The story driving equity markets (S&P500 -8.8% for example) through April was more of the same: higher inflation, higher commodity prices, higher interest rates and lower valuations ascribed to growth companies. Whilst we understand the optimal portfolio positioning for such an environment has been to own commodities, cyclicals and value stocks, we also understand that playing this game profitably requires an ability to dance close to the door as macro-economic variables can change quickly. If we were to bet the portfolio based on a guess of the future economic environment, we would do so with the knowledge that we are likely to be right as often as we are wrong. Instead, we focus on where we have an edge.

Our edge is in identifying durable businesses that can grow their cash flows through the full economic cycle. Over a long enough time-horizon, we are likely to experience the full spectrum of economic environments. Similarly, over a long enough time horizon, highly durable growth companies will be worth multiples of the low return, cyclically-driven companies we seek to avoid.

Unsurprisingly, attribution was characterised by some of our growth companies moving lower: Tyro, IDP Education, Block & Aristocrat. We did experience an offset from our short positions however, most of which contributed positively this month. The shorts are doing their job of cushioning the damage caused by the longs. This will help the fund recover from a higher base when, eventually, a recovery does dome. Special mentions for our short contributors go to the speculative, cash burning companies, many of which have no revenue. Covid winners that are now covid sinners such as e-commerce and healthcare companies also contributed to performance on the short side.

In terms of future opportunity, there are two key areas forefront of our minds.

The first is the businesses that exhibit all of the ingredients for superior long-term shareholder returns (i.e. high ROIC, durable business models with proven execution) are getting cheaper and therefore implying higher future returns. We feel the sting of having many of these already represented in the portfolio but nonetheless are enthusiastic to accumulate more shares in these companies at increasingly attractive prices.

The second area of opportunity are also companies that have seen recent share-price weakness but are distinct from the first group in that there is little to no fundamental value to support their valuations. These companies are often biotechs, aspiring resource producers or technology developers that lack a clear link between their cash burn and incremental revenue growth. Not only do these stocks do poorly when market sentiment becomes cautious, but they tend not to recover when sentiment returns due to a lack of execution and an investor base that has already moved on to the next shiny thing. Years of bullish share market conditions have presented a plethora of these opportunities and we continue to add them to our short portfolio.

The most obvious area of market speculation currently is in battery minerals. There is no shortage of these names on the ASX, however few are likely to have commercial operations. Unproven mining methods, chemical processes and or spicy jurisdictions that have never produced lithium before all loom as potential headwinds for these projects. Meanwhile, a lot of optimism has been built into projects that have a material chance of disappointing. Selectively and within risk tolerances, we have taken a short position in some of these names which worked in April.

As I have discussed in recent blogs, US ten-year treasury bonds have risen from approximately 0.5 per cent in mid-2020 and are now approaching 3.0 per cent. At the beginning of 2022, they were 1.5 per cent - and have effectively doubled in four months - as the concept of "transitory inflation" was reduced to rubble from the war in Ukraine pushing up commodity prices, continued supply bottlenecks and the general tightness of the labour markets as many economies exit COVID-19.

In many Western World economies, the rate of inflation is hitting between 30-to-40-year highs and examples include New Zealand at 6.9 per cent; the UK at 7.0 per cent; Germany at 7.3 per cent and the US at 8.5 per cent. Most Central Banks have moved very late in their tightening cycle and cash rates of around 1.0 to 1.5 per cent are still very low by historical standards. Australia's record low cash rate at 0.10 per cent compares, for example, with the "Emergency Low" cash rate of 3.0 per cent implemented on the back of the Global Financial Crisis over 13 years ago.

Much of the Western World adult population have enjoyed an enormous bull market for their prime asset - their house. But with house prices and household debt at record levels relative to household disposable income, indebted households will be sweating rising interest rates, and this could have a knock-on effect.

In the US, for example, 30-year fixed mortgages have hit 5.35 per cent, a 12-year high. Given they were under 3.0 per cent not so long ago, this has added around one-third to monthly mortgage payments on a standard 30-year repayment mortgage. And for those Americans buying today, post the 20 per cent year-on-year increase for the average house, this means they are now paying around 50 per cent more on the mortgage than they would have been a little over a year ago.

Buyers who fixed in a high proportion of their mortgage for some years will be less affected by rising interest rates. In the past I have pointed out that early in 2021, a four-year fixed loan in Australia was sub 2.0 per cent. Today, that rate is closer to 4.5 per cent. What this means is that today's housing buyers are taking out variable loans at closer to 2.3 per cent but are vulnerable to the RBA moving late with the interest rate tightening cycle.

No matter how you cut it, the psychological boost and wealth effect enjoyed from strongly rising house prices will likely be missing in the foreseeable future and this means indebted households are more vulnerable to Central Bank tightening late in this inflationary cycle.

Author:  David Buckland, Chief Executive Officer

Is the RBA risking a recession to solve inflation?

The RBA hikes rates by 25bps, with more set to come in 2022 as Australia's central bank attempts to keep a grip on inflation.

With oil and commodity prices set to continue to be at elevated levels due to Russia's war with Ukraine, could a series of rapid rate hikes rates push the Australian economy into recession??

Tune in to hear Darren and Chris discuss this in episode 27 of The Rate Debate.

The small and mid-cap universe offers the potential to invest in tomorrow's large companies today. In this article, we'll look at ways to navigate this huge global market while balancing the opportunities and risks.

Given a backdrop of conflict in Ukraine and a lingering pandemic, investors face a lot of uncertainty at the moment.

Due to concerns about inflation, interest rate rises and tightening monetary policy in early 2022, investors in small and mid-cap equities have been favouring "value" stocks with lower price-earnings (P/E) valuations over higher P/E "quality" companies recently.

We also saw small and mid-caps underperform large caps in 2021, based on the (not always accurate) perception that big equals safer.

There is now an opportunity to invest in quality small and mid-cap companies…at compelling valuations

All this means there is now an opportunity to invest in quality small and mid-cap companies with the potential to weather economic cycles.

These companies are available at compelling valuations. But in today's unpredictable environment, is it possible for investors to buy tomorrow's potential large caps without taking high risks?

Narrowing the search

The global small and mid-cap equity investable universe is vast. Two thirds of the world's listed corporates are small or mid-cap companies. That's 7850 stocks.1

Very few analysts cover the sector, which means experienced investors can exploit market inefficiencies.

With such a huge opportunity set, where do investors begin to look? At abrdn our starting point since the late 90s has been our stock screening matrix. Our information feeds measure the quality, growth, momentum and valuation factors that our continuous backtesting has found to be predictive of share price performance.

The above illustration shows the select companies we look for; those with strong quality, growth and momentum characteristics.

Our screening matrix highlights a shortlist of companies which look attractive from a quantitative perspective. Small and mid-cap specialists carry out rigorous fundamental research on these top-scoring companies, including meeting with senior management, financial analysis, an assessment of ESG risks and opportunities, as well as a peer review process.

The result is a 'best ideas list' which comprises of regional analysts' highest conviction names. Each list typically contains 15-20 stocks.

Our portfolios have high weights to these strongest conviction companies, while ensuring a sufficient level of diversification as well as clear, deliberate and persistent style tilts to quality, growth and momentum.

Factors in focus

We've talked about the factors that we believe are important when selecting companies with the potential to enlarge their market capitalisation over the long term. But what are the key indicators of these three characteristics?

Growth 

In our view, it's important to look for companies with profitable, sustainable, growth. Small and mid-cap businesses with supportive end markets, as well as the ability to gain market share and expand profit margins, have the greatest potential to become tomorrow's large caps.

Momentum

We also look for signs that companies are exhibiting momentum, such as seeing upward earnings revisions and a history of consistently beating earnings forecasts.

Growth and momentum characteristics have the potential to be sustained for many years, which partly explains why small caps have outperformed large caps over the long term.2

Quality

The graphic below shows what we believe are the key indicators of company quality:

Measures such as balance sheet strength, management pedigree and sustainable competitive advantage allow companies to successfully navigate changing economic cycles. Of course, investing in quality is also about avoiding loss-making, blue sky or highly leveraged businesses, as well as those with extremely cyclical earnings or a history of dividend cuts. Because of this, we believe, 'quality' companies have the potential to deliver higher returns over the long term with less volatility. This results in a more favourable risk-return profile. 

ESG - a key indicator of quality

One indicator shown above is ESG (environmental, social and governance). For us, ESG factors are financially material and can affect any company's performance both positively and negatively. A strong record on ESG issues is a key sign of company quality and can potentially help to reduce risk. Therefore, in our view, understanding ESG risks and opportunities should be an intrinsic part of any small and mid-cap research process, alongside other financial metrics.

We also think informed and constructive engagement with company leaders can help investment managers to encourage and share positive ESG practices - potentially protecting and enhancing the value of investments for years to come.

Well-resourced investment managers have the confidence to rely on their own ESG research, investing in companies which meet their own criteria, even when not covered by external ratings agencies. You can read more about The Importance of ESG in Small Cap Investing in our recent article.

Risk and opportunity

Looking forward, the outlook for higher interest rates, potentially sustained high inflation, and a lower growth environment suggest uncertain times are ahead.

Companies selected using a quality, growth and momentum process combined with ESG analysis are potentially well-placed to weather economic downturns. Far from being dependent on externally-driven cycles, these companies are likely to expand in a predictable, sustainable way.

They are also more likely to be market leaders able to pass on inflationary costs in the form of higher prices, as well as having strong margins and robust balance sheets. Furthermore, portfolios constructed in this way are more likely to be diversified across products, markets and geographies.

We also believe that in a changing world, smaller, nimble, well managed companies that can pivot their businesses more quickly than mega caps are well placed to take advantage of evolving opportunities.

Final thoughts

Many high quality small and mid-cap companies with the potential to expand and grow are currently available at attractive valuations. In today's uncertain world, we believe a robust, repeatable investment process focusing on quality, growth and momentum can help investors select the large cap leaders of the future with favourable risk-return profiles.

Author: Alexandra Popa, Macro ESG Research, Abrdn Research Institute

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

Request for the recording now!

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