THE INVESTMENT ENVIRONMENT - Markets Volatile; Ukraine Invaded

The S&P 500 declined 5.3% in January. Gold and oil were up; crypto and bond prices down. The Russians invaded the Ukraine on 24th of February but markets already had a full slate of concerns prior to the invasion.

Inflation refuses to go away: consumer prices were up 7.5% and housing prices up 18.8% in the USA with even smaller markets showing this level of increase. The Bloomberg Commodity Index is up over 12% ytd, led by crude and gasoline. Fertilizer is double the price from a year ago and the world's largest supplier of weedkiller - an important input in food production - declared a force majeure due to shortages of the key ingredient glyphosate.

Many key commodities futures have slipped into backwardation indicating low stockpiles of the world's most important commodities (food, energy, metals) without the usual supply response. The Goldman Commodity analyst described the situation as "unprecedented".

Our hearts go out to the brave Ukrainians in their struggle and of course their problems dwarf any investment issues. But the Russian invasion makes the global investment landscape even more uncertain: Russia is the 5th biggest trading partner with the EU, the #1 supplier of energy to the EU, and, with the Ukraine, an important exporter of corn and wheat.

Uncertainties have increased; the value of a non-correlated investment strategy like Life Settlements is greater than ever.

THE LIFE SETTLEMENT MARKETS - Markets Stable; Tertiary Markets Active

LS Markets were stable with average gross, projected IRR's in the 12% to 14% range on completed transactions. There were interesting developments in the tertiary market where several larger portfolios were offered including one with over 100 policies. There was some indication that the sellers were motivated and that at least some of the portfolios were of good quality, which is a marked difference from most of the past two years where tertiary trades were mostly the undesired policies to be avoided at all costs.

The Life Settlement news magazine "The Deal" reported encouraging developments in the fight to prevent insurance companies from competing with Life Settlements by offering special "enhanced cash surrender offers" which may violate insurance laws in at least some States, in part because the offers may favour some policy holders over others.

The issue was raised and discussed at a recent meeting of the National Association of Insurance Commissioners with several States having already fined some carriers for such offers and other States starting to review their own legal and regulatory framework and how it applies to this relatively recent development.

It appears to be another example of insurance companies trying to make life difficult for the Life Settlement industry with limited success, probably due to quality legal representation and lobbying of the LS industry and the fact that each policy holder has a vote.

Written By Tony Bremness

Some investors have asked us how to handle a falling market as many of their investments are losing a lot of money.  Here is a summary list of our suggestions about what can be done to stop the unnecessary pain, and adapt portfolios to the new environment.

1. Recognise the Game has Changed
Investors have been conditioned in recent years to think that the FED (US central bank) has their back and will be there to bolster markets after any meaningful fall.  But while this has been the case in the last few years, the rise of inflation and its attendant political challenges mean that this may no longer be the case, and it is certainly not currently.  Inflation is now the key issue for the US population having hit high levels over 7% for 2 months in a row.

Inflation hurts the poor and the middle class who make up the majority of US voters. A significant majority of US voters don't own much in the way of anything that benefits from price increases and haven't benefitted meaningfully from historic asset price inflation.  Hence a heavily politicised FED may be forced politically to prioritise fighting inflation ahead of boosting investment markets.  They do this by reducing stimulus and raising interest rates.  Unfortunately for investors, fighting inflation through reducing balance sheet expansion and raising interest rates only works by crushing demand first.  This means economic demand and demand for equities need to get crushed as a necessary precondition to central banks effectively fighting inflation, if they attempt to do so.  We might think of this as a policy mistake or a central bank choice, as other measures of fighting inflation (such as addressing supply and labour force issues) are better than anything central banks can do - but it is what it is and comes attendant potentially dramatic effects on mainstream markets.

Effectively, one needs to acknowledge the investment cycle, as we highlighted in our article in early January "Four Ways to Massively Improve Performance in 2022: 

https://www.livewiremarkets.com/wires/four-ways-to-massively-improve-performance-in-2022

By recognising that the game has changed, investors can pivot their portfolio approach from what has worked in a bull market driven by disinflation and interest rates moving to 0, to what works better in a bear market caused by inflation, higher interest rates and reduced stimulus and demand (as massive stimulus packages are withdrawn and inflation bites into real wages growth).

The first thing that astute investors can and are doing is reduce the risk of losing money by selling or reducing assets that don't work outside a bull market, and which are at risk of building larger losses.  Importantly, it is not losing small amounts but losing large losses in bear markets that destroy investors' long term geometric returns.  By way of illustration of this, if you lose 33% you need a massive 50% gain to get back to even; lose 50% and you need 100% gain just to stay still.  Furthermore, the journey of the investor is far from pleasant when you are in large losing territory much of the time.  Far better not to lose the 33% or 50% in the first place as there is no good cure, but only prevention.

2. Take Advantage of Volatility
Simplistically, the assets which are less likely to work when inflation and interest rates are rising are financial assets such as most bonds and credit instruments, and interest rate sensitive assets such as stocks and property (this also depends on the relative rate of change of interest rate). You may recognise these as the assets that dominate the portfolios of most individuals, advisers and super funds, and probably your own portfolio.  It makes sense to better diversify portfolios and create a more balanced portfolio by reducing these interest rate sensitive assets in favour of assets and strategies which are less interest rate sensitive - as well as those which are more resilient to geopolitical shocks and a weaker economy.

The assets which are better suited to rising inflation and interest rates include numerous alternatives.  These alternatives include skill dependent rather than market dependent managers, market neutral and long short funds, volatility funds, insurance strategies, some CTAs, commodities such as oil and gold, and small subsets of the equity and property market such as shorter duration equities including resources, farmland and water.  You probably don't own much of these currently and hence aren't protecting capital from losses as well as you could be in early 2022.  The asset classes don't have the marketing and media budgets of the mainstream approaches so you probably don't know as much about them.

Importantly, these assets are less likely to lose large amounts over an inflationary period compared with the financial assets mentioned previously.  Not losing much in tough periods is the name of the game for long term returns and compounding, as well as the more risk averse.  By potentially making money or not losing as much, the assets and strategies mentioned are far better suited to protecting capital and enabling long term compounding of your wealth, and particularly so compared with financial assets which are being meaningfully devalued.  Furthermore, they offer a way of crystallising and cashing in strong equity and property gains of the last few years permanently, while still offering growth potential in the future.

3. Take Advantage of Volatility
2022 will likely provide great buying opportunities from the large amount of volatility caused by inflation, changing central bank priorities and policies, and geopolitical risks and conflict.  By not being fully invested in risk assets, investors have the opportunity of increasing exposure to these assets selectively at a later time when they may be cheaper and better value.  One way of doing this is instead of being invested in long only funds predicated and reliant on markets always going up, is investing in aligned and more flexible funds that are investing dynamically and which can change their equity weightings for you.  A heavy focus on valuation combined with market sentiment and technical analysis can help these funds pick when it is most prudent to buy risky assets such as most equities.  Most importantly, these funds can better align portfolio design and portfolio managers with investor preferences for absolute rather than relative returns ("positive" rather than "driven by benchmark" returns).

4. Emphasize Better Value Niche Assets
As market over-enthusiasm and deleveraging occurs, the most commonly held assets are the ones most at risk.  More niche assets which aren't "over owned" with leverage and which have their own fundamental and differentiated driver of returns are less likely to do poorly in market falls.  Precious metals are but one example of this which benefit from rising geopolitical tension.  It makes more sense to own precious metals in the current environment than an overpriced long duration stock in a commonly held ETF that disappoints its aggressive growth assumptions as stimulus is withdrawn.  Better still is a truly diversified and actively run portfolio of differentiated assets and strategies, with numerous diversifying return sources of which precious metals is just one, and which is not entirely dependent on any one strategy working.

In summary

There is much you can do not to be a deer in the headlights.  Inflationary periods haven't been seen for a long time and most investors need to learn how to adapt to this different environment while it lasts. The ostrich approach with a portfolio suited to an entirely different economic regime doesn't work well when inflation is here.  If you're losing large money, it's probably because your portfolio is poorly diversified and extrapolating history that is no longer with us, rather than being adapted to the times.  It is far more prudent in current circumstances to adapt to the new investment environment, and buy a broader mix of assets that provide diversification and resilience.  This includes a wide range of alternatives, managers that can take advantage of volatility, and better value niche assets.  True diversification is the only free lunch in town right now and there is a delicious smorgasbord on offer to choose from. Venison and ostrich is missing from the menu.

Why we don't try to predict macro-market changes.

We don't need to, no investor does. It is well established that the total returns of a stock follow the earnings growth of a business in the long term. 

Companies that can sustainably grow their earnings at a high rate over the long term are called compounders. Investing in a portfolio of compounders is one of the best ways to generate wealth for longer-term oriented investors that beat market averages. A major benefit of compounders is that market timing is rarely an issue, hence risk is also reduced.

Our industry spends an inordinate amount of time trying to predict or forecast the future of markets. Sophisticated soothsaying by in-large. The probability of getting this right on a consistent basis is very low. Many espouse otherwise but a check of their historical records on predictions are quite revealing. 

Consider this:

• $10,000 invested in the S&P 500 Index in 2000 was worth over $42,000 by December 2020. A healthy return of circa 7.5% pa. 
• 70% of this return came from just 10 days. Miss those 10 and your funds grew to only $19,300. For those managers in the 'predictions game' this is what is at stake.
• Miss the best 20 days and your account balance fell lower to $11,500. That's less than 5% of the potential return of remaining fully invested. 

What about the worst 20? It is also valid that avoiding the worst 20 days would have boosted your return beyond the fully invested 7.5% annualised return.

The best and worst return periods show that extreme events have a large bearing on investor returns. Based on volatility around extreme events (and their mostly unpredictable appearances), it is impossible to predict the worst and best days. 

Indexing cannot filter in/out the extremes. If only those sophisticated 'crystal balls' in the hands of commentators and fund managers actually worked! Insync's "active" basket of 28 compounder stocks, carefully constructed to control the risk, delivers outperformance over passive benchmarks, over both full and multiple investment cycles, and does so without having to predict extreme events.

Fastest decline in history. The Covid-19 pandemic clearly demonstrates the folly of an approach based on prediction. It created the fastest stock market decline in history catching out investors who believed prediction works. Let's say however, you were right and got out in time. Next and without warning, the fastest recovery in history then occurred. Unless you were in the market you missed out in a big way.

Predictions require constant and correct timing decisions. Stay in or out? If out, when? Then to where? And for how long? Thus, multiple questions need to be answered just for each event. Now, repeat over the life of your investment hundreds of times. No person or organisation has successfully got these answers sustainably right to produce great enduring outcomes.

Market timing strategies also cannot benefit from the compounders. This is because timing tends to interrupt the powerful process of the conversion of earnings into price appreciation. Insync's focus on investing in compounders means we don't need to concern ourselves with the low hit-rate strategy of market timing stocks we hold. This is just one way we lower risk to our investors yet retain above average returns over time that endure.

Examples of compounders
IDEXX and Adobe have been in the Insync portfolio for a number of years. Typical to our holdings they deliver sustainable compound earnings growth. Selling these two stocks in anticipation of, or during, the crisis would have resulted in us missing the substantial upside in their earnings growth and the ensuing stock returns they produced since the Covid induced market lows.

Funds operated by this manager: 

Premium Asia Fund, Premium Asia Income Fund, Premium China Fund

In this episode on the Good Value podcast (recorded Monday 21 February 2022), Alison Savas is joined by the Executive Vice President and CFO of Norsk Hydro, Pål Kildemo.

Norsk Hydro is a long-term holding in Antipodes' global portfolios, including the ASX-listed Antipodes Global Shares (Quoted Managed Fund) active-ETF (ASX: AGX1).

Not only is the Oslo-listed company one of the largest aluminium producers in the world, it also has one of the lowest carbon footprints.

Alison and Pål discuss Norsk's low-carbon, low-cost production, the opportunity for a green aluminium premium, and the structural trends impacting the aluminium market. 

Inflation, interest rates and liquidity. The equity market is finally taking notice that all three of these issues are very real. The most speculative stocks were the biggest beneficiaries of recent liquidity abundance and are now most at risk should liquidity retreat - which is exactly what bond markets and most central banks are confirming.

In short, the Fed has signaled the liquidity party in SPACs, tech, crypto, concept stocks and promotions is now over. Please go home.

Investment results are best considered over a full cycle, and in the case of monetary policy and liquidity we are now seeing what the other half of that looks like. In the past two years we have often been asked if our definition of quality costs us the ability to participate in innovation. Putting aside how early you need to be in the innovation cycle to capture outstanding returns we question whether much of what passed as innovation by companies and alpha by investors was anything more than just a liquidity bubble.

I guess we will only know for sure once this cycle completes, but it does make a mockery of the popular growth stock returns narrative, which may be explained almost completely by sentiment and not at all by superior business performance.

Generating Positive Returns in a Deflating Bubble

Many investors draw parallels between this market to the tech bubble and aftermath in the early 2000s. We think this a very instructive analogy, but a more recent period may also hold lessons for small cap investors navigating the next few years.

For six long years, from December 2010 to December 2016, the S&P/ASX Small Ordinaries index delivered investors zero total return as the resources and mining services bubble - which had grown to a huge weight in the index - crested and painfully deflated. Because there was such high divergence in returns before and then during this deflation period, many active small cap managers were still able to generate reasonable absolute returns (5-10% or more per annum) from 2010 to 2016. The trick of course was to avoid getting caught up in the deflation of market values for those stocks that had run up hard in the commodity super cycle (after the peak the small resources index declined by 17.5% per annum from Dec 2010 to Dec 2016) and invest in previously unpopular, overlooked and under-valued companies (the small industrials index increased by 8% per annum over the same period).

Today, dispersion in the small cap market is similarly extreme. This means active managers have many compelling investment opportunities away from stocks exposed to liquidity withdrawal and excessive valuation.  Microcap stocks are probably the most at risk given their high prices, lack of profitability and sensitivity to liquidity conditions. Microcaps in January 2022 remind us of small resources in December 2010.

For many months we have discussed what these opportunities look like - and for a sample of names readers can always refer to the top 10 fund holdings - but to reiterate what we believe will allow investors continuing to generate returns worthy of staying invested in equities, below is a list of attributes to consider:

• A proven business model and aligned management who can reinvest excess cashflow into sensible growth opportunities (organic and/or M&A)
• Cash generative business with a high return on equity
• Strong balance sheet
• Clean accounting - no excessive expense capitalisation, aggressive revenue recognition or high equity dilution
• An ability to grow organically
• Strong or improving sustainability (ESG) characteristics
• Possibly a boring industry that has been ignored for the past few year
• Reasonable or even cheap valuation

At the end of January, our portfolio is composed of companies that have in aggregate grown EPS at 15% per annum for the past three years but have been de-rated (PE multiples have declined) as the market was more interested in paying up for "liquidity party" stocks. Our current portfolio look-through return on equity is almost 20% and after price declines in January the P/E multiple is now around 13x. Expressed as a pre-tax earnings yield, our portfolio is offering almost 9% more than the Australian 10yr government bond - a metric worth watching as bond yields rise.

Innovation is not over. We will always be on the lookout for genuinely innovative companies that solve customer problems in novel ways and have an economic competitive advantage that captures this value for shareholders. Hopefully the current turmoil and the upcoming reporting season provides more of these opportunities for the fund.

February 1^st, 2022 marks the first three years of the Longwave Australian Small Companies fund performance. Few strategies can outperform in every short-term market environment. Even fewer can do so applying a long term, low turnover investment strategy where the goal is not to keep churning the portfolio into the stocks du jour. We are often asked "in what market environment would your investment approach struggle?". Before COVID, we had said a period like the dot-com bubble in the late 1990s was one in which we would likely struggle to outperform, as fundamentals and valuation took a back seat to sentiment and liquidity. Given the lessons of this period were recent and accessible to investors we thought it unlikely to recur anytime soon. We were wrong. The period from April 2020 to November 2021 ended up being exactly that type of market. So more than 50% of the first three years of our fund performance has been in a period quite hostile to our investment approach. We managed to tread water rather than sink in relative performance terms, holding the portfolio in good stead as we likely move into a market better suited to our fundamental quality and valuation based approach.

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

The current equity correction has taken a lot of the froth out of the market. But caught up in the carnage have been a number of high quality companies with years of growth ahead. Which is why I think this could be a very good time for investors to take a look at some of these businesses, including Pro Medicus, Megaport and REA Group.

January has seen an acceleration of selling that began as a rotation out of high-flying tech stocks in late November and December (the Nasdaq peaked on November 19, 2021). The carnage for technology stocks deteriorated further when the US Federal Reserve's last policy meeting minutes revealed a more hawkish attitude towards rates and bond purchases than many expected.

Simply put, it now appears central banks are accelerating their normalisation of both monetary policy and balance sheets. As one broker eloquently observed, "it follows that equity market valuations...also normalise."

According to Goldman Sachs prime broking, during the last two sessions of December 2021 and the first two sessions of January 2022, technology selling, in dollar terms, reached its highest level in more than a decade.

Inspired by central bank 'Wealth Effect' ideology, negative real yields on cash have been in place for the bulk of the last 11 years giving investors ample opportunity to be frog marched out of cash and into almost anything else. As we have written about frequently over the last five years, booms and bubbles have hitherto formed in everything from property and bonds, to coins, stamps and low digit number plates, to NFTs, cryptocurrencies and anything else related to the blockchain and the metaverse.

In the stock market, technology and healthcare sector valuations, particularly in the US (in turn thanks to private equity's game of pass-the-parcel) became the most stretched at the beginning of the year. And US equities, perhaps consequently, had been expensive by most measures.

As bond yields now move higher, the short-term ownership of high-flying tech names - particularly long-duration stocks with earnings pushed well out into the future - becomes more difficult to justify.

Not all technology companies are created equal

I have often written, investing in shares involves the ever-present risk of setbacks, and quality is the investor's best friend. An examination of how the current tech sell-off has played out reveals some merit in the idea that not all technology companies are created equal.

Last year I pointed out companies including Apple, Amazon, Microsoft, Google and Facebook generated levels of profitability previously unfathomable. As these companies become larger, their profitability also increases. As their equity grows so too does their return on equity. Think of a bank account with $1 million earnings interest of 1% per annum, and as the equity in the bank account grows to $1 billion, the interest rate earned also rises to 40% per year. Such business economics weren't even contemplated in business schools just a decade ago.

These superior business economics perhaps explain the discriminating selling of tech names in the first month of 2022. Perhaps the most useful observation however is about investor behavior itself. 

As commonly defines these pullbacks, investors have simply shortened their time horizons. Long-term investment plans have been abandoned and in their place is a preoccupation with what will happen to prices tomorrow. Interest in long-term company fundamentals is exchanged for short-term fears about interest rates.

The current equity correction will cull much of the leverage and froth built up in recent years. What it won't do is change the course of growth for many high-quality companies.

Setbacks are a normal and healthy part of investing. Indeed, the only unusual thing is their absence. The market has been swinging manic-depressively for centuries. From wild bouts of optimism - when only the most enthusiastic appraisals will be entertained, to periods of deep depression - when sellers are willing to sell even the best companies for cents in the dollar, investors can count on one thing: opportunity.

Now is therefore the time to rebalance portfolios, taking advantage of the lower prices and PE deratings that have been experienced by some of the highest quality names in the market (see Table 1).

Table 1: Relative 'De-rates' since 4 January 2022 

And keep in mind, none of the assets now falling are held in large volume by systemically important financial institutions. Banks don't own cryptocurrencies or NFTs, or the promise of smart contracts to reduce agency costs and remove the middleman. They don't own the profitless prosperity stocks either. 

In other words, this sell-off will not lead to a financial crisis. This is therefore a plain vanilla correction that will see investors who have taken on too much risk in the quest for returns suffer more than those who have been disciplined about quality and value.

And remember my call that 2022 should be a good one for investors? There are 11 months to go with plenty of potential opportunities now available.

Written By Roger Montgomery