Testifying before the US Congress in 2010, Warren Buffett made the following comment:

"Basically, the single most important decision in evaluating a business is pricing power. You've got the power to raise prices without losing business to a competitor, and you've got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you got a terrible business. I've been in both, and I know the difference."

Microsoft has been a top three holding of the AIM Global High Conviction Fund for several years now, and remains firmly entrenched there. There are numerous reasons for us having such high levels of conviction in the business, but among the highest was our belief that Microsoft possessed significant latent pricing power.

Looking across Microsoft's suite of offerings, it has been clear to us for some time that the value their products and services provide their commercial clients has been increasing, while their prices have not kept pace. To our thinking, this was strategically shrewd, as adding new features and applications to the existing Office 365 and Microsoft 365 bundles meant that clients were continuously receiving greater functionality (and integrating it into their workflow) without being asked to dip into their pockets for the privilege. The fact that Microsoft held off on increasing their prices for nearly a decade provided it with - in our opinion - a 'hidden-in-plain-sight' asset that would create value for its owners at some point in future. (It also revealed to us that management has its priorities straight: first, look after your customers and make sure you indisputably create a consumer surplus for them; if you are successful at that, the returns to equity owners should take care of itself over time!)

During August, Microsoft announced its first meaningful price increase for these bundles in many years:

 
There can be little doubt that the price increases above reflect real pricing power and the strength of the underlying business franchise: a very good business, indeed.

Beyond the strength inherent to its own businesses, Microsoft remains exposed to several secular trends that we see as playing out over the next several years, of which higher incidences of remote working is but one. 
Federal Reserve Chairman Powell, of all people, agrees. In response to a question on how the US economy would look different to the pre-pandemic economy asked at a recent (online) lecture to students, he commented:

"I think we know that we're not simply going back to the economy we had before the pandemic, but it will take time to see exactly what the changes look like. [...] It seems a near-certainty that there will be substantially more remote work going forward. So that's going to change the nature of work, and the way work gets done."

In this latest Australian Equities Insight, Dion Hershan, Head of Australian Equities, looks at some of the easy ways for investors to get hurt in the current environment.

With the market at ~7,600 (ASX 200) - up a stunning +67% (excluding dividends) from the nadir in March 2020 - it's pretty clear that complacency is creeping in. In fact, FY2021 the 'pandemic year' saw the ASX 200 up +24%, its strongest financial year on record.

Complacency is observable in so many ways, and not just through SPACs, crypto, Robin Hood IPO'ing and becoming 'meme stock' etc. We are in a glass half full (arguably of Red Bull) environment where everything is perceived as 'good news'. Inflation is viewed one day as a sign of a strengthening economy, and the following day the lack of inflation is seen as a catalyst for more QE.

In some respects, the lack of volatility in the market is unnerving. The VIX in the US is at 17, well below the 20-year average (19.7) and the 2020 crisis level (peak of 82). The S&P 500 is up +18% this year, with only two drawdowns of more than 4% (at -4.2% and -4.0%).

With the economy and the consumer in good shape, it's difficult to make the case for a collapse or even a major correction. Clearly, though, there are headwinds emerging for markets. These include inflation, interest rates, stretched valuations and fading levels of government support.

We are selective rather than bearish, we are mindful that there are some 'easy ways to get hurt' in the current environment:

1. Buying mining companies purely for their dividend yield

With iron ore prices roughly three-times the 10-year average, mining companies are like ATMs at present. But as iron ore goes from US$200/tonne (vs [1]

2. Ignoring valuations, or basing them off today's interest rates

Valuation seemingly hasn't mattered for the last three years, evidenced by the top-quartile of the ASX 200 going from a P/E of 28 times to 44 times forward earnings. With momentum feeding upon itself, this period may well prove to be the exception to a long standing norm. If/when the wind changes, that top quartile of the market is likely the most vulnerable.

Additionally, while almost everything looks cheap when interest rates are close to zero and investors are using 2-3% discount rates, it clearly won't always be this way. Valuations for a range of companies simply won't stack up when rates begin to move higher.

3. Extrapolating what happened in 2020 either favourably or unfavourably

For so many reasons, 2020 wasn't a year that was in any way representative. Toll road traffic declines of up to 80% and supermarkets growing sales at >10% shouldn't be extrapolated.

4. Ignoring Chinese policy directives

As a command economy, China's government tends to follow through on policy. There were clear signs of overheating in China in 1H21, with recent directives to cut steel production, curtail property price growth, tighten credit, curtail speculation in commodities and cut emissions. These factors are an ominous lead indicator for commodity prices, which are largely being ignored.

5. Buying things that are shiny & new (IPOs)

While IPOs can represent compelling opportunities, they are one of the most asymmetric aspects of public markets. IPO candidates are invariably spruced up and over-hyped, with investors forced to make quick decisions based on limited information and rationed access to management. There are more than a few examples of high profile IPO duds which should be burnt into investor memories.

6. Speculating on M&A targets

With the flurry of recent M&A activity (e.g. Spark Infrastructure, Sydney Airport, Afterpay etc.) it's tempting to speculate and invest on who might be next. That's like long-range weather forecasting: you might get one right but it's probably more luck than genius. You need to buy businesses on fundamentals; it's dangerous to assume there is a 'greater fool' who will buy out a weak business at a large premium.

7. Slavishly following benchmarks

The ASX 200 is narrow; at this point four banks and the three iron ore miners are 61% of aggregate earnings. Both groups rely very heavily on unsustainable factors, with iron ore prices three-times normal and bad debts at their lowest levels on record. It's critical to look beyond the majors and be able to tactically shift where required.

Our strong advice is to enjoy the moment but don't extrapolate it. There is a graveyard full of commentators that have tried to call turning points - I won't attempt to! - but we would encourage investors to take a more balanced view.

At Yarra we aren't getting caught up in the hype of a bull market driven by a narrow group of factors. The coming years might well be defined by what you chose to avoid owning. We continue to be excited about long term holdings in the portfolio with great medium to long-term potential such as TPG, Link and Worley.

[1] Source: GS Investment Research, Jul 2021.

When investing in real estate, higher inflation is more likely to be a friend than a foe, helping protect investment from supply side issues and driving up the residual value of improvements, says Justin Blaess, portfolio manager at Quay Global Investors.

"We take the view that investors shouldn't fear inflation, particularly when it comes to real estate," he says.

"Indeed, we believe real estate - and thereby listed real estate - is a good inflation hedge. Land is tangible, and well-located land has an intrinsic value; it can be used as a place to build shelter or as a place to do business or access services.

"Because of supply constraints, well-located land will generally appreciate over time. In addition, the cost of replacing any improvements built on the land will also increase through inflation. This is significant, because if there is excess demand for a type of real estate, the market will have to accept rising costs and thereby the rents required to economically justify construction - regardless of the inflation environment.

"Investors in real estate - both direct and listed - can therefore benefit from a higher inflation environment, particularly compared to global equities investments."

Mr Blaess says it's worth understanding how listed real estate has performed in previous periods where inflation has been elevated.

"Some questions for investors to consider include: at what levels of inflation does real estate perform best? Can there be too much inflation? Not enough inflation? What if the current US bond yields are correct (currently 1.2 per cent per annum) and we are headed for sustained low inflation?"

To answer these questions, Quay analysed US REIT and S&P500 real and nominal returns by constructing indices for when headline CPI was both less than and greater than 3 per cent and in increasing increments of 1 per cent. From these indices the average monthly nominal and real returns could be calculated for the purpose of comparison.

"Our analysis shows that listed real estate is an excellent hedge for inflation and has historically delivered strong positive nominal and real returns in higher inflationary environments. It also offers a better relative return when compared to general equities.

"This is especially so when inflation is in the moderate 3 to 6 per cent range, where listed real estate has historically generated more than double the real return relative to equities. Even with very high inflation (6 per cent and above), listed real estate continues to outperform equities (albeit at a lower relative level than in a moderate inflation scenario).

"It's also interesting to note that over the past 50 years, inflation has been above 3 per cent more often than below. When it has been below 3 per cent, listed real estate nominal and real returns have been quite a bit lower than in a moderate inflation environment. And contrary to common belief, in lower inflation settings listed real estate returns actually tend to lag equities.

"So as someone with a vested interest in the performance and outlook for real estate, when it comes to inflation, we say 'take a long view and don't be fearful'," Mr Blaess says.