The last time Australia's official cash rate had a five in front of it, the world was going through the biggest financial crisis since the Great Depression. Within the next two years, rates could be back up at that level, bringing a world of pain to borrowers, equity markets and business balance sheets.

The prediction comes as share-markets around the world tumble amid expectations the US Federal Reserve will within weeks kick off the next interest rate-rise cycle. 

"We've already seen rationalisation start to come into the market. We can see that institutions and investors as a whole are no longer prepared to just pay up for these high-growth, expensive companies, many of which are not actually generating profits" 

If you look at the irrational behaviour happening over the last 12 months, it's resulted in 60 out of the ASX top 200 companies not being profitable. That's alarming.

While capital market conditions were favourable over the past two years, with excess liquidity pumped into the system, these hyper-growth businesses were the outperformers. However, these sorts of businesses are highly reliant on capital markets supporting them; they've got to keep going back to the well to survive. 

That well will run dry quickly if rates jump up to the level, we forecast. I see the Reserve Bank kicking off its own rate-rise cycle by the middle of the year, well before the 2024 start date the central bank was tipping just months ago.

The pressure on the RBA intensified last Tuesday, when headline inflation in the year to December 31 was revealed to have surged to 3.5 per cent, while underlying inflation was 2.6 per cent. Many now expecting the central bank to move this year.

I am predicting that the fallout for equities from the rate move would result in the share market contracting up to 15 per cent this year. The S&P/ASX 200 Acc. was down over 6% in January on the mere suggestion of a new rate-rise cycle. 

"We think there's a real risk now that rates are going to increase by amount to 3 - 5 per cent over the next two years"

The RBA might try and hold fire as long as they can, but then I think they're going to have to accelerate at a greater rate than what they would have preferred. You could easily see that 3 to 5 per cent occur over an 18-month period from July 1 this year.

If you also think about the amount of debt people and institutions have taken on over the last few years, you lift that cost of debt from 2 per cent to 6 per cent or 7 per cent over the next 24 months and it can have dire consequences not only on the property market, but also on equity markets and business balance sheets.

The key for investors looking to emerge unscathed is to ditch the recent investing mindset. 

"Investors who continue with the mindset of traditional investing over the next five years could risk giving away a significant amount of the wealth they've generated over the last five. Now more important than ever, investors need to apply a lot more active management to their portfolio, as opposed to the buy and hold index approach that worked very well over the past decade - invest for tomorrow, not yesterday"

The alternative investment manager isn't suggesting investors completely back away from equities, but to reconsider how to best manage that equity allocation. To this point, the Lucerne Alternative Investment Fund (LAIF) has in recent months increased its exposure the energy sector, which has outperformed as constraints to supply chains continue. Ironically, this was a sector ignored by much of the market in recent times with the push toward clean energy. "We feel there is more upside in this sector and some market commentators believe oil could reach USD200 per barrel".

Our message to investors out there is to get in front of this and start to think differently. Move away from that herd mentality, which only works well until it doesn't. 

LAIF, which actively manages a portfolio of alternative funds covering asset classes and themes including long-short equities, volatility, precious metals, resources, digital assets and convertibles, returned ~24 per cent last year, bettering the 22 per cent in 2020. For this year, the fund is tipping it can achieve an 8-12 per cent return, after delivering a return of ~1.5% In January. 

Author: Anthony Murphy, CEO

As an investor, you are often urged to act quickly on the latest investment opportunity or regret missing out. For those interested in profiting from long term structural change it seems odd that we would need to act so quickly. Surely a profound opportunity that will change the world over many decades allows you time to sort the wheat from the chaff? If the opportunity is so fleeting delaying action misses all gains, then perhaps it wasn't the structural change it was promoted to be.

At the end of 2021, it is now clear that the last 25 years was one of these generational opportunities to participate in the digitisation of, well pretty much everything. The question we ask: how early did you need to be? Well it turns out that when structural trends run for decades, investors are afforded plenty of opportunity to participate and capture these returns.

The examples we use are flawed by survivor bias, but we think as time went on the likelihood that Apple, Microsoft, Amazon, Google and Facebook were likely to be structural winners became a lower risk assumption. What returns were lost by waiting until these became the more obvious winners?

We start in 1995, when in August Windows95 launched and Netscape IPO'd (Yahoo followed in April 96, Amazon in Jun 97 and eBay in Sep 98). We have marked this as the beginning of the Internet era for public market investors.

Let's start with Microsoft. Had you purchased Microsoft in August 1995 and held to end Dec 2021 you would have made 19% per annum over 25 years. If you had of waited until the dot com peak (Mar 2000) that would reduce to 11% p.a. Maybe you wanted to wait until the dot com settled. A purchase in Aug 2004 (when Google IPOd) returned 19% p.a. Maybe you had doubts about Steve Balmer and waited until Satya Nadella became CEO (Feb 2014) - you would have made 33% per annum in the almost 8 years since.

In 1995, Apple was still in the wilderness. Steve Jobs had yet to return (1997) and the iPod was still six years away. Holding Apple from 1995 to Dec 2021 has returned 27% per annum (with a near death experience along the way). If you waited until the iPod launched, you got 38% per annum since Oct 2001. Maybe you waited until the iPhone launched (Jun 2007) to achieve 30.5% p.a. Warren Buffett ended up buying AAPL more than nine years after the launch of the iPhone (Nov 2016) yet has still realised a 46% p.a. return over the five years since.

We see a similar pattern with Amazon (37% p.a. from IPO, 20% p.a. from dot com peak, 33% p.a. from when Warren Buffett bought in Dec 2018), Google (26% p.a. from IPO, 28% p.a. from May 2017 when Charlie Munger said "we blew it" for not buying Google) and Facebook.

None of this was obvious or easy at the time. Looking backwards gives a false sense of inevitability to history that is anything but. The future for electric vehicles, artificial intelligence, robotics, blockchain and genomics may contain generational investment opportunities. Unfortunately, there are hundreds if not thousands of companies vying to be the few winners left standing and reward their shareholders as Apple, Microsoft, Amazon, Google and Facebook (and others) over the past 25 years have done. What is hidden from history are all the failures investors have endured along the way - either companies that failed to meet these lofty goals, or investor temperament that failed to hold onto the ultimate winners through an uncertain path.

Flywheels or Waterwheels

As small cap investors, Longwave invest in much younger industries and businesses than is typical of large caps. It is more likely that the industries and companies we invest in are younger than Australia's banking, mining, insurance, property and supermarket leaders. Just because we are not investing in 100+ year old industries doesn't however mean we spend our time funding businesses that are 10 months old. There is a lot of industry growth lifecycle between 10 months and 100 years - and the current wave of investment neophiles would have you believe any company more than a decade old is ex-growth.

Our investment approach is to wait until the likelihood of success is more certain. Not guaranteed - because nothing is - just more certain than largely unproven early-stage companies. One measure of more likely success is the demonstration of a genuine and observable growth flywheel. Flywheels are sometimes over-used however we like the metaphor for the image of internally generated and sustained momentum. We seek flywheels that are self-sustaining. A profitable business with high growth opportunities reinvesting positive cash flows internally (capex, R&D, sales and marketing) to drive higher growth and higher cash flows and higher investments and higher growth etc.

Many of the current crop of growth business look more like waterwheels than flywheels. Superficially the effect is similar (more investment -> more growth -> more investment) but the missing part is internal cash generation funding growth investments. Like a waterwheel, these pseudo growth businesses require external liquidity to keep turning. Maybe some of them really are self-sustaining and are using external liquidity to spin faster. Or maybe they are just not going to succeed should this external funding dry up.

Every investor has their own philosophy and process and there are many methods we acknowledge we don't pursue that may work for those investors. Our process seeks high quality small companies that have been seasoned by the reality of free market competition to emerge as genuine flywheels, not waterwheels in disguise.

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

"We have two classes of forecasters: Those who don't know - and those who don't know they don't know" - John Kenneth Galbraith

The problem with precision

Most forecasts begin with a starting point which is often anchored to current data. Forecasters tend to modestly extrapolate up or down from this level. This tendency to stick close to current conditions or consensus views, limits a forecaster's ability to comprehend the full range of possibilities or the impacts of more extreme circumstances.

Research by the IMF explored the ability of economists to predict recessions between 1992 to 2014. It was a disaster. Economists consistently failed to predict a recession in GDP by a significant margin. Even as conditions deteriorated, economists stubbornly anchored their forecasts to the preceding non-recessionary period and adjusted their predictions downwards too little, too late.

Figure 1: Evolution of Economist Forecasts in the Run-up to Recessions 1992-2014

Source: "How Well do Economists Forecast Recessions?" An, Jalles, Loungani 2018

Moreover, investment success is not dependent on the preciseness of predictions but instead the variance from the consensus. Equities generally price in the risks and opportunities that the market is aware of. It is often the unforeseen events which have dire consequences or large rewards.

The real trick of contrarian value investing is to invest when market pessimism already prices in the most dire scenario such that it is still a reasonable investment even if this comes to pass and a fantastic one should the situation improve.

A case study - Oil Search

In May 2020, in the midst of COVID-19's first wave we initiated a position in Oil Search. This was an extremely volatile time for investors with the everchanging circumstances from the spread of COVID-19 without knowledge of a successful vaccine. The demand shock from global lockdowns, flights grounded and recessionary conditions sent some oil futures sharply into negative territory before recovering slightly to historically low levels.

Volatility in oil is not uncommon. In fact, short dated oil futures historically have a standard deviation of 37%. Mixing in the unknowns of COVID, it became a very difficult proposition to forecast the oil price over the next year and beyond. By considering a range of scenarios, we instead weighed up the supporting evidence for a sensible range of outcomes.

Our fundamental assessment was that supply rationalization and a return to pre-COVID demand was a more likely situation than the alternative, and hence more supportive of the high case argument. Conversely, market estimates were in the range of $40 to $65 /bbl at the time, likely a short-sighted anchoring to recent levels. The Merlon high case of $80 seemed ludicrous by most forecaster's standards.

Yet, oil futures hit $80 in November of the following year.

Figure 2: WTI Brent Oil Futures and Merlon High/Low range

Source: Bloomberg, Merlon Capital Partners

Applying our range of oil price assumptions yielded the valuation sensitivity of Oil Search for our high/low oil price. With substantial upside to the high case compared to a more limited low case downside, this represented a very attractive risk/reward skew. Having a range allowed us to remain acutely aware of the downside risk as the stock price changed and new information came to light.

Figure 3: Oil Search Share Price and Merlon High/Low range

Source: Bloomberg, Merlon Capital Partners

Behavioural pitfalls

Part of our investing philosophy is a healthy skepticism of popular opinion coupled with an awareness of our possible misjudgment and human bias. Here are two biases that we observe to be particularly pervasive in equity markets today and where we are vigilant in avoiding.

1. Recency bias. Recency bias favours recent events over historic ones. Like many living with COVID over the past two years, we commonly hear that certain trends are here to stay: Zoom business meetings, working from home, higher in-home consumption, a shift from urban centres to coastal or regional living. While we consider the possibility some of these may be permanent, we are cautious on extrapolating near-term conditions too far into the future.

Notably, we saw the recency bias play out in the oil market as forecasts anchored too heavily on COVID conditions. There was little allowance in the market for oil prices to rise above $60 which led to the outsized returns when it did (and to the detriment of those who avoided oil).

2. Overconfidence and Narrow ranges. In Nicholas Taleb's book "The Black Swan" he highlights a study, where students were asked to estimate "how many Redwoods are in Redwood Park, California?" Students would respond with a range between two numbers in which they were 98% confident the answer fell into.

45% of respondents failed. They had used a range that was too narrow due to overconfidence in their ability. These students were the cream of the crop Harvard MBAs.

Our human inclination is to narrow our ranges as we gain more knowledge. The more "expert" we become, the higher our tendency to overstate our abilities, and in turn our ability to forecast. And our propensity to become arrogant can blind us to risks beyond our ability to incorporate them.

In December 2019, we made public a letter to the Caltex board of directors, alongside our valuation range of $20 to $40 for Caltex, in support of the Alimentation Couche-Tard proposal to acquire for Caltex for $38 including the value of franking credits. The board rejected the offer and the chairman noted our valuation range was too wide. Less than 3 months later the shares traded at $20, triggered by the pandemic, and are currently trading at $30 more than 2 years later.

The Merlon Process

We utilise a broad scope of possibilities when evaluating companies because it is often the improbable and unpredictable that generates above market returns. It acts to limit our overconfidence in our central case and reflect on what else might go right or wrong.

1. Range of outcomes. We consider all our stocks in a valuation range between the worst and best case long run scenarios. This holistic view considers scenarios in addition to our central case, the skew in outcomes and the materiality of payoffs.

2. Long term. We mitigate possible recency bias by observing a long history (usually 10 years) and capturing a spectrum of business performance over time instead of over-emphasising the latest result. 

3. Downside protection. We define risk as the permanent loss of capital in the long run. We consider "what happens if we are wrong?" and open a discussion on downside risks often dismissed in a precise thesis. This degree of downside is explicitly factored into our level of conviction and portfolio weights.

4. Conviction. Cheap stocks are usually cheap due to valid concerns. We look for an explicit view, contrary to consensus. Has the market narrowed its expectations too finely (see overconfidence, above), thereby dismissing any chance of improbably good news? Alternatively, is it leading us into a value trap by missing meaningful tail risks?

To our clients and prospective clients, it can be difficult to admit that we may not know how the future might unfold. Will COVID be permanent? How will we be using the internet in the future? Will interest rates return to higher, more normal, levels?

In this regard we are more aligned with John Maynard Keynes' view that "it is better to be approximately right than precisely wrong".

Two years into COVID-19 the future is no less clear than when we started. This does not mean we fly blindly but rather undertake deep fundamental research to prepare for the possible outcomes. By factoring in best- and worst-case scenarios and being humbly introspective in our forecasting ability, we strive to tilt the odds in our favour.

Written By Joey Mui, Analyst/Portfolio Manager

It didn't start out this way intentionally but at Equitable Investors we have developed a habit of kicking off each monthly update of the Dragonfly Fund with a quote that resonated or was reflective of that point in time. We find wisdom, common sense and inspiration in many places - not just in the words of the investment greats. From Ron Barron to ron Barassi, the words we drew on for the 12 months of calendar 2021 follow.

January 2021

"Stocks that have a well-recognised brand, or a well recognised story have seen unprecedented buying relative to the rest of the market... this leaves an opportunity for investors that are willing to go the extra mile in researching stocks." 

― Fabiana Fedeli, Fundamental Equities Outlook Q1 2021, Robeco

February 2021

"We should be careful to get out of an experience only the wisdom that is in it and stop there lest we be like the cat that sits down on a hot stove lid. She will never sit down on a hot stove lid again and that is well but also she will never sit down on a cold one anymore"

― Mark Twain

March 2021

"To make money in stocks you must have "the vision to see them, the courage to buy them and the patience to hold them. Patience is the rarest of the three." 

― Thomas Phelps, 100 to 1 in the Stock Market

April 2021

"The game of life is a lot like football. You have to tackle your problems, block your fears, and score your points when you get the opportunities."

― Lewis Grizzard, Don't Sit Under The Grits Tree With Anyone Else But Me

May 2021

"We're guessing at our future opportunity cost... But if we knew interest rates would stay at 1%, we'd change. Our hurdles reflect our estimate of future opportunity costs." 

― Charlie Munger

June 2021

"There are pockets of what look like appreciable over-valuation and pockets of significant undervaluation... we can find plenty of names to fill our portfolios" 

 ― Bill Miller, Miller Value Partners

July 2021

"Those explorations required skepticism and imagination both. Imagination will often carry us to worlds that never were. But without it, we go nowhere. Skepticism enables us to distinguish fancy from fact, to test our speculations."

 ― Carl Sagan, Cosmos

August 2021

"If the Chairman of the Federal Reserve with all the data and tools at his disposal couldn't predict what the 'market' would do, it was unlikely others could either. Which made us focus on investing in well managed, competitively advantaged, growth businesses...not the 'stock market' "

 ― Baron Funds founder Ron Baron

September 2021

"There are two ways you can get yourself revved up - fear of failure and love of success. Personally, I like both things to be working in you, the same as you can win a game at one end of the ground and save it at the other."

― Melbourne Football Club legend Ron Barassi.

October 2021

"Many people believe that investors must make the macro decision to be either bullish or bearish. Our preference is to be agnostic, objectively finding absolute bargains... we are neither bullish nor bearish. We are value-ish."

― Baupost Group founder Seth Klarman

November 2021

"Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves... In trying to time the market to sidestep the bears people often miss out on the chance to run with the bulls."

― former American fund manager Peter Lynch 

December 2021

"Most market commentary is focused on... 'expiring knowledge'. This is the headline news that fills our screens today, which in five and 10-years' time we will look back on and realise didn't actually mean anything from a long-term investment perceptive."

― Paul Black, WCM Investment Management

Portfolio Manager Ofer Karliner, outlines why listed infrastructure and utilities stocks rallied in the fourth quarter, the likely recovery in airport assets, why high carbon scores can be a misleading guide to ESG risks for infrastructure stocks, and why, even if interest rates rise, the infrastructure portfolios still comes with diversification, inflation protection, capital growth and yield benefits if the universe is defined correctly. 

In the current market environment, investors are faced with the challenge of finding attractive current income solutions that offer protection from rising interest rate risk, particularly as many traditional fixed income strategies (proxy: Bloomberg Barclays Global Agg) have suffered negative monthly returns in recent months. Meanwhile, the potential for bouts of volatility is increasing amid rising inflation concerns. To solve for this conundrum, we seek to unearth investment solutions offering higher yields and diversification for Australian investors within the defensive part of their portfolios, and what we view as the more senior, high quality segments of the corporate debt and alternative credit markets; we call it the "sweet spot" of credit. This encompasses a $5.7 trillion¹ opportunity set across U.S. and European loans, corporate bonds, and alternative credit markets.

Importantly, we believe a dynamic, flexible approach to investing in the "sweet spot" of credit offers:

1. Strong diversification benefits due to varying risk return profiles and low correlation to traditional fixed income and equities
2. Opportunity to generate alpha while mitigating risk by shifting targeted exposures through active portfolio management as value shifts between markets can generate attractive entry points into each asset clas​​​​​s 

To illustrate the challengses that traditional fixed income investors are facing today, as well as the relative value opportunities available in the corporate debt and alternative credit markets, Chart 1 plots the current yield against interest rate duration for various fixed income asset classes. The size of the bubbles represents the market value of each asset class.

With the outlook of a low default and higher rate environment ahead, we believe certain higher beta, floating rate instruments, specifically bank loans and CLO debt securities, screen attractive from a relative value perspective as they provide high levels of current income and low duration of less than one year. In a rising rate environment, the coupon of floating rate assets adjusts to shifts in short-term interest rates, and as a result, these assets exhibit lower price volatility relative to fixed rated securities.

Looking forward, while we anticipate increased price volatility and dispersion in the credit markets as interest rates and inflation remain at the forefront of policy decision making, we view bank loans and CLO debt securities as attractive allocations within fixed income as we expect retail and institutional demand to remain robust. Additionally, we believe valuations will be supported by strong fundamentals and improving credit metrics, low default expectations and robust capital markets.

Across our multi-asset credit portfolios, including the Ares Global Credit Income Fund ("AGCIF"), we seek to find the most attractive relative value opportunities in the "sweet spot" of credit in order to deliver higher yields with optimal downside protection and lower volatility. Specific to AGCIF, performance has benefited from tactical asset allocation and credit selection, as illustrated by its annualized since inception net return of 9.2%.² In addition to weathering varied market environments, we believe AGCIF is particularly well suited to serve a growing appetite for stable incoming-producing strategies among Australian investors as it targets a per annum distribution of 3%-4%. Further, the current ex-ante volatility of AGCIF averages approximately 0.5×2 the volatility of the broader bank loan and high yield bond universe, illustrating our keen focus on downside protection and volatility management.

Active allocation has proven paramount in successfully navigating the volatile market environment during 2020 and remains critical to unlocking value, particularly as market conditions evolve heading into the end of 2021 and early 2022. Informed by quantitative analysis and fundamental research, our demonstrated ability to express relative value across the credit markets continues to drive strong and stable monthly performance year-to-date, as illustrated in Chart 2.

In summary, as investors seek attractive income solutions in today's market environment, many may struggle to determine how best to position their credit exposure in order to maximize yield and mitigate risk. By accessing the "sweet spot" of credit, comprised of corporate debt and alternative credit asset classes, we believe investors can overcome these challenges. At Ares, our differentiated approach to capitalizing on the best risk-adjusted return opportunities across the investable universe is rooted in the scale and integration of our Global Liquid and Alternative Credit strategies, which allows us to fully leverage extensive research capabilities, proprietary technologies and longstanding relationships.

Written By Teiki Benveniste,  Head of Ares Australia Management

Broad trends are quite often easy to identify but what is much harder to do is identify specific industries and companies that are going to economically benefit from these trends and deliver compound annual returns for shareholders over the long term.

Genomics or heart disease? 

A key insight from Insync's work on the ageing population is the projected rate of growth in the 70-75 age bracket. This is the fastest growing five-year age bracket for all people over the age of 55 for the next 15 years and beyond. The proportion of people of this age that develop heart related issues are astronomical. 

In 2017, of all deaths for people over the age 70, 43% were caused by cardiovascular disease. This is 2.6x the number of the next largest cause of death which is cancer. A major issue for this age cohort is that many patients are unable to undergo open heart surgery as the risks are too high for many.
 
The Heart - an age-old problem where the demand is accelerating

The heart is a highly focused organ. It has just one job to do, and it does it supremely well. It beats. Slightly more than once every second; that's 100,000 times a day and as many as three and a half billion times in a lifetime. It rhythmically pulses to push blood through your body and recycle it. And these aren't gentle thrusts, they are jolts powerful enough to send blood spurting up to three meters if the aorta is severed.

Advances in medical procedures for the heart has been one of the success stories of modern medicine. The death rate from heart disease has fallen from almost 600 per 100,000 in 1950 to only 168 per 100,000 today. As recently as 2000, it was 257.6 per 100,000. Yet it is still the leading cause of death. In the United States for example, more than 80 million people suffer from cardiovascular disease. 

The cost to the US alone of treating heart disease has been put as high as US$300 billion a year. If left unchecked cardiovascular disease costs are projected to exceed US$1 trillion by 2035 according to the American Heart Association.

The combination of a rapidly ageing population and the escalating burden on healthcare systems allow companies that are treating heart disease to be significant economic beneficiaries. A market that is already very large today will become significantly larger and at a faster rate in the decades to come.

In comparison to surgical procedures, TAVR has a higher survival rate (99%), lower rate of stroke, bleeding, and other complications. General anaesthesia is not necessary in the procedure and most patients leave after just an overnight stay. This provides a significant cost saving as hospital surgery, anaesthesia and costs of stay are significant burdens to healthcare systems.

It takes time for the right company to appear. 

Like many new and exciting technologies, it has taken time. Over 15 years in fact, for the market to start adopting TAVR to a level where the companies pioneering the technology become highly profitable and industry leaders. 
Insync's record of successfully investing in Megatrends matches a combination of high and accelerating adoption rates, with a leading player beginning to dominate in one of its primary business sectors. This results in businesses which are both highly profitable and can grow sustainably at high levels over extended periods of time. 

Insync's investment focus is on both Megatrends and profitability 

Many healthcare and innovation investors have focused on genomics and gene editing. After all, it's emerging and exciting- the possibilities are immense. 
Insync however considers this technology to still be in the 'hype phase' of its investment cycle. The pathway to identify future profitable winners is still highly uncertain and that adds significant risks to investors. Investing in the innovative treatment of the heart is a more assured way to grow your wealth (and health).
Not all innovation however leads to profitable growth in a company. Having the right methods to then assess which company, if any, can harvest a Megatrend and possesses the right financial and market position is equally as important. Simply holding a 'sector bet' across many stocks (e.g., with a passive ETF) in a sector such as healthcare presents additional and heightened risks, that Insync investors do not have to bear. 

Written By Michael Collins, Investment Specialist

A year ago, I wrote an article in The Australian which set out the factors I thought would make it a very good year for equities. So far, the local market has behaved as expected - despite all the turmoil in the world - with the All Ordinaries up 13.6 per cent for the 12 months to 31 December 2021. Looking ahead, I think markets will continue to reward investors, particularly those who invest in quality businesses.

Significant price moves are always determined by the magnitude of surprise. The bigger the surprise, the bigger the move. And so, in the absence of a black swan - something completely unexpected - market returns will be determined by earnings growth. And, completing the idea, the best returns will come from those companies whose earnings grow faster than currently anticipated.

For those who believe the market will crash, it is worth remembering such events are typically triggered by the unexpected, the black swan. Those who profited greatly from the Global Financial Crisis were so few and far between a book was written about them. The logic on which they established their trades at the time of the crash was not widely known. When the idea a large cohort of subprime borrowers might be unable to make their first loan repayment was published, it was not widely embraced as a market catalyst. Generally, it won't be what we already know that brings on a correction.

For now, we can probably rule out a correction from inflation or the current Omicron strain of COVID-19 because there are as many adherents of these ideas as there are detractors.

Most of the headlines warning inflation isn't transitory cite manufacturers and retailers who state emphatically prices aren't coming down. But that isn't tantamount to accelerating inflation. It just means there will be no deflation. If US inflation this year is seven per cent but next year 6.5 per cent, the retailers and the manufacturers will be right - prices aren't going down. It is also true however that price increases are decelerating and that's called Disinflation.

Disinflation, when it coincides with economic growth, is historically very good for equities, especially growth equities. Innovative companies and those with pricing power, which tend to be those with sustainable competitive advantages do best in a disinflationary economic expansion. Read any of our documentation and you will find we have always preferred businesses with sustainable economic advantages because it is these companies that produce attractive returns on their equity.

Supply chain bottlenecks have impacted almost every corner of commerce and while these bottlenecks remain, inflation will be elevated. Our channel checks of impacted businesses, which include wholesalers, hospitality and retailers, digital, healthcare, IT and advertising, suggest the bottlenecks are lingering. And while that is true it isn't tantamount to further acceleration in the inflation rate.

With respect to the inflation discussion, I currently believe only a surprise acceleration would be negative for the market in aggregate. Even fears of such an acceleration won't cause a crash because those fears have persisted for a year now. And don't forget inflation has surged without crashing the market.

Following the virus, I believe, is more imperative than following inflation.

A new definition for fully-vaccinated is emerging - three doses. On that definition, about one per cent of the world is fully vaccinated, including me. Of course, that means plenty of opportunity for variants to emerge. Understandably, Main Street is worried a variant emerges, able to undermine the current crop of vaccines. Trading at near record highs, market prices suggest such an outcome is not anticipated, so such a development could be an unmitigated disaster.

As investors we do have to keep a close eye on the progress of COVID-19.  Transmissibility appears to be increasing with each variant. The original variant had a basic R number of about three, followed by Alpha, estimated to have an R0 of 4-5 and Delta, with an R0 of 6-8. Omicron appears to be even higher. Measles has an R0 which has been estimated to be as high as 18 and is therefore one of the most infectious human-to-human diseases. COVID-19 may yet have a long way to evolve. Such developments aren't being widely discussed, so it is these developments, investors should be tracking closely.

But of course, through every crisis the highest quality companies, by definition, have fallen less and then rallied first and fastest afterwards.

I suggest the same pattern will emerge during and after the next crisis.

Take a look at the Buy Now Pay Later (BNPL) sector. We have warned investors about this space since 2018.  Describing the players as nothing more than factoring businesses we pointed to three things that investors were missing or deliberately ignoring:

1. Factoring businesses make frightfully thin and unattractive margins,
2. The BNPL companies would be unable to accelerate their growth without rising dilutionary capital or debt, and
3. US based companies not even operating in Australia were falling over themselves to list in Australia, suggesting the prices investors were willing to pay here were out of sync with the rest of the word and therefore a bubble.

Since we published those many warnings, Afterpay is now down about 49 percent from its 2021 highs and the rest of the field has fallen a minimum of 70 percent from their highs.

Investing in quality, avoiding the rubbish and not jumping at the shadows that are already a part of the investment landscape are the keys to navigating markets and it will be no different in 2022.

There is the ever-present risk of a 10-15 percent correction but in the absence of a COVID-19 Black Swan, I think investors have little to worry about in 2022. Indeed, if disinflation also emerges, we may just find markets record another strong year. And longer term (sooner if international borders open to migrant workers), I currently expect we will return to structurally lower wages growth and therefore structurally lower inflation and interest rates. All very positive for markets.

Written By Roger Montgomery

Like any fund manager a life settlements fund has a team of specialists and an asset to analyse and purchase to maximise return. 

It must be understood that the market is tiny where only 3,200 life insurance policies came onto the market last year in the USA. Given the surrender rate of several hundred thousand each year, it is a small number. A lot of people don't often know what a valuable asset they have paid for over many years and simply let them close down. 

People buy insurance to protect a family or a mortgage debt in the event of untimely death but once the family has grown up and left home and the house paid for, the need for insurance has gone. Typically the insured will contact the insurance company and just accept the contractual surrender value. Some will instead speak to their agent and learn that there is a chance of a far greater cash sum by selling the policy to an investor. In this instance the agent will contact a Licensed Broker whose job it is to represent the seller. He will prepare a file which will include all the policy details and arrange for the insured to have a medical examination the results of which will be provided to one (or more) of the actuarial firms that provide a Life Expectancy (LE) for the individual where the LE is a number usually given in months. 

It is worth making the point that the LE is not the month in which the insured is expected to die but rather the midpoint on a probability distribution curve where of 1,000 people of the same age and gender and with the same health issues, 500 are expected to die before the LE and 500 after. The file is then sent to Licensed Providers in the U.S. who are the only people legally able to buy an insurance policy from an insured and who represent the investors who are typically managers; an auction process follows. 

The managers have a great deal of certainty around many of the metrics of the asset; the death benefit is known; the premium costs are known and the credit risk is immaterial; the only thing that is not known is the maturity date. Managers do have the LE which has been provided by the actuarial firms that service the life settlement market and can have access to the medical records but most simply rely upon the LE. 

It then remains for the manager to choose what discount rate to apply to the cashflows (given the assumed LE) and to make a bid for the policy on that basis. The market usually trades policies where the purchase price assumes a projected internal rate of return (IRR) of between 12% and 14% (though there is wide dispersion around this range) and on this basis the purchase price offered is usually around four times more than the contractual surrender value offered by the insurance company. 

Most middle-class Americans do not have sufficient assets to fund a comfortable retirement, let alone pay for all the medical and care costs that might be anticipated. Selling their life insurance contract, rather than surrendering it to the insurance company, in many cases makes a very significant difference to the quality of their lives going forward. 

If the LEs were right and were in fact the mid-point of the mortality curve then the manager could rely upon the law of large numbers, buy lots of policies and expect gross IRRs across the portfolio to be 12% to 14%. The asset is very expensive to track and fund costs are correspondingly high so management fees and fund costs will reduce this gross return by 4% or 5% leaving a net-to-investor return in this situation of 7% to 10%. 

Most managers and investors do rely upon the accuracy of the LE and the law of large numbers. However, if instead of 500 dying before the LE and 500 after what happens is that only 450 die before and 550 die after, then the LEs from which the policies were purchased and the portfolio was valued are wrong and where the gross projected IRR was 12% to 14%, the gross actual IRR turns out to be 8% to 10%, with a corresponding net-toinvestor return of 3% to 6%. 

It is obvious that you can test the accuracy of LEs historically, but how can you be sure if forward-looking LEs are accurate? 

Consider this: With a probability distribution curve over a large population, for any given LE it is possible to predict how many deaths the portfolio would experience each year with a high level of statistical confidence. So, even though the LE has not yet been reached, deaths should already be occurring and the number can be compared with those expected. If the actual number of deaths is (statistically significantly) less than expected, the LE is too short and should be pushed out to fit the early years' experience. 

History has shown that the LEs provided by the actuarial firms have been and continue to be too short and consequently investor expectations have not been met. If a manager is able to construct a portfolio where half the insureds die before the LE and half afterwards then the gross projected IRRs are preserved and this is the focus of the Laureola investment approach. 

The six actuarial firms that provide LEs to the market have strengths and weakness across different illnesses and clusters of illnesses. This fact is known qualitatively by all the participants in the life settlement market, including the Licensed Brokers who first bring the policy to the market. It should be no surprise that the Brokers choose the shortest LE available because this pushes the price (and their commission) up. 

Laureola's four-person investment team spent two years analysing the strengths and weaknesses of the LE providers and has a much better understanding quantitively of how short or long they are with respect to various health conditions. Additionally, Laureola has a medical and scientific advisory panel which reviews the LE in the light of current research. Areas of expertise of the panel include heart disease, circulatory disease and cancer - illnesses which account for the death of two thirds of American citizens. For example the heart specialist (who is working on the leading edge of new treatments for heart disease and has several patents for medical devices) might advise the investment team that there are treatments being developed which might prolong the life of a particular insured with heart or circulatory problems beyond current estimates, in other words that he/she is more likely on average to live beyond the given LE than die before; this would be a reason not to buy this policy. 

Or in the case of a cancer patient, the Chief Scientific Officer might advise the investment team that a particular insured with a particular from of cancer with particular features and at a particular stage is more likely on average to die before the given LE which would be a reason to consider buying the policy. 

It is not enough just to buy cheap policies (as measured by the discount rate) because the real value is extracted from this asset class by choosing policies which mature before the LE; all the value of a cheap policy is lost if the insured lives too long past his/her LE. The added value of the Laureola investment team is its focus on the mortality of every single policy in the portfolio. 

Once a policy has been purchased and is held within the portfolio, it needs to be understood that the health of the insured might worsen or improve over time, affecting its value within the portfolio. Changes in the health of the insureds is critical information for an investment team focussed on the mortality of every policy. Most managers outsource what is loosely referred to as "tracking" to third parties where the information sought is when there has been a death. 

Laureola carries out the tracking function internally with a team dedicated to forming relationships with the insureds. In the case where the health of an insured has improved, for example by surviving cancer, the team will quickly learn about it and although the improvement in health and life expectancy is to be celebrated, the mortality of the policy has worsened from Laureola's standpoint and the policy has become an underperforming asset. In these circumstances, the investment team is likely to consider selling the policy to another manager. Policies are valued very conservatively within the portfolio and Laureola's experience is that in those circumstances where they have sold policies they have done so at a price higher than the prices marked on the book, thus making cash profits on the sale. 

Laureola Advisors is an established boutique manager in the life settlement space with a 9-year track record (and only 2 negative months). Over 80% of Laureola's published returns are realised gains, i.e. profits from death benefits or policy sales. Returns which are derived from mortality secure the non-correlation sought by many investors. 

It takes a 12-person team to run Laureola's life settlements operation because the qualitative input requires time and expertise alongside the quantitative analysis to maximise returns.

Written By John Swallow, Director of Investor Relations