Portfolio positioning in a time of uncertainty

Loftus Peak

21 March 2022

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War in Ukraine

The unprovoked conflict in Ukraine has unleashed a human tidal wave of misery, dislocation and death, the scale of which has not been seen since World War II. A columnist for the New York Times referred to the war as "the most dangerous confrontation for the world since the Cuban missile crisis (of 1962)." 

Just one month ago, we wrote of the onset of higher interest rates and inflation as major factors influencing markets, having considered but not believing that Putin would be so irrational as to start a war. 

This is not the correct forum to deal with the human and geopolitical consequences of this, so we won't. But it is appropriate to ask: How will the war in Europe affect investors globally? The broadest economic sanctions ever enacted have resulted in the collapse of the ruble (by 50%), the delisting of Sberbank (one of Russia's largest) on some European exchanges, and a well-advanced movement by some countries to source oil and gas from places other than Russia. 

 

This is forcing up the price of energy, at the pump and the meter, which will likely drive inflation even higher than its current levels, spurring the US Federal Reserve to continue its tightening policy. But the Fed will also consider the possibility that higher energy costs could suppress demand, thus reducing the need for more serious interest rate rises - an unscripted but possible outcome. 

Separately, we are of the view that now that Russia is considered an unreliable energy partner for the Europeans, the impetus to de-carbonisation will accelerate.  

Portfolio positioning

We do not know how this will end, but last month we wrote highlighting the quality of the portfolio. "Irrespective of macroeconomic conditions, this (quality) has always been an integral part of the portfolio construction process, and was a decision informed by the numerous corrections and crashes witnessed by the investment team over their lifetimes.

"It is for this exact reason that a majority of Loftus Peak's holdings are in quality companies - those with established business models, strong balance sheets and cashflows, with a much lower allocation to 'riskier' companies. This has always been the case, but in more recent months we have increased the tilt to quality even more than usual."

Despite the short-term volatility and underperformance of a select few names, we believe the Fund is well positioned for a period marked by slowing economic growth and rising costs of capital because of the inherent characteristics of the big disruptive companies, which are amongst the strongest in the world.

Further, earnings growth in the majority of the Fund's holdings continues to be strong, adding to the conviction we have in the long-term secular trends to which we are exposing our clients. Although the short term might remain volatile and uncertain, we believe that over the medium and long term the safest place to be is in quality companies riding secular tailwinds. 

Disruption no longer implies excess risk

During the early days of disruption, between 1995 and 2005, there was considerable investment risk as typically the mechanism was via start-up companies, which mostly were light-on for profits, let alone cashflows and balance sheets. It was by no means clear, for example, that classified advertising would migrate on-line, that cars would go electric, movies would be shown on mobile phones or that taxi services would be replaced by Uber and the like.

Investors who bought before the bursting of the 2000 bubble did not do well… for a while. But those that understood what Apple, Amazon and Google were doing on the global stage - and that part is very important - made simply stellar returns.

Fast forward to today. The word disruption, for reasons related to its investment history as well as its more general meaning, still has a negative connotation. It is not unfair to prefer the safety of an 'undisrupted' world to the uncertainty that disruption implies.

But it is time to move on. Some of those early-stage disruptive companies are listed in the top ten by value in the world today, including Amazon, Nvidia, and Taiwan Semiconductor Company. Properly managed, disruption no longer need equate to excessive risk.

Funds operated by this manager:

Loftus Peak Global Disruption Fund

Chris Gosselin, CEO of FundMonitors.com, speaks with Filippo Sciacca, Director of Investor Relations & Asset Management at ASCF.

The ASCF High Yield Fund has a track record of 5 years and has outperformed the Bloomberg AusBond Composite 0+ Yr Index since inception in March 2017, providing investors with an annualised return of 8.73% compared with the index's return of 2.73% over the same period.

Funds operated by this manager: ASCF High Yield Fund, ASCF Premium Capital Fund, ASCF Select Income Fund

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Like kites, do portfolios rise against or with the wind?

Spatium Capital

March 2022

For the runners, cyclists or outdoor sportspeople within our readership, a handful of circumstances will almost always result in a proverbial groan: headwinds. That gust of wind that makes turning that corner on the bike or spending the next half of a game with a wind impediment less enjoyable, is unfortunately a part of exercising amongst the elements. Headwinds, as it were, have become known as such a physical inconvenience that they are also a common analogy for when situations in life are met with obstacles that inhibit progress. The counter to a headwind therefore is a tailwind, where benefits and/or privileges fuel our progress, bypassing or simply overcoming the obstacles (or headwinds) that come our way. 

If we then take this concept and apply it to a fund manager's portfolio, how many would attribute their performance success to an investing skill or purely an outcome of a bull market? Put another way, did the manager overcome genuine obstacles (a headwind) to achieve success, or were they the beneficiary of a rising market (a tailwind)?

Recent research published by social scientists Dr Gilovich and Dr Davidai in 2016 suggests that people are more likely to both recall and overweight their headwinds more poignantly than those of their tailwinds. Their theory claims that when people benefit from a tailwind, the satisfaction is adapted to quickly and is relatively short-lived, whilst a headwind's dissatisfaction is 'consumed' over a longer-period. Using the sporting analogy at the top of the above paragraph, many can relate to the internal monologue that goes on when a headwind is faced; often, longing for the tailwind. Usually, this monologue does not end until the tailwind is experienced. At which point, a brief sense of relief is felt and the team or individual go about adjusting to the new advantage. Almost without a second thought!

This tendency to recount information in a way that confirms one's view (confirmation bias) that they had more obstacles than benefits has been coined by Gilovich and Davidai as the headwind-tailwind asymmetry. It is suggested that because a headwind is an obstacle that needs to be addressed, whether that be in a career, sport, relationship or an investment context, there is a greater propensity for these events to be etched into our memories. Their very existence can in fact precede critical junctures and choices in our lives. Conversely, a tailwind is a privilege that often goes unseen by its very nature of not necessitating significant effort or attention. It's harder to recount a privileged education, upbringing, career opportunities or investment successes when they were already occurring without requiring effort.

At Spatium, we pride ourselves on having outperformed the benchmark (a headwind) without having a beta in excess of the benchmark, or resorting to leverage or gearing within the fund (an easy 'tailwind' during a rising market environment). Conversely, when the market winds inevitably change, Spatium has had a long-term average of losing only half as much as the benchmark.

When assessing managers, portfolios, or even individual companies, one must be critical: "has this business overcome genuine headwinds, and has the strength, knowledge and processes to do so again in the future"

or,

"has this business simply benefitted from structural tailwinds", such as declining interest rates, or similar paradigm shifts, those of which may be unlikely to be repeated at the same amplitude (or in the case of rising interest rates, potentially work as a headwind) into the future.

In aggregate, one should enjoy just as many tailwinds as headwinds over the years, with the key focus being maximising ones advantage during tailwind periods, and remaining convicted to persevering through intermittent headwinds.

Author: Jesse Moores, Director

Funds operated by this manager:

Spatium Small Companies Fund

How private debt can help guard against rising inflation

Revolution Asset Management

March 2022

Funds operated by this manager:

Revolution Private Debt Fund II, Revolution Wholesale Private Debt Fund II - Class B

DISCLAIMER

This information has been prepared by Revolution Asset Management Pty Ltd ACN 623 140 607 AFSL 507353 ('Revolution'). Performance numbers provided are as at the date of this article, and subject to change. Although every effort has been made to verify the accuracy of the information contained in this document, Revolution, its directors, officers, representatives, employees, associates and agents disclaim all liability (except for any liability which by law cannot be excluded), for any error, inaccuracy in, or omission from the information contained in this document or any loss or damage suffered by any person directly or indirectly through relying on this information. The information in this document is not financial product advice and has been prepared without taking into account the objectives, financial situation or needs of any particular person. All investments involve risk. Past performance is not a reliable indicator of future performance.

Pet Humanisation Megatrend

Insync Fund Managers

March 2022

Funds operated by this manager:

Insync Global Capital Aware Fund, Insync Global Quality Equity Fund

How Alphabet is using AI to power its future business success

Montaka Global Investments

March 2022

Most investors suspect that AI sits at the core of Alphabet's key businesses (Search, YouTube, Cloud, etc). But many are still underestimating how AI is creating unimaginable opportunities in completely new industries for the technology giant.

Like Microsoft and its cloud computing division Azure, Alphabet's AI capabilities appear to be following a similar path of explosive growth after years of incubation.

Below we look at 4 ways that Alphabet is using AI to significantly enhance its businesses, respond to competitive threats, and also generate solutions to some of the world's most pressing problems (such as renewable energy) that we couldn't imagine solving just a few years ago.

We expect these 4 examples - and AI more broadly - to make Alphabet even more mission-critical to customers, open immensely larger markets for the company, and drive increased profitability for many years to come - all of which will continue to underpin Alphabet's role as a core holding in Montaka's investment portfolios.

1. Google Search - Like a duck ...

Alphabet is obviously best known for the ubiquitous Google Search engine that has maintained its competitive advantage for over two-decades and holds over 90% global market share. This is a frightening feat in an industry that innovates as quickly as technology.

Unsurprisingly, the incredible moat that surrounds Search has its foundation drenched in Alphabet's most cutting-edge AI research and development.

In many ways Google Search is like a duck, the query box has not changed for over twenty years, but while it might look calm on the surface, it is paddling like crazy underneath!

For example, at the end of 2019 Google Search incorporated BERT, a neural network-based AI technique for natural language processing, which was hailed by Alphabet as the "the biggest advancement made to Search in the last five years".

Just two years later (2021), Alphabet introduced MUM, a next-generation AI and a step-change enhancement to existing capabilities noting; "MUM is a big advancement in Search, 1,000 times more powerful than our current systems. It has the ability to learn and transfer knowledge across 75 languages".

Incredibly, the speed at which these mind-blowing AI breakthroughs are being melded into Google Search is accelerating.

And just this year (Feb 2022), Sundar Pichai (CEO) revealed on Alphabet's Q4 2021 earnings call, that Search was now running a new AI architecture called Pathways. He highlighted that "AI models are typically trained to do only one thing, but with Pathways, a single model can be trained to do thousands, even millions of things". This is expected to represent a major enhancement to Search quality and add further monetization options to the business.

2. YouTube - AI helps Alphabet clean up content

AI is also driving enormous efficiencies at YouTube.

Alphabet's YouTube is the largest online video platform in the world, with over two billion monthly active users who watch more than one billion hours of content per day and upload 500 hours of new content per minute!

Operating a network of this scale is a herculean engineering feat, but more impressive is how Alphabet is applying artificial intelligence to make the platform safer and more trusted for consumers and advertisers.

At the scale YouTube operates, it is physically impossible for humans to moderate every piece of content that is uploaded. This is a huge problem given the size of YouTube's userbase and their voracious appetite for video content.

Explicit and inappropriate content can have a significant impact on children, promote violence, spread disinformation, and alienate advertisers. It is no secret that many online platforms struggle with the problem of content moderation which will remain a perpetual challenge. However, Alphabet has made incredible progress using its cutting-edge artificial intelligence.

Utilizing AI and promoting trusted sources across YouTube has resulted in a mind-blowing 85% reduction in content that violates YouTube's policies.

Alphabet's AI decimated inappropriate content on YouTube

Source: Alphabet, Montaka

Alphabet can now detect nearly 95% of all violative content on YouTube with automated AI flagging and address it before it becomes a problem.

These results were driven by the application of scalable, automated AI technologies which will likely continue driving margins higher across YouTube as the need for expensive, manual human moderation of content fades.

The high-grading of content on YouTube also makes advertisers more confident that their brands and products are promoted in an appropriate fashion, drawing more advertising dollars to the platform and incentivizing creators to produce more content (flywheel).

3. AI is accelerating Alphabet's ability to counter new competition

AI is also helping Alphabet to quickly adapt to competitive threats.

Early in the pandemic Alphabet identified TikTok and its highly addictive, AI-enabled recommendation engine as a competitive threat. TikTok's engagement numbers were growing extraordinarily quickly as consumers demanded short-form, vertical videos during lock-down and were flocking to the platform.

The speed with which Alphabet was able to create YouTube Shorts and address this video content gap in its ecosystem, highlights Alphabet's incredible leadership across AI and how it can be applied to support and enhance its core business.

YouTube Shorts was created as a concept in the depths of the pandemic and has now grown to over 15 billion global daily video views inside of 18 months. This is a startling demonstration of exponential growth, YouTube's ecosystem, and the power of Alphabet's AI.

Alphabet's AI enabled the creation of YouTube Shorts

Source: Alphabet, Montaka

While TikTok does not disclose global daily views, it is believed to have 4 to 5 billion in the U.S. alone and many more globally. It is a serious competitor that may have impacted the business more dramatically if not for Alphabet's extraordinary AI capabilities that enabled YouTube Shorts to be so successful.Source: Alphabet, Montaka.

Interestingly, YouTube Shorts has largely been focused on engagement, user experience and product market fit, rather than monetization. Alphabet has significant runway ahead with respect to this incremental revenue stream with CEO Sundar Pichai noting "there's a lot more to do, [it's] super early...[we are] testing how shopping can be integrated with Shorts...the opportunity space here is pretty broad and it's exciting".

4. AI is helping Alphabet to solve the unsolvable

AI is also helping Alphabet address some of the world's most intractable problems, including sources of renewable energy.

The ocean potentially contains an unlimited source of carbon free and costless energy, if only we had the technology to unlock it. If we could find a solution to nuclear fusion, we could turn a single glass of seawater into a full year of power for an entire household. It would produce virtually no emissions and be available on-demand ... but it has long been science fiction.

That is until DeepMind, Alphabet's cutting-edge AI division took on the problem.

Nuclear fusion is the process that powers the sun and all the stars in the universe. It involves smashing hydrogen atoms together (fusion), rather than splitting uranium atoms (fission) and releases quadruple the amount of energy of a typical nuclear fission reaction.

Nuclear fusion produces four times the yield of nuclear fission

Source: HyperPhysics

A major challenge of nuclear fusion is the temperature required to perform it. Given the enormous gravitational pressure at the core of the sun, nuclear fusion can be achieved at around 10 million degrees Celsius. However, this level of pressure is not possible on earth. In fact, we need an environment that is 10 times hotter than the core of the sun for nuclear fusion.

There is no material that can withstand such high temperatures, so fusion needs to be achieved in a plasma (super-heated gas) and held inside a continually changing magnetic field to control the reaction, something that is incredibly difficult to do.

A further constraint around nuclear fusion research has been the ability to run experiments. To create a fusion reaction, scientists use a machine called a 'tokamak' to simulate sun-like conditions on earth. However, after three seconds of activity the tokomak needs 15 minutes to cool down.

Software-based plasma simulators are even slower and require several hours of compute time to simulate just one second of real-time data. This is a highly inefficient way to carry out research, effectively rendering nuclear fusion a pipedream given our inability to address the problem.

Enter Alphabet's DeepMind, in what has been hailed a major breakthrough and published in the prestigious scientific journal Nature, constructed an algorithm built on AI reinforcement learning to control the magnetic fields that govern plasma in a fusion reaction. DeepMind's algorithm predicted it would be able to control a real-life reaction for two seconds which was then applied to a real-life tokamak.

The AI was spot-on. It controlled the plasma reaction exactly as predicted in the real-world. Over-time it is hoped Alphabet's AI will produce algorithms that enable plasma reactions to go on far longer than two seconds, and move humanity a step closer to solving the eternal problem of nuclear fusion.

If successful, Alphabet's nuclear fusion AI would likely be sold as-a-service to customers looking to produce energy from this source. Potentially unleashing an explosive new revenue stream for Alphabet in the future.

Inside a Tokamak Fusion Reactor (Illustrative)

Source: Financial Times

A TECHNOLOGICAL INFLECTION

Artificial Intelligence is enhancing all areas of Alphabet's business, from those with valuable monetization models including Search, YouTube and Cloud, to emerging opportunities like autonomous driving (Waymo).

Increasingly however, AI is creating opportunities in unexpected areas that Alphabet has not historically participated, raising the potential for it to disrupt entirely new industries and create brand new revenue streams in areas such as energy, biotechnology and beyond (i.e. real-options).

Investors overlook and take for granted that silently sitting beneath the surface of Alphabet is perhaps the most cutting-edge AI apparatus the world has ever seen. It represents an insurmountable competitive advantage that will continue to strengthen for decades to come and propel the business forward in unimaginable ways.

For readers interested in exploring AI from a broader and more general perspective, we cover many of our key insights in our AI Whitepaper which readers can access here.

We believe that the months and years ahead will present opportunities to make attractive, multi-generational investments and we are prepared and well-positioned to take advantage of these.

Note: Montaka owns shares in Alphabet (Google)

Author: Amit Nath, Senior Research Analyst

Funds operated by this manager:

Montaka Global Fund, Montaka Global Long Only Fund

DISCLAIMER
The purpose of this article is to provide general information / commentary and does not purport to give financial advice. The information provided is general in nature and does not take into account your investment objectives, financial situation or particular needs. The information is selective and may not be complete or accurate for your particular purposes and should not be construed as a recommendation to invest in any particular investment.
You should consider your own investment objectives, financial situation and particular needs before acting upon any information provided and consider seeking advice from a licenced financial advisor. Investing involves the risk of capital loss. Not all investments are appropriate for all people.

Supply chains, logistics and inflation

Forager Funds Management

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Funds operated by this manager:

Forager Australian Shares Fund (ASX: FOR), Forager International Shares Fund

War. What is it good for?

Montgomery Investment Management

March 2022

Funds operated by this manager:

Montgomery (Private) Fund, Montgomery Small Companies Fund, The Montgomery Fund

[1] Noble (1915, p. 87).