Semiconductors sell off

The semiconductor pull-back accelerated in March. Investor concerns centred on slowing demand for consumer electronics in the wake of economic pressures brought on by inflation and interest rate hikes. Severe lockdowns in China related to COVID also added to these fears.

Readers will recall that a few months ago we wrote extensively about how semiconductors are playing a burgeoning role for consumers and businesses. We also explained why this trend is likely to continue, driven by secular growth drivers such as Cloud, the Internet of Things and automotive (where silicon content will increase from virtually nothing to 20% of a premium car's bill of materials (BOM) by 2030 - see illustration above). Despite the market's fears, it is worth highlighting that for a majority of our semiconductor holdings, demand still far outstrips supply. This implies that over the short-term any reduction in consumer electronics demand is likely to be taken up by other, new verticals where demand looks set to double, and possibly double again. Given all this we think that the recent sell-off is overdone.

A very simple way to illustrate this point is to compare the forward Price-to-Earnings (PE) ratios of semiconductor companies to that of the broader market (S&P500). That is, how much are investors paying per dollar of a company's earnings in twelve months time. We don't use relative measures like this to drive investment decisions, but much of the market does, so at the very least it's useful as a rough guide. Logically, investors should be willing to pay more for companies that are growing earnings faster, all else equal. But this isn't the case when it comes to many of the key semiconductor companies underpinning much of the world's disruption.

Take Qualcomm for example, a company that is already essential in 5G for smartphones and increasingly so in connected devices (for example dog collars with GPS trackers) and automotive. It is currently trading at a forward PE ratio of 13x and is expected to grow its earnings by 70% in 2022. This compares to the broader market (S&P500) which is trading at a forward PE ratio of closer to 20x and is expected to grow earnings by 15% in 2022. The market is paying almost twice as much for less than a quarter of the earnings growth! In addition, the 13-year discounted cash flow model we maintain on the company confirms this under-valuation.

It is in times like this that our investment philosophy and process provide comfort. Our valuation methodology is informed by how the world is changing and the direction in which it is heading, typically a longer time horizon than that of the broader market. We firmly believe that the market will 'capitulate' on its negative semiconductor stance as key companies continue to deliver exceptional earnings results, evidencing their growing importance across many industries. It is this process that has produced favourable outcomes for clients over the almost eight years we have been managing the strategy.

Semi

We don't invest in Russian companies, and have dramatically reduced our holdings in Chinese companies in the past year, a position which has hardened since the overly friendly deal struck between the leaders of the two countries, Vladimir Putin and Xi Jinping, during the Winter Olympics, and which preceded the invasion of the Ukraine by just four days.

Russia could have been lumped in with investment in the 'emerging markets' asset class, but frankly, it never made the cut. Putin's financial and political relationship with the oligarchs, the bedrock of the kleptocracy, made buying into Russian companies like search engine group Yandex opaque at best.

There were many other reasons as well. He has systematically cracked down on media freedom, jailed political opponents and passed legislation authorising the murder of enemies of the state outside Russia (symmetrical with the powers it had within Russia), which of course resulted in the radioactive poisoning of Putin critic Alexander Litvinenko in the sushi bar of London's Millennium Hotel.

Had we ignored the geopolitics and invested in Russia - on the basis of low financial valuations of many companies - the outcome would have been negative given that the economy has been crippled by the sanctions now being applied by NATO countries and others.

China too has become increasingly difficult as an investment proposition. We first included companies in China because the political environment styled 'socialism with Chinese characteristics' had unshackled the economy and created the super-growth for companies such as Alibaba, which disrupted bricks-and-mortar retail, banking and transport. This also made a material difference to the lives of many Chinese people. Of course, there was always a measure of autocracy, but the balance that was struck allowed enough private enterprise for commerce to thrive and set China on a tear that lifted 850 million people out of rural poverty and into the middle class.

The most obvious marker that there was to be a change was the 2017 crackdown in Hong Kong by President Xi. The situation continued to deteriorate over the following years, and then Xi canned the float of Ant Financial and levied Alibaba with a US$15b fine - a 'common prosperity' payment. Later, China Inc nobbled the ride-sharing company Didi, until that moment a credible competitor to Uber.

At many points in the past five years there was a temptation to suggest the changes in China couldn't get worse. But in October last year Xi upped the ante on Taiwan, flying 150+ fighter jet sorties over Taiwanese air space on the 100th anniversary of the birth of the Chinese Communism Party. The clear message: Taiwan must become part of China again. Sound like Russia's approach to Ukraine?

It's no surprise that the countries with the strongest innovation track records are also those with the most liberal political structures. Ever wonder why South Korea is such a technology powerhouse, while North Korea… isn't? Or why Taiwan's TSMC is the largest and most successful semiconductor manufacturer in the world, while China lags, or for that matter why there isn't a Russian Apple? It isn't that the folk aren't as smart - more a case of where is the incentive to build a great company if it can be appropriated by the state and its mates?

Which is not to say that liberal democracies are motivated by altruism. The semiconductor industry built by William Shockley, then his employees at Fairchild and Andy Grove at Intel was underwritten by the US wish to dominate weaponry and space, requiring top grade guidance systems which required the latest silicon.

Geopolitics and our investment process

For Loftus Peak, as managers of the Fund, geopolitical matters such as these are expressed in the valuation process by the discount rates used to determine entry and exit prices. Companies listed in countries with autocratic political systems mostly attract higher discount rates. This results in the price targets we ascribe to companies operating in these countries being lower and so too the Fund's overall exposure in terms of weighting to those countries. The outcome of this is an absence of holdings in Russia and a low weight to holdings in China, both of which have broadly worked.

Performance and portfolio positioning

An appreciating Australian dollar drove the weakness in absolute performance and the pullback in semis led to relative underperformance against the benchmark of -2.0% in March against our benchmark MSCI All Countries World Index (net, as expressed in AUD from Bloomberg). We believe the market has started to recognise the value of quality companies - those with robust business models, pricing power, strong balance sheets and cash flows. We expect this trend to continue as the macroeconomic environment begins filtering through to company earnings.

We recognise that during times of uncertainty - war, inflation, interest rate hikes - markets tend to focus on that which is directly in front of them (the next quarter, or two). However we take a longer-term view and gain comfort in the Fund's positions knowing their growth is being driven by powerful secular trends that will continue for the next decade and that many of these quality companies are now trading at even more attractive prices. We took advantage of the market lows in March to increase our weighting to equities by around 5%, purchasing a number of quality companies that had been on our watch list but were previously precluded from the portfolio on the basis of valuation. Cash exposure at the end of March was 7.4%.

The Co-Founders of Collins St Asset Management, Michael Goldberg and Vasilios Piperoglou, alongside Head of Distribution & Investor Relations, Rob Hay, are hosting an interactive webinar (existing clients only) where they will be sharing their insights into the investment thesis underpinning the launch of the upcoming Convertible Note Fund.

With capital preservation at the heart of the team's philosophy, Michael and Vasilios will articulate the compelling asymmetrical risk / return outcomes that can be achieved through convertible note exposure and how debt like downside / equity like upside can create the potential for an 8% p.a. yield as well as capital appreciation over the medium term.

The team at Collins St Asset Management have developed deep knowledge and experience in the field of convertible notes, having completed numerous transactions with profits of between 30% and 100% within the flagship Collins St Value Fund since 2016.  Throughout that time the investment process has continued to evolve and be refined to the point where Collins St Asset Management are regularly being introduced to new opportunities with the volume of potential transactions being greater than what could be exclusively accommodated within the Collins St Value Fund.

To that end, and as a natural extension of the same research process that has delivered investors a net return of 19.1% p.a. since inception in the Collins St Value Fund, the team are excited to present this opportunity to you and look forward to your attendance at the webinar.

*Please note that past performance is not a reliable indicator of future performance and ensure you receive and read a copy of the Information Memorandum for the Fund in full prior to making any investment decision with respect to the Fund.  The Fund is available to those investors who qualify as 'wholesale' or 'sophisticated' only.

Speakers: 
Michael Goldberg, Co-Founder
Vasilios Piperoglou, Co-Founder
Rob Hay, Head of Distribution & Investor Relations

Register here!

Thanks to COVID-19 online shopping has catapulted in popularity. Subsequently, so has the Buy Now Pay Later (BPNL) universe. But, with so many BPNL players in the industry, which one do you choose? 

Size does matter and reach is paramount for merchants who want to offer a range of payment providers but must nearly always include bigger players like PayPal.

PayPal wins for merchants and many purchasers because:

1.    PayPal has 396 million customers

2.    PayPal processes approximately 60% of all online retail spending (ex-China)

3.    PayPal thrives without late fee income unlike most competitors 

4.    PayPal is already indirectly in the Chinese market via Go Pay and Shanghai-based Union Pay with potential to reach 500 million Chinese shoppers

5.    Information Technology Resources - PayPal launched its BNPL response far quicker than any smaller player could imagine

Merchants don't want a window full of logo stickers for payment providers and Millennials are too savvy to have a phone full of BNPL apps. They want proven providers when managing their money and money transfers.

Other Global Tech stocks/themes include: NVDIA, Amazon, VISA, Apple Pay, Nintendo, Hydrogen, and Low Emission energy. 

Disruptions stocks can provide investment returns now

Insync's investment strategy concentrates on disruption and its interrelationship with a global Megatrend rather than just investing in disruptive companies.

Our investment philosophy revolves around high quality companies. We look for companies that are benefiting from disruption, have long runways of growth through exposure to global Megatrends and are highly profitable.

Continuing Instability, More War; Credit Excesses.

The war in the Ukraine continues with shocking humanitarian suffering and carnage not seen in Europe in 8 decades. The ongoing war and related sanctions will likely lead to sustained inflation, more market instability and heightened geo-political uncertainties. The reaction of the Russian leadership to any failure on the ground cannot be predicted.

In China, an outbreak of Covid has led to strict lockdowns, with the inevitable economic downturn and possible social unrest. China has her own deflating financial bubble, primarily in real estate: the yields on major Chinese Developers ranged from 15.5% (Country Garden) to 109% (Evergrande). Excess credit leads to instability in all countries.

Real world inflation continues to be an issue - another outcome of credit excess exacerbated by war, Covid and supply-chain problems. Many commodity prices are up double digits, wages are up, and central banks appear to be starting a tightening cycle: the first since 1994, nearly 30 years ago. Most Fund Managers will be seeing one for the first time.

Investors must contemplate multiple scenarios, including current inflation, credit instability, rising default rates, and probable deflation in financial assets.

Inflation and Life Settlements. 

Should Life Settlements be part of investors' portfolios in times of inflation? A rational analysis will begin by establishing three assumptions: expected return on the LS portfolio, expected inflation, and the time horizon.

The expected return of the Laureola LS strategy is 8% to 12%; the actual return in the past few years has been between 6% and 9%. At least this has the validity of being backed by realised gains.

• Let's use 7% as a conservative assumption with a high probability of being realised. (Laureola's portfolio is currently valued at a 13.5% IRR - gross of fees and fund costs, so there is a buffer).
• As for inflation expectations, there are as many as there are investors. Current YOY inflation is above 8%, but the broad market expects inflation to average 3.34% according to the 5-year TIPS auction last week. This has been climbing since April 2020, so let's use 4% to have some buffer above current market expectations.
• Let's use 5 years as the time horizon, as we have the 5-year figure for inflation expectations, LS returns are more reliable over the 3-5 year time frame, and seasoned investors will typically prefer a longer time frame for their decisions.

Mathematically, a 7% return will be helpful, even in a 4% inflation environment. Investors can adjust both figures according to their analysis, but there is a significant buffer. Despite the fixed income characteristics, LS prices are only modestly correlated to interest rates. The IRRs on LS have ranged between 6% and 12% above Treasuries and LS prices have proven to be more dependent on capital flows and liquidity. The prices of LS may vary over the coming 5 years, but the realised return on those already purchased will not be affected. The realised return on LS is reliant primarily on getting the mortality right, and that is why Laureola has such a strong focus on understanding the mortality of each insured. Control for this variable will beat inflation in most scenarios.

Performance and positioning

Investors are concerned about the effects of inflation on their portfolios. There is no doubt a place for assets that directly protect against inflation, such as commodity exposure, real estate, or possible gold. But a portfolio focussed only on these assets may not do well in other scenarios, e.g. more moderate inflation or deflation resulting from a credit crisis. A stable 7% annual return over 5 years will provide investors with 40% more purchasing power 5 years from now.

Laureola has always delivered 7% or better over 5 years and, as the strategy is based on mortality, it brings the added benefits of genuine non-correlation, stability and protection from geo-political and economic shocks.