On Wednesday, April 27, Laureola Advisors shared an update on Q1 2022. 

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ABOUT LAUREOLA ADVISORS
Laureola Advisors was founded with the belief that investors deserve access to the unique benefits of Life Settlements, with the advantages of a specialist and focused asset manager. 

The best feature of the asset class is the genuine non-correlation with stocks, bonds, real estate, or hedge funds. Life Settlement investors will make money when others can't.

Like many asset classes, Life Settlements provides experienced and competent boutique managers like Laureola with significant advantages over larger institutional players.  In Life Settlements, the boutique manager can identify and close more opportunities in a cost effective manner, can move quickly when necessary, and can instantly adapt when opportunities dry up in one segment but appear in another. Larger investors are restricted not only by their size and natural inertia, but by self-imposed rules and criteria, which are typically designed by committees.

The Laureola Advisors team has transacted over $1 billion (US dollars) in face value of life insurance policies.

March witnessed the third month of the fear-based swing to stocks perceived as short-term winners from the Ukraine invasion and Covid related supply chain issues. Think: materials and economically sensitive stocks. These same events also precipitated a knee-jerk move away from stocks viewed as 'growth' related at the same time. The ensuing impact on inflation from both of the above events added to fear-based motivations.

Consider this: Most stocks receiving current price lifts (commodities, energy & banking) tend to possess various combinations of low PEs, a history of business underperformance, low returns on invested capital, high Credit Default Swap prices, low sales growth, and lesser margin control. Few successful fund managers have enriched investors built around these factors. In the last few months these stocks outperformed by a large margin those that are; highly profitable, with strong margins and price control, long run earnings growth, lower debt, and not as reliant on macro factors (like inflation). It's interesting to note that many leading "value-managers', have also posted negative returns. Banking, industrial cyclicals, and housing related stocks generally trade on low P/E ratios, yet they too had their prices weaken recently. This is principally due to the 'supply side' commodity price shock at a time when macro-economic growth is weakening. This is not the environment for a rising tide to lifting all value stocks.

In our minds, this swing represents the same but opposing side of the unjustifiable prices that many tech/disruption stocks enjoyed until recently. Neither group are worthy of serious, risk aware and longer-term investment. It's why we invest in companies that can sustainably deliver strong above average Earnings Growth. Their stock prices tend to always follow (Barr the odd event-based, short-lived exception like the one we are experiencing now).

Are the businesses enjoying stock price rises today also the winners of tomorrow?

Lately we are all experiencing one tectonic event after the next. Foundations of the political and economic framework that have dominated much of the world since the 1980s are now being challenged; the impacts on globalisation, the questioning of the USD central role, and previously deeply embedded structural relationships in the energy markets to name a few.

Regular readers of our newsletter know that our approach is far less dependent than our peers are on these issues, including inflation and interest rates. The jury is still out on whether inflation will be a temporary or a longer-term phenomenon.

Covid and the tragic invasion of Ukraine have created significant commodity, energy, and labour mobility pressures. Companies that:

• can raise prices are clearly better placed than those that do not.
• enjoy high margins and operating leverage are better protected than low margin businesses with high marginal costs and no pricing power.
• possess high incremental return on capital may be able to not just defend their profitability but actually see it expand!

These are the required factors for a business to continue delivering healthy returns in real terms and are thus the same attributes Insync seeks.

Most companies are not able to do this. Those companies possessing the most levers to pull going into an inflationary period are also the most likely to protect and even thrive for their investors. There will likely be tougher times ahead, quality growth investors should find themselves better positioned than most to weather the storm and come out substantially ahead.

Why earnings power is crucial

A shy, humble investor living on a suburban street in a small mid-western US city is often cited for his quips.

"In the short-term markets are a voting machine. In the long-term it's a weighing machine"

Over shorter periods sentiment in markets can shift wildly depending on the narrative of the day. This is driven by perceptions of investors trying to gauge where we are in the economic cycle, the path of inflation and interest rates, the impact of a geopolitical crisis, and what style of investing will be best equipped for the future. These are impossible to predict with any degree of certainty or to do so consistently.

The one thing that is more certain over time is that in the long-term, share prices follow the consistent growth in the earnings of a business.

We know that the most profitable companies remain profitable even ten years later fuelled by the enduring, large megatrends.

Megatrends are so predictable you can set your watch by them. This is whether it is the rising importance of the Gen Z'ers, the acceleration in the number of people aged 70+, GDP+ growth in spending on skin and beauty, or the insatiable desire to spend on experiences. A portfolio of the most profitable companies tied to megatrends provides consistency in earnings leading to strong stock price returns. They are also mostly impervious to interest rate settings, the state of the economy or current commodity prices.

3 portfolio examples of why Earnings Growth is good for investors

The evidence shows it all. Here are 3 companies in our portfolio. The coloured line in each graph is the path of earnings over the past 10 years. The white line is the share price performance.

Observe the strong correlation between the earnings growth and share price performance. From time to time the two lines deviate based on an 'event', as is the case now. Obviously, present prices present an outstanding opportunity to invest.

These highly profitable businesses benefitting from Insync's identified megatrends have become even more attractive due to recent price falls. This is because their ongoing and established earnings power remains intact. Such excellent buying opportunities do not often present themselves.

The 'coiled Spring' phenomenon continues to gain energy. 

In this episode, CIO Steve Johnson is joined by whisky-naysayer (and Senior Analyst) Chloe Stokes to discuss the bid for Twitter, social media monetisation, and control in volatile markets. Chloe also shares her experience as a younger investor and reveals the stocks (and burgers) currently on her watchlist.  

"As shareholders, we can't help but be disappointed. We bought [Twitter] because we thought the platform had a lot of potential," Chloe tells Steve. "It's obvious that we think it's worth more than the bid, because we held it through periods where it was trading much higher and still thought it was worth more than those higher prices. So, we are definitely not happy from a price perspective, but on the other hand, we can't stop talking about it."

Timestamps

02.30 Start
07.15 Is Twitter offer the right price?
11.12 What is causing concern in the social media ecosytem?
19.02 Meta price in distress
26.26 Stock to watch
32.00: Whisky tasting - Suntory Toki

Whenever stranded assets are mentioned we are likely to conjure the image of a dilapidated oil terminal that no longer has any value attached to it due to alternate fuels or costly environmental regulations. Commercial real estate rarely enters our consciousness and as a result the REIT sector has never had the intense ESG spotlight shone on it by the public or the wider investor base.

How is ESG impacting investing?

ESG focused investing has really ramped up in recent history and has gradually shifted from just the direct operations of a company to now analyzing the impact of all its organs. As a result, firms will have to reflect and act on every part of their operations - whether that includes a manufacturer assessing the carbon intensity of its HQ, a pharmaceutical trying to lessen water usage at its distribution centre or a tech company maximizing the air quality on its campuses. Thus, the real estate occupied by those firms will become increasingly scrutinized and assets that cannot be adapted to the tenant's growing requirements risk becoming obsolete and costly for its owners to hold.

While there are many prisms to look at commercial property from an environmental perspective, the NABERS (National Australian Built Environment Rating System) Energy rating guide is arguably the most comprehensive in its coverage, especially for Australian office assets. Buildings are given a rating on their energy efficiency using a 1 - 6 star system on a relative basis compared to their peers.

While there are similar NABERS ratings on water, indoor air and waste, energy has grown to be the most prolific due to legislative requirements. Under the current system all commercial offices over 1000sqm that wish to advertise for leasing or selling purposes must disclose their NABERS energy rating. Furthermore, in order to attract the government as a tenant the base building requires a minimum 4.5 star NABERS rating. As a result, NABERS has become the leading benchmark for assessing the 'green-ness' of a property.

What can businesses expect to see?

The current landscape in the Australian market is that of institutional investors leading the pack and commandeering more of the higher star rating assets. Morgan Stanley research found that the three biggest listed office landlords had a significantly high performing portfolio with Mirvac (MGR), Dexus (DXS), and GPT achieving a portfolio average rating of 5.5, 5, and 5 respectively for their office assets. This has largely been the result of an active development pipeline helping refresh the age of the portfolio as well as conscious decisions to refurbish older assets to meet modern environmental standards.

Employees are also increasingly expecting their employers to be environmentally conscious - a survey by HR resource company ELMO found that 71% of Generation Z workers would refuse to work for a company that was not seriously dealing with climate change. Furthermore, ambience and aesthetics are also rising in importance with a future workplace wellness study found that 31% of employees lose the equivalent of 60 minutes of productivity if the environmental wellness of their environment such as air quality and other factors were not satisfactory. Increasingly the mental health of employees is being brought to the fore thanks to the pandemic and companies who wish to be seen as socially responsible will need to accommodate this. Employers are taking note - JLL reported that 73% of their APAC based tenants surveyed saying they will be retrofitting assets by 2025 to meet these requirements such as achieving net zero and ensuring the office is a pleasant location to be.

The COVID pandemic has shaken up the office sector in various ways. Vacancies in CBDs have ballooned, with Sydney climbing from 4% pre-pandemic to 13% currently. Companies are re-assessing their space requirements which will certainly be influenced on how successfully they are able to persuade staff to return to the office. With widespread reports of labour shortages, it looks that the balance of power has shifted towards the employees. Employers in a post-COVID world will face the dual challenges of keeping their staff by aligning their actions with the staff's ESG values as well as also providing enticements to lure them back into the offices - no doubt challenges landlords will have a stake in. 

It has become clear that for employers to retain talent and encourage employees back to their offices for physical collaboration, they will need to ensure their assets and workspaces are up to scratch. Feedback from asset owners and leasing agents are that expectations from tenants are shifting to asset owners providing the amenities required by their employees such as coffee shops or breakout areas whereas previously the landlord was only responsible for the capital to ensure the base building was environmentally friendly. The costs of these amenities historically would be recouped through higher rents or lower incentives however the supply/demand dynamics in this market means tenants have effectively externalized a portion of their costs to meet environmental and social expectations to landlords.   

Where are we seeing vacancies?

If history is any guide, the current over-supply situation (highlighted by elevated vacancies) will  result in lower rental price growth and higher incentives (in the form of fit out contributions or rent-free periods) which negatively impact the cashflow of the landlords. While this trend was observed in 2020-2021, our channel checks have found that the performance of assets have become increasingly bifurcated. Prime grade assets (Premium & A grade) continue to hold onto higher rents and lower vacancy while the declines in rents has mostly been felt in B grade assets and below. One asset owner has even stated that they are seeing further bifurcation with A grade starting to lose some of its lustre leading to a 'Premium vs everything else' situation. This trend has been accelerated post-COVID with a common theme in the Feb-2022 reporting season being an acute sense of 'flight to quality'. For example Mirvac called out 80% of their vacancies were located in their lower tier assets.

This is not surprising given higher-grade assets predominately have 5-6 star ratings further enhanced with numerous amenities to maintain tenants and their increasingly demanding staff. The Australian listed market and other large institutional owners have been acutely aware of this and have largely been successful in ensuring their portfolios are at the higher end of the NABERS spectrum. Conversely, B-grade assets and below are mostly held by private owners. Typically such owners have less access to capital and as such may struggle to make the necessary investment to upgrade the asset ratings. Refurbishments required to drive an increase in the NABERS ratings require significant capital and often involve asset downtime (from 1 - 2 years). Activities such as replacing the cladding of a building has shown to potentially cost >10% of the asset value itself. As such, we expect more and more assets becoming more obsolete as the capital costs to upgrade older assets are prohibitive especially for non-institutional investors.

Additionally, debt markets are also starting to differentially price ESG factors. In 2021 GPT issued their inaugural Green Bond of $250m and we expect this to be the first of many. Whilst this has not translated to lower cost of debt for green assets yet, expectations are that liquidity pools will become more discerning around ESG which over time should translate to higher cost of debt for ESG-poor assets.

Ultimately while we are concerned about the current oversupply in the market and the uncertainty in the sector's vacancy outlook due to COVID and increased working from home, we are somewhat comforted by the fact that the Australian listed players have positioned themselves relatively well in regards to the sustainability of their asset portfolios. This should partially offset future structural uncertainties as we believe not all the competing supply in the market is fit for purpose and given ESG requirements on buildings are only getting more stringent, we expect the pool of 'ESG-ready' assets to shrink further.

Apparently, Confucius did not say "One Picture is Worth Ten Thousand Words" after all. It was an advertisement in a 1920s trade journal for the use of images in advertisements on the sides of streetcars. Even without the credibility of Confucius behind it, we think this saying has merit. Each month we share a few charts or images we consider noteworthy.

Online sales volumes have retreated in absolute numbers and as a share of total sales as the charts from the Australian Bureau of Statistics and the US Census Bureau show. US government bonds are on track to deliver their worst annual loss, Compound Capital Advisors highlights. Bank of America links the preceeding surge in central bank liquidity with the value of "Big Tech" stocks. A correlation between inflation worries and the relative valuation of small caps is charted by BCA Research. Quantitative Value co-author Tobias Carlisle shows that "unexcellent" stocks have outperformed "excellent" stocks over time. We return to BofA to look at how hedge funds and fund managers have become reluctant to take on risk. And, finally, "The Plateau of Latent Potential" is a chart from the book Atomic Habits that spoke to us.

Online retail sales in Australia (monthly to February 2022)

Source: ABS

Online retail sales in the US (quarterly) as a % of total sales

Source: US Census Bureau

Bloomberg Barclays Aggregate Bond Index, Total Return (1977-2022)

Source: Compound, @CharlieBilello

Central bank liquidity and the market cap of "Big Tech"

Source: Bank of America

Business Inflation Worries & US Small Cap Valuation Indicator

Source: BCA, @Scutty

Comparison of "Unexcellent" and "Excellent" Stock Portfolios

Source: @Greenbackd

Hedge Fund Equity Exposure

Source: Bank of America

Net % of Fund Managers taking higher than normal risk

Source: Bank of America

The Plateau of Latent Potential

Source: @JamesClear, Atomic Habits via @SvnCapital

April Edition

Markets always present a multitude of opportunities and obstacles.  However at any given point in time there are only a select few, around which traders coalesce.  Commentary and action align to these few factors, which then powerfully drive markets. Recognising this, and the rationale for it, or indication of a pivot in market trends helps identify and reprioritise risk. In this way, issues which the market has long ignored can suddenly seem to be the only thing that matters.

During the GFC, the market seemed only to care about balance sheets. In recent years it has been pre-occupied with innovation and disruption. Today, we are grappling with the most fundamental changes to international relations since the end of the Cold War. These risks have always been present, yet the reprioritisation of these risks is changing the flow of funds, between nations, between asset classes, and within the underlying sectors of asset classes.   

Small cap investing: Top down has become paramount

A trend of the last decade has been the grouping of stocks into ever more diverse 'baskets' (often known as an index). Today these 'baskets' are sold by securities dealers as a product. Stocks can be grouped by industry, quantitative factors or thematic association. In the past, the profit motivation behind these classifications formed part of a two-step process.

1. Identify companies exposed to sectors and factors expected to benefit from ongoing or forecasted tailwinds.
2. Assess the actual and prospective performance of these companies relative to expectations and peers and select the best stocks.

When investors purchase a basket from a dealer, they are de-emphasising stock selection.  

In recent years we have observed a shift in Australian Small Companies market dynamics. Increasingly, money is deployed with a greater emphasis on macro-strategy (i.e. step one above); yet seemingly without significant focus applied to the fundamental performance of the underlying businesses (step two).

The outcome is a growing number of companies exhibiting a divergence between their share price performance and operational performance. The most obvious demonstration of this has been the increasing correlation of stocks within certain baskets. For example, the correlation of Australian Technology stocks to the US NASDAQ index. This correlation ignores the fact that each Australian tech stock has its own fundamental and operational opportunities and challenges distinct from the success of Nvidia, Facebook, Netflix or Tesla.

In contemporary markets, it seems that share price performance depends on being allocated to the 'right' group of stocks rather than actual business performance. This has been particularly evident in the last two reporting seasons. We saw many companies fail to deliver on expectations.  Yet their share price performance was more powerfully explained by broader market trends than their underlying performance. It is important to note that this relates not only to profit but outcomes have also been skewed for looser metrics, such as revenue.

The willingness of markets to overlook operational performance of individual stocks is not sustainable.  However we do not dictate how the market chooses to reward speculation. Markets are expressions of emotions as well as logic and we cannot expect them to be rational. What we can look for is catalysts which might change sentiment and behaviour. At this point in time, there are several. None of these are new, yet suddenly they have become relevant.

Looking ahead

We believe identifying and responding to change faster than the market is key to successful investing.

So much has changed since March 2020 and the market is still adapting.  The assumption that markets will resume their pre-covid trajectory ignores the profound changes that have occurred.  The following trends are reshaping market dynamics in our view.

1. Demographics

The ageing global population has been apparent for a long time however its adverse impact has been offset by globalisation and trade, which delivered to enterprises the gift of a huge increase in the pool of available labour. While its sustainability has always been questionable (particularly due to the ageing population in China) it has not registered as a concern for markets. The escalation of tensions in global markets brings the challenges of a shrinking workforce into sharper focus.

2. ESG

Awareness of Environmental, Social and Governance issues is challenging the status quo. For example, the current US Trade Representative Katherine Tai has been vocal in raising ESG issues at the World Trade Organisation, arguing that trade policy must take the environment and workers' rights into account. Whilst coming from a different angle, this approach is a continuation of the more assertive trade policy adopted by the previous US administration. Trade frictions will not only impact labour markets but will also alter the flow of capital through financial markets. When President Trump first pushed back against free trade the market seemed less concerned. Now it is clear that scrutiny of trade relationships is bipartisan. The market must now reprioritise this risk.

3. Geopolitics

Relationships between the world's great powers were evolving prior to the pandemic. Tensions were evident due to conflicts in Syria and Crimea. Since the shocking invasion of Ukraine there has been a call to action. Today global leaders are not only worried about the equitable distribution of the benefits of trade, but also the security and resilience of their economies. Our own Prime Minister has recently committed to support development of 'Just in Case' rather than 'Just in Time' models for critical supply chains.

Aligning national security with industrial development is a significant contrast to decades of globalisation. It will require substantial investment and impact trade relationships, labour markets and capital markets. The weaknesses of globalisation have always been obvious. The sudden need to address these weaknesses has become a priority which is rapidly changing the investment landscape.

4. Market structure

The pandemic forced economic change at a scale and breadth almost unimaginable to contemporary financial markets. GFC-era measures were enhanced and expanded to ensure the resilience of financial markets. There was also increased validation for the role of Government in the economy. The US Federal Reserve has put in place massive backstops to ensure the liquidity of the market for US Treasuries and the core banking system. Yet today, with extra ordinary guard rails around banking and risk-free assets, there may be scope for a lower strike of the famous "Fed Put" on markets.

5. Experience

The current cohort of market leaders have enjoyed their dominant position for an extended period. Software as a Service and the Cloud are no longer new concepts and markets have had time to become more discriminating about which companies they are going to support. After a period of time, all start-ups progress from 'promising' to having a demonstrated track record. Good or bad. The incipient pivot from judging the best known and loved start-ups of the last decade on what they promise to deliver relative to what they have delivered is inevitable yet will seem sudden.   

In summary, plenty has changed…

These five themes will force markets to reprioritise their risk assessments. None of these risks are obscure or unknown, however changing events is triggering a reassessment. The market tends to focus on a relatively small number of issues.  So when these change, price movements can seem extraordinary.

Therefore, we adapt

There are important implications for investors in Australian Small Companies. Over the last half decade investors converged around a growth thematic supported by the theory that low inflation, low interest rates and market-friendly central banks would remain enduring features. As a result, investing in baskets of stocks aligned to this theme became as important if not more so than  understanding the actual performance of underlying businesses.

Changes in the inflation and monetary outlook also challenge the significant weight of money aligned with the established macro-strategic positioning. Investors can adapt by re-evaluating the outlook for the businesses they are invested in on a case-by-case basis, then refocusing on those businesses which they consider enduring or alternatively finding new investments which can be beneficiaries of change. 

Author: Sinclair Currie, NovaPort Principal and Co-Portfolio Manager