As an investor, you are often urged to act quickly on the latest investment opportunity or regret missing out. For those interested in profiting from long term structural change it seems odd that we would need to act so quickly. Surely a profound opportunity that will change the world over many decades allows you time to sort the wheat from the chaff? If the opportunity is so fleeting delaying action misses all gains, then perhaps it wasn't the structural change it was promoted to be.

At the end of 2021, it is now clear that the last 25 years was one of these generational opportunities to participate in the digitisation of, well pretty much everything. The question we ask: how early did you need to be? Well it turns out that when structural trends run for decades, investors are afforded plenty of opportunity to participate and capture these returns.

The examples we use are flawed by survivor bias, but we think as time went on the likelihood that Apple, Microsoft, Amazon, Google and Facebook were likely to be structural winners became a lower risk assumption. What returns were lost by waiting until these became the more obvious winners?

We start in 1995, when in August Windows95 launched and Netscape IPO'd (Yahoo followed in April 96, Amazon in Jun 97 and eBay in Sep 98). We have marked this as the beginning of the Internet era for public market investors.

Let's start with Microsoft. Had you purchased Microsoft in August 1995 and held to end Dec 2021 you would have made 19% per annum over 25 years. If you had of waited until the dot com peak (Mar 2000) that would reduce to 11% p.a. Maybe you wanted to wait until the dot com settled. A purchase in Aug 2004 (when Google IPOd) returned 19% p.a. Maybe you had doubts about Steve Balmer and waited until Satya Nadella became CEO (Feb 2014) - you would have made 33% per annum in the almost 8 years since.

In 1995, Apple was still in the wilderness. Steve Jobs had yet to return (1997) and the iPod was still six years away. Holding Apple from 1995 to Dec 2021 has returned 27% per annum (with a near death experience along the way). If you waited until the iPod launched, you got 38% per annum since Oct 2001. Maybe you waited until the iPhone launched (Jun 2007) to achieve 30.5% p.a. Warren Buffett ended up buying AAPL more than nine years after the launch of the iPhone (Nov 2016) yet has still realised a 46% p.a. return over the five years since.

We see a similar pattern with Amazon (37% p.a. from IPO, 20% p.a. from dot com peak, 33% p.a. from when Warren Buffett bought in Dec 2018), Google (26% p.a. from IPO, 28% p.a. from May 2017 when Charlie Munger said "we blew it" for not buying Google) and Facebook.

None of this was obvious or easy at the time. Looking backwards gives a false sense of inevitability to history that is anything but. The future for electric vehicles, artificial intelligence, robotics, blockchain and genomics may contain generational investment opportunities. Unfortunately, there are hundreds if not thousands of companies vying to be the few winners left standing and reward their shareholders as Apple, Microsoft, Amazon, Google and Facebook (and others) over the past 25 years have done. What is hidden from history are all the failures investors have endured along the way - either companies that failed to meet these lofty goals, or investor temperament that failed to hold onto the ultimate winners through an uncertain path.

Flywheels or Waterwheels

As small cap investors, Longwave invest in much younger industries and businesses than is typical of large caps. It is more likely that the industries and companies we invest in are younger than Australia's banking, mining, insurance, property and supermarket leaders. Just because we are not investing in 100+ year old industries doesn't however mean we spend our time funding businesses that are 10 months old. There is a lot of industry growth lifecycle between 10 months and 100 years - and the current wave of investment neophiles would have you believe any company more than a decade old is ex-growth.

Our investment approach is to wait until the likelihood of success is more certain. Not guaranteed - because nothing is - just more certain than largely unproven early-stage companies. One measure of more likely success is the demonstration of a genuine and observable growth flywheel. Flywheels are sometimes over-used however we like the metaphor for the image of internally generated and sustained momentum. We seek flywheels that are self-sustaining. A profitable business with high growth opportunities reinvesting positive cash flows internally (capex, R&D, sales and marketing) to drive higher growth and higher cash flows and higher investments and higher growth etc.

Many of the current crop of growth business look more like waterwheels than flywheels. Superficially the effect is similar (more investment -> more growth -> more investment) but the missing part is internal cash generation funding growth investments. Like a waterwheel, these pseudo growth businesses require external liquidity to keep turning. Maybe some of them really are self-sustaining and are using external liquidity to spin faster. Or maybe they are just not going to succeed should this external funding dry up.

Every investor has their own philosophy and process and there are many methods we acknowledge we don't pursue that may work for those investors. Our process seeks high quality small companies that have been seasoned by the reality of free market competition to emerge as genuine flywheels, not waterwheels in disguise.

Written By David Wanis, Founding Partner, CIO and Portfolio Manager

"We have two classes of forecasters: Those who don't know - and those who don't know they don't know" - John Kenneth Galbraith

The problem with precision

Most forecasts begin with a starting point which is often anchored to current data. Forecasters tend to modestly extrapolate up or down from this level. This tendency to stick close to current conditions or consensus views, limits a forecaster's ability to comprehend the full range of possibilities or the impacts of more extreme circumstances.

Research by the IMF explored the ability of economists to predict recessions between 1992 to 2014. It was a disaster. Economists consistently failed to predict a recession in GDP by a significant margin. Even as conditions deteriorated, economists stubbornly anchored their forecasts to the preceding non-recessionary period and adjusted their predictions downwards too little, too late.

Figure 1: Evolution of Economist Forecasts in the Run-up to Recessions 1992-2014

Source: "How Well do Economists Forecast Recessions?" An, Jalles, Loungani 2018

Moreover, investment success is not dependent on the preciseness of predictions but instead the variance from the consensus. Equities generally price in the risks and opportunities that the market is aware of. It is often the unforeseen events which have dire consequences or large rewards.

The real trick of contrarian value investing is to invest when market pessimism already prices in the most dire scenario such that it is still a reasonable investment even if this comes to pass and a fantastic one should the situation improve.

A case study - Oil Search

In May 2020, in the midst of COVID-19's first wave we initiated a position in Oil Search. This was an extremely volatile time for investors with the everchanging circumstances from the spread of COVID-19 without knowledge of a successful vaccine. The demand shock from global lockdowns, flights grounded and recessionary conditions sent some oil futures sharply into negative territory before recovering slightly to historically low levels.

Volatility in oil is not uncommon. In fact, short dated oil futures historically have a standard deviation of 37%. Mixing in the unknowns of COVID, it became a very difficult proposition to forecast the oil price over the next year and beyond. By considering a range of scenarios, we instead weighed up the supporting evidence for a sensible range of outcomes.

Our fundamental assessment was that supply rationalization and a return to pre-COVID demand was a more likely situation than the alternative, and hence more supportive of the high case argument. Conversely, market estimates were in the range of $40 to $65 /bbl at the time, likely a short-sighted anchoring to recent levels. The Merlon high case of $80 seemed ludicrous by most forecaster's standards.

Yet, oil futures hit $80 in November of the following year.

Figure 2: WTI Brent Oil Futures and Merlon High/Low range

Source: Bloomberg, Merlon Capital Partners

Applying our range of oil price assumptions yielded the valuation sensitivity of Oil Search for our high/low oil price. With substantial upside to the high case compared to a more limited low case downside, this represented a very attractive risk/reward skew. Having a range allowed us to remain acutely aware of the downside risk as the stock price changed and new information came to light.

Figure 3: Oil Search Share Price and Merlon High/Low range

Source: Bloomberg, Merlon Capital Partners

Behavioural pitfalls

Part of our investing philosophy is a healthy skepticism of popular opinion coupled with an awareness of our possible misjudgment and human bias. Here are two biases that we observe to be particularly pervasive in equity markets today and where we are vigilant in avoiding.

1. Recency bias. Recency bias favours recent events over historic ones. Like many living with COVID over the past two years, we commonly hear that certain trends are here to stay: Zoom business meetings, working from home, higher in-home consumption, a shift from urban centres to coastal or regional living. While we consider the possibility some of these may be permanent, we are cautious on extrapolating near-term conditions too far into the future.

Notably, we saw the recency bias play out in the oil market as forecasts anchored too heavily on COVID conditions. There was little allowance in the market for oil prices to rise above $60 which led to the outsized returns when it did (and to the detriment of those who avoided oil).

2. Overconfidence and Narrow ranges. In Nicholas Taleb's book "The Black Swan" he highlights a study, where students were asked to estimate "how many Redwoods are in Redwood Park, California?" Students would respond with a range between two numbers in which they were 98% confident the answer fell into.

45% of respondents failed. They had used a range that was too narrow due to overconfidence in their ability. These students were the cream of the crop Harvard MBAs.

Our human inclination is to narrow our ranges as we gain more knowledge. The more "expert" we become, the higher our tendency to overstate our abilities, and in turn our ability to forecast. And our propensity to become arrogant can blind us to risks beyond our ability to incorporate them.

In December 2019, we made public a letter to the Caltex board of directors, alongside our valuation range of $20 to $40 for Caltex, in support of the Alimentation Couche-Tard proposal to acquire for Caltex for $38 including the value of franking credits. The board rejected the offer and the chairman noted our valuation range was too wide. Less than 3 months later the shares traded at $20, triggered by the pandemic, and are currently trading at $30 more than 2 years later.

The Merlon Process

We utilise a broad scope of possibilities when evaluating companies because it is often the improbable and unpredictable that generates above market returns. It acts to limit our overconfidence in our central case and reflect on what else might go right or wrong.

1. Range of outcomes. We consider all our stocks in a valuation range between the worst and best case long run scenarios. This holistic view considers scenarios in addition to our central case, the skew in outcomes and the materiality of payoffs.

2. Long term. We mitigate possible recency bias by observing a long history (usually 10 years) and capturing a spectrum of business performance over time instead of over-emphasising the latest result. 

3. Downside protection. We define risk as the permanent loss of capital in the long run. We consider "what happens if we are wrong?" and open a discussion on downside risks often dismissed in a precise thesis. This degree of downside is explicitly factored into our level of conviction and portfolio weights.

4. Conviction. Cheap stocks are usually cheap due to valid concerns. We look for an explicit view, contrary to consensus. Has the market narrowed its expectations too finely (see overconfidence, above), thereby dismissing any chance of improbably good news? Alternatively, is it leading us into a value trap by missing meaningful tail risks?

To our clients and prospective clients, it can be difficult to admit that we may not know how the future might unfold. Will COVID be permanent? How will we be using the internet in the future? Will interest rates return to higher, more normal, levels?

In this regard we are more aligned with John Maynard Keynes' view that "it is better to be approximately right than precisely wrong".

Two years into COVID-19 the future is no less clear than when we started. This does not mean we fly blindly but rather undertake deep fundamental research to prepare for the possible outcomes. By factoring in best- and worst-case scenarios and being humbly introspective in our forecasting ability, we strive to tilt the odds in our favour.

Written By Joey Mui, Analyst/Portfolio Manager

It didn't start out this way intentionally but at Equitable Investors we have developed a habit of kicking off each monthly update of the Dragonfly Fund with a quote that resonated or was reflective of that point in time. We find wisdom, common sense and inspiration in many places - not just in the words of the investment greats. From Ron Barron to ron Barassi, the words we drew on for the 12 months of calendar 2021 follow.

January 2021

"Stocks that have a well-recognised brand, or a well recognised story have seen unprecedented buying relative to the rest of the market... this leaves an opportunity for investors that are willing to go the extra mile in researching stocks." 

― Fabiana Fedeli, Fundamental Equities Outlook Q1 2021, Robeco

February 2021

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and that is well but also she will never sit down on a cold one anymore"

― Mark Twain

March 2021

"To make money in stocks you must have "the vision to see them, the courage to buy them and the patience to hold them. Patience is the rarest of the three." 

― Thomas Phelps, 100 to 1 in the Stock Market

April 2021

"The game of life is a lot like football. You have to tackle your problems, block your fears, and score your points when you get the opportunities."

― Lewis Grizzard, Don't Sit Under The Grits Tree With Anyone Else But Me

May 2021

"We're guessing at our future opportunity cost... But if we knew interest rates would stay at 1%, we'd change. Our hurdles reflect our estimate of future opportunity costs." 

― Charlie Munger

June 2021

"There are pockets of what look like appreciable over-valuation and pockets of significant undervaluation... we can find plenty of names to fill our portfolios" 

 ― Bill Miller, Miller Value Partners

July 2021

"Those explorations required skepticism and imagination both. Imagination will often carry us to worlds that never were. But without it, we go nowhere. Skepticism enables us to distinguish fancy from fact, to test our speculations."

 ― Carl Sagan, Cosmos

August 2021

"If the Chairman of the Federal Reserve with all the data and tools at his disposal couldn't predict what the 'market' would do, it was unlikely others could either. Which made us focus on investing in well managed, competitively advantaged, growth businesses...not the 'stock market' "

 ― Baron Funds founder Ron Baron

September 2021

"There are two ways you can get yourself revved up - fear of failure and love of success. Personally, I like both things to be working in you, the same as you can win a game at one end of the ground and save it at the other."

― Melbourne Football Club legend Ron Barassi.

October 2021

"Many people believe that investors must make the macro decision to be either bullish or bearish. Our preference is to be agnostic, objectively finding absolute bargains... we are neither bullish nor bearish. We are value-ish."

― Baupost Group founder Seth Klarman

November 2021

"Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves... In trying to time the market to sidestep the bears people often miss out on the chance to run with the bulls."

― former American fund manager Peter Lynch 

December 2021

"Most market commentary is focused on... 'expiring knowledge'. This is the headline news that fills our screens today, which in five and 10-years' time we will look back on and realise didn't actually mean anything from a long-term investment perceptive."

― Paul Black, WCM Investment Management

Portfolio Manager Ofer Karliner, outlines why listed infrastructure and utilities stocks rallied in the fourth quarter, the likely recovery in airport assets, why high carbon scores can be a misleading guide to ESG risks for infrastructure stocks, and why, even if interest rates rise, the infrastructure portfolios still comes with diversification, inflation protection, capital growth and yield benefits if the universe is defined correctly. 

In the current market environment, investors are faced with the challenge of finding attractive current income solutions that offer protection from rising interest rate risk, particularly as many traditional fixed income strategies (proxy: Bloomberg Barclays Global Agg) have suffered negative monthly returns in recent months. Meanwhile, the potential for bouts of volatility is increasing amid rising inflation concerns. To solve for this conundrum, we seek to unearth investment solutions offering higher yields and diversification for Australian investors within the defensive part of their portfolios, and what we view as the more senior, high quality segments of the corporate debt and alternative credit markets; we call it the "sweet spot" of credit. This encompasses a $5.7 trillion¹ opportunity set across U.S. and European loans, corporate bonds, and alternative credit markets.

Importantly, we believe a dynamic, flexible approach to investing in the "sweet spot" of credit offers:

1. Strong diversification benefits due to varying risk return profiles and low correlation to traditional fixed income and equities
2. Opportunity to generate alpha while mitigating risk by shifting targeted exposures through active portfolio management as value shifts between markets can generate attractive entry points into each asset clas​​​​​s 

To illustrate the challengses that traditional fixed income investors are facing today, as well as the relative value opportunities available in the corporate debt and alternative credit markets, Chart 1 plots the current yield against interest rate duration for various fixed income asset classes. The size of the bubbles represents the market value of each asset class.

With the outlook of a low default and higher rate environment ahead, we believe certain higher beta, floating rate instruments, specifically bank loans and CLO debt securities, screen attractive from a relative value perspective as they provide high levels of current income and low duration of less than one year. In a rising rate environment, the coupon of floating rate assets adjusts to shifts in short-term interest rates, and as a result, these assets exhibit lower price volatility relative to fixed rated securities.

Looking forward, while we anticipate increased price volatility and dispersion in the credit markets as interest rates and inflation remain at the forefront of policy decision making, we view bank loans and CLO debt securities as attractive allocations within fixed income as we expect retail and institutional demand to remain robust. Additionally, we believe valuations will be supported by strong fundamentals and improving credit metrics, low default expectations and robust capital markets.

Across our multi-asset credit portfolios, including the Ares Global Credit Income Fund ("AGCIF"), we seek to find the most attractive relative value opportunities in the "sweet spot" of credit in order to deliver higher yields with optimal downside protection and lower volatility. Specific to AGCIF, performance has benefited from tactical asset allocation and credit selection, as illustrated by its annualized since inception net return of 9.2%.² In addition to weathering varied market environments, we believe AGCIF is particularly well suited to serve a growing appetite for stable incoming-producing strategies among Australian investors as it targets a per annum distribution of 3%-4%. Further, the current ex-ante volatility of AGCIF averages approximately 0.5×2 the volatility of the broader bank loan and high yield bond universe, illustrating our keen focus on downside protection and volatility management.

Active allocation has proven paramount in successfully navigating the volatile market environment during 2020 and remains critical to unlocking value, particularly as market conditions evolve heading into the end of 2021 and early 2022. Informed by quantitative analysis and fundamental research, our demonstrated ability to express relative value across the credit markets continues to drive strong and stable monthly performance year-to-date, as illustrated in Chart 2.

In summary, as investors seek attractive income solutions in today's market environment, many may struggle to determine how best to position their credit exposure in order to maximize yield and mitigate risk. By accessing the "sweet spot" of credit, comprised of corporate debt and alternative credit asset classes, we believe investors can overcome these challenges. At Ares, our differentiated approach to capitalizing on the best risk-adjusted return opportunities across the investable universe is rooted in the scale and integration of our Global Liquid and Alternative Credit strategies, which allows us to fully leverage extensive research capabilities, proprietary technologies and longstanding relationships.

Written By Teiki Benveniste,  Head of Ares Australia Management

Broad trends are quite often easy to identify but what is much harder to do is identify specific industries and companies that are going to economically benefit from these trends and deliver compound annual returns for shareholders over the long term.

Genomics or heart disease? 

A key insight from Insync's work on the ageing population is the projected rate of growth in the 70-75 age bracket. This is the fastest growing five-year age bracket for all people over the age of 55 for the next 15 years and beyond. The proportion of people of this age that develop heart related issues are astronomical. 

In 2017, of all deaths for people over the age 70, 43% were caused by cardiovascular disease. This is 2.6x the number of the next largest cause of death which is cancer. A major issue for this age cohort is that many patients are unable to undergo open heart surgery as the risks are too high for many.
 
The Heart - an age-old problem where the demand is accelerating

The heart is a highly focused organ. It has just one job to do, and it does it supremely well. It beats. Slightly more than once every second; that's 100,000 times a day and as many as three and a half billion times in a lifetime. It rhythmically pulses to push blood through your body and recycle it. And these aren't gentle thrusts, they are jolts powerful enough to send blood spurting up to three meters if the aorta is severed.

Advances in medical procedures for the heart has been one of the success stories of modern medicine. The death rate from heart disease has fallen from almost 600 per 100,000 in 1950 to only 168 per 100,000 today. As recently as 2000, it was 257.6 per 100,000. Yet it is still the leading cause of death. In the United States for example, more than 80 million people suffer from cardiovascular disease. 

The cost to the US alone of treating heart disease has been put as high as US$300 billion a year. If left unchecked cardiovascular disease costs are projected to exceed US$1 trillion by 2035 according to the American Heart Association.

The combination of a rapidly ageing population and the escalating burden on healthcare systems allow companies that are treating heart disease to be significant economic beneficiaries. A market that is already very large today will become significantly larger and at a faster rate in the decades to come.

In comparison to surgical procedures, TAVR has a higher survival rate (99%), lower rate of stroke, bleeding, and other complications. General anaesthesia is not necessary in the procedure and most patients leave after just an overnight stay. This provides a significant cost saving as hospital surgery, anaesthesia and costs of stay are significant burdens to healthcare systems.

It takes time for the right company to appear. 

Like many new and exciting technologies, it has taken time. Over 15 years in fact, for the market to start adopting TAVR to a level where the companies pioneering the technology become highly profitable and industry leaders. 
Insync's record of successfully investing in Megatrends matches a combination of high and accelerating adoption rates, with a leading player beginning to dominate in one of its primary business sectors. This results in businesses which are both highly profitable and can grow sustainably at high levels over extended periods of time. 

Insync's investment focus is on both Megatrends and profitability 

Many healthcare and innovation investors have focused on genomics and gene editing. After all, it's emerging and exciting- the possibilities are immense. 
Insync however considers this technology to still be in the 'hype phase' of its investment cycle. The pathway to identify future profitable winners is still highly uncertain and that adds significant risks to investors. Investing in the innovative treatment of the heart is a more assured way to grow your wealth (and health).
Not all innovation however leads to profitable growth in a company. Having the right methods to then assess which company, if any, can harvest a Megatrend and possesses the right financial and market position is equally as important. Simply holding a 'sector bet' across many stocks (e.g., with a passive ETF) in a sector such as healthcare presents additional and heightened risks, that Insync investors do not have to bear.