price we have to pay. The current investor exuberance around

chasing returns in hyped up sectors has the Insync portfolio of quality growth companies trading at circa 50% below our assessed valuations.

A question to ponder is this.....

Would you buy into highly profitable businesses if you could buy them at such a large discount? And after doing all your investigations and crunching the numbers, its forward earnings were compounding strongly. Or would you buy a very richly valued popular business whose forward looking numbers don't support its price but everyone was enthusiastic about it today? This is the choice that investors face and this sets up perfect conditions for the Insync portfolio to deliver strong returns.

P.S. Insync is of course categorised as a 'Quality Growth' Investor.

Traditional valuation metrics are losing their predictive power.

PE (Price/Earnings) and PB (Price/Book) ratios have been declining in their ability to predict value. The main reason is in the "E" part of the P/E ratio.

Our modern global economy is increasingly driven by intangible assets. Items such as intellectual property, R&D, brands, and networks. In the last decade or so this has accelerated to dominate in many key industries. In the past capital equipment and other tangible assets used to figure large on balance sheets.

'Intangibles' now represent 84% of the market value of the S&P 500 as depicted above. The old focus supported the old P/E and P/B ratios suitability. The problem occurs when it is applied to this new world - to the industries and companies that invest heavily in intangibles. It creates a misleading and distorted picture.

By example, when Pfizer invests R&D in a new drug for Covid-19 (forecasted to generate sales of US$45.7 Bn this year), or Amazon spending on building their cloud capability (sales of US$60 Bn expected from this division), these investments are classified as intangibles.

They have to be expensed through their income statements. This means it significantly depresses their earnings today despite these 'investments of expenditure' creating significant sales and profits for many years to follow. Their resulting P/E and P/B ratios are thus negatively impacted. This is important to remember when investing for the future. Beware of using the rear-view mirror. Life has changed. Fastest decline in history.

By way of contrast, old-industry companies, say a steel company, has to invest heavily in property and machinery (tangibles). The accounting rules treat these investments as capital expenditures. It immediately goes onto the balance sheet and does not detract from that year's earnings unlike intangibles. Effectively this inflates its present earnings and the book value. P/E and P/B ratios look good.

This inconsistent treatment of the drivers of future growth between intangibles and tangibles leads to wrong conclusions on what actually represents good value and what does not. P/Es are thus not a useful indictor for industries with high intangibles, and even more misleading if taking an average across a broad index.

Conventional portfolio blending methods.
Passed their Used By date?

Many research houses lump funds managers into simplified groupings primarily based on P/E ratios.

Growth managers tend to be holding businesses with higher than market average P/E or P/B ratios. Value managers holding a portfolio of low P/E ratios, and GARP or Core managers somewhere in-between.

Not only is this old measure being over-used to compare managers in the same group, it is further adapted as the primary means of blending managers across entire client portfolios and investment models. People tend towards simplicity even if its misleading. Given the change in intangible expenditures this is an increasingly unwise approach for professional advice givers. It is also worth noting that P/B and P/E ratios represent two of the three variables used to determine stock inclusion in the widely followed style index, MSCI World Value.

The key driver of future earnings - intangibles, is not being appropriately reflected in the income statements and balance sheets in a rapidly changing economy. Accounting rules have not yet adapted. This, we strongly contend, is a key reason for the long-term underperformance of Value indices post the Global Financial Crisis.

Intangibles- a key to investing in today's world

Even though it is impossible to measure the value of intangibles precisely, it is essential for investment professionals to come up with a logical approach to incorporate intangibles into their decision making; otherwise, they risk being relics in this new age of information.

At Insync we have developed a systematic way of incorporating the cashflows that intangibles are delivering into our valuation methodology. This results in a more accurate assessment of the value of a business and a key reason of our successful stock selections.