There is a long held ideal that when investing in equities, the level of volatility is correlated to the return; the more risk you put on the table the greater the return you expect to get back. Of course, the amount of time invested also needs to be considered, but for investments over 3 years (and beyond) this ideal is generally accepted, as evidenced by the number of scatter graphs used in fund marketing material.

Volatility is managed by fund managers in several different ways, but generally it comes down to portfolio construction. The number of stocks in the portfolio, the size of the position held in each stock (and sector), and the buy and sell triggers, all affect the volatility of the portfolio.

Typically, the funds management industry uses Standard Deviation as a measure of volatility. Standard Deviation measures the dispersion of monthly returns both above, and below the average monthly return. The smaller the funds standard deviation, the less volatile it is. The larger the standard deviation, the more dispersed the returns are and the more volatile it is.

But does this show through in data, and is past volatility any sort of indicator of how a manager should have performed?

We have looked at the returns and standard deviation over the past 3 and 5 years of all Long Only Australian Equity Funds (107 funds) on the www.fundmonitors.com database and broken these into quintile rankings. The funds with the best performance fall into the 5th quintile (best) and funds with the lowest standard deviation fall into the 5^th quintile (best).

Looking at the data over 3 years as at the end of May 2021:

• Of the 22 funds that made up the 5^th quintile for performance, only 9 of them were in the 1^st quintile for standard deviation, showing that strong performance does not require higher standard deviation.
• One of the funds in the 5^th quintile for performance was also in the 5^th quintile for standard deviation and 4 of the funds were in the 4^th quartile for standard deviation.
• At the other end of the spectrum, only 6 the funds in the 1^st quintile (22 funds) for performance (worst performers) were in the 5^th quintile for standard deviation showing that standard deviation and return are not correlated over this timeframe.

Running the data over 5 years shows that standard deviation and return become slightly more correlated:

• 12 of the 19 funds in the 5^th quintile for performance were also in the 1^st or 2^nd quintile for standard deviation.
• For funds in the 5^th quintile for performance the average 5-year performance was 16.14% p.a. and the average standard deviation was 19.03% p.a.
• For the funds in the 1^st performance quintile the average 5-year performance was 6.48% p.a. and but the average standard deviation was quite high at 15.27% p.a.

Clearly, while there is some minor correlation in this data, the ideal of using standard deviation as a measure of manager skill, especially in isolation, is not a prudent investment conclusion. Investors and advisors should be looking at multiple risk data points such as Sharpe Ratio, Sortino Ratio, Up and Down Capture and Downside Deviation, to help them make the most effective investment decisions.

The value creation that Private Equity can bring to businesses, by contributing expertise across strategy, M & A and process enhancement is well documented and particularly applicable to private family or founder owned companies. This value creation comes when growth is accelerated through customer expansion, operational efficiencies are improved,  cost are reduced,  IT systems are implemented and additional talent is employed.  In an analysis of the US Private Equity mid-market, Adams Street Partners found that over 70% of value creation either came from revenue growth or multiple expansion largely as a result of business process enhancement, as opposed to value growth through financial engineering or debt leverage, which is often the perception of how value is created.

What is possibly more important but less well-documented is the value that is created through the "art of the exit": being able to determine the right time to sell and identifying the best method of selling a company to maximise investor returns. 

There is a common misconception that the primary source of equity release or exit from a private equity fund's portfolio comes from an Initial Public Offerings (IPO) and listing on a public share market, which was predominately the case in the late 1990's and early to mid 2000's where there were a number of high profile Private Equity IPO exits that generated significant returns for private equity investors.

However, there are at least three main methods of equity release that Private Equity fund managers consider when planning to exit a business, often years in advance of the actual exit outcome:

1. IPO: by listing a company on a public exchange, a seller can often achieve an optimal pricing outcome by removing the discount that is typically applied to unlisted business valuations.  Further premiums can be achieved by listing when equity markets are more buoyant making timing an important decision.  As attractive as IPO's may seem, one drawback to an IPO as the primary source of an exit for Private Equity backed businesses is that IPO windows, that is those periods where public investor appetite exists to buy new listing opportunities, can rapidly close and we have seen this occur recently with a number of high profile IPO's being withdrawn due to a reduced level of support from brokers and their clients.  Another drawback can be that after listing, sellers need to retain equity in the listed company which introduces market risk that is not desirable for most private equity investors.
2. Trade sale: Selling to a larger or listed company often in the same industry sector who may be looking to expand their existing operations to other geographic regions or to add to their existing product or service offerings.  These exits can attract premiums in situations where the purchaser is listed and trading at a higher earnings multiple thus gets an automatic uplift through multiple arbitrage.  Alternatively, there are private buyers who may be prepared to pay a premium for a business that provides a strategic platform to launch a new growth initiatives.
3. Secondary Sale to a global private equity fund or institutional investor: These exits often occur where an acquirer is looking to either achieve a long term yield on the dividends from an acquired company or otherwise seek to expand the existing companies offerings to an expanded global market.

Private equity managers add significant value when it is time to sell / exit a portfolio company by allowing the company's executives to remain focussed on growing the business while the private equity managers utilise their expertise to pinpoint the right method and time to achieve the best price for the sale of the business.

In this article we will look at examples of some recent exits from the Vantage's Private Equity Growth Fund portfolios (VPEG2 & VPEG3) to illustrate how Vantage's private equity managers are able to generate significant returns for Vantage Fund investors:

1. IPO: Lynch Group

During April 2021, VPEG2 underlying fund Next Capital Fund III, completed the fully underwritten bookbuild for the IPO of portfolio company Lynch Group. Lynch Group successfully listed on the ASX on 6 April 2021, raising ~$206 million at $3.40 per share. The transaction followed a transformational investment period for the Company across the 5.4 years of ownership by Next Capital.

ynch Group has evolved from predominantly an Australian supermarket wholesale business with a fledgling growing asset in China, to the largest Asian vertically integrated grower and multi-channel wholesaler of cut flowers and potted plants across Australia and China. Next Capital sold ~50% of the fund's shareholding into the IPO. The remaining ~17.0% holding will be in escrow until release of Lynch's audited 1H FY22 financial results in March 2022. This IPO exit delivered Next Capital Fund III and its investors, including VPEG2's investors a strong multiple of invested capital.

2. Trade Sale: MessageMedia

During June 2021, Vantage's VPEG2 & VPEG3 underlying funds Mercury Capital Fund 2 (MCF2) and Fund 3 (MCF3) announced the sale of MessageMedia for USD$1.3 billion (AUD$1.7 billion) to Sinch, a leading global cloud communications business listed on the Nasdaq Sweden. This exit marks an excellent investment for Mercury Capital Fund 2 and Fund 3 and is representative of the strong partnership that Mercury formed with the founder Grant Rule and the management team.

Following MCF2's investment in MessageMedia in August 2018, the business transformed from a primarily Australia and NZ based SMS provider to the leading global Server Message Block (SMB) Customer Engagement platform. MCF3 subsequently made an additional investment in MessageMedia during November 2019, which further supported the business's transformation in rebuilding the management team, consolidating the platform and the successful add-on investment of US-based messaging platform SimpleTexting. Once completed, the sale will deliver MCF2 and 3 investors, including VPEG2 & VPEG3 investors with an exceptionally strong return on investment.

3. Secondary Sale to Institutional Investor: iseek

During June 2021, VPEG2 underlying fund Next Capital Fund III announced the sale of iseek, Australia's leading cloud, Data Centre and Connectivity provider to a UK based Information Technologies and Telecommunications Infrastructure Fund.

Following Next's acquisition of iseek in August 2018, management have heavily invested in the construction of two state of the art physical data centres in Brisbane and Townsville and captured material contract tenders from large state government agencies and tier one corporate clients. These initiatives, along with the industry tailwinds of organisations outsourcing data storage providers, positioned the business to have a strong long-term opportunity set, representing an attractive investment for the international acquirer. The sale of iseek will deliver another robust investment return to Next Capital Fund III investors, including VPEG2 investors.

All three of these transactions will result in excellent performance outcomes for our investors.  In fact, across the June 2021 quarter, five underlying company exits were either completed or announced from Vantage Fund portfolios. These exits will deliver Vantage's Funds an average gross 4.9 X return on invested capital, representing an average gross Internal Rate of Return of 73.9% per annum.

MORE EXITS PLANNED FOR THE SECOND HALF OF CY2021

The market environment and economy generally remains very supportive of exits at the moment and a number of other companies across Vantage's portfolios are also positioning for exit across the second half of 2021. As managers across each of Vantage's Funds position each underlying company for sale, the number of exits from each Vantage Private Equity Growth Fund portfolio is expected to increase. These exits will ultimately provide Vantage Fund investors with an increase in returns and further distributions, providing a robust platform for each Vantage Fund to deliver their targeted returns to investors over the term of each fund.

Vantage Private Equity Growth 4 (VPEG4) remains open for investment to new investor until 30 September 2021.

Please click below to access further information about VPEG4

A few weeks ago, I hosted some teenagers from an East London school on a (virtual) visit to learn about the investment business. In search of common ground, we focused on environmental, social and governance (ESG) questions and had an interesting exchange on climate change, sweat shops and overpaid bosses.

We also discussed the difficulty of deciding how a company stacks up on its ESG credentials. To help us along, I asked them to look through a sustainability lens at the websites of Tesla, Boohoo and BP and to review the recent news flow. Their conclusions were not what I predicted.

Needless to say, all three companies have had ESG challenges along the way so it seemed a fair question to ask the students which they would score most highly from a sustainability point of view on their day as a pretend investment analyst. To cut a long story short, they all singled out BP.

I had expected Tesla's electric vehicle story to put it on top, especially as the visit pre-dated the company's recent bitcoin embarrassment. But while they were all over Boohoo's employment record, what really caught their attention was the oil major's description of its clean energy ambitions. All credit to BP's comms, but it was not what I expected.

It's good to get out of the investment bubble where ESG is an article of faith and into the real world where these issues are just one among many. That's true whether you are still at school or the boss of a quoted company, as a recent sustainability-focused survey of our actual investment analysts confirmed.

What is abundantly clear from this global snapshot of 150 researchers, and the thousands of companies they follow, is that ESG as an investment approach is new, fragmented, complicated and inconsistent.

There are huge variations in how companies view sustainability and in how investors are attempting to measure it. The absence of common standards is glaring.

Focusing in on climate, some of the findings are unsurprising. Some sectors are well on the way to a new and cleaner world. Utilities represent an obvious green investment opportunity as the proportion of renewables rises. The energy sector, on the other hand, is more notable for its risks as fossil fuels are phased out and companies are left owning worthless stranded assets. Industrials sit in the middle, with clear opportunities to benefit from the climate transition but major risks too in the form of tighter regulation, disrupted supply chains and old-world legacy businesses.

What is also evident is a yawning gap between the parts of the world where the environmental challenge is well understood and factored into long-term business plans and the places where it is not. More than 70pc of analysts in Europe think companies have the right plans in place to decarbonise by 2050. In Latin America, Eastern Europe, the Middle East and Africa that proportion falls to a big round zero. American and Chinese companies are notable laggards on this front too, although the latter are starting to catch up fast since President Xi's adoption last year of a 2060 net zero target.

A couple of significant problems emerge from the survey. The first is that companies have been slow to link executive pay to real achievement on reducing emissions. Only a third of companies do this and only half expect their boards to demonstrate a focus on ESG more generally. Without financial incentives, sufficient progress is unlikely.

Secondly, while companies are increasingly keen to talk about ESG and sustainability, there remains a woeful lack of the internationally agreed standards that would enable investors and consumers alike to scrutinise their claims. Interestingly, in some countries like Japan, there are as many companies understating their progress in this area as over-inflating their achievements. The problem is bigger and more nuanced than greenwashing.

There's no shortage of regional standards being developed but none has yet gained any traction on a global scale. Until Europe, Asia and the US talk the same language about ESG, employ the same taxonomies and implement the same criteria to decide what is and what is not sustainable, we'll all be flailing around trying to make sense of different reporting frameworks, or worse, no reports at all.

One further problem is the clumping together of environmental, social and governance factors under one sustainability umbrella. It is too easy for companies to trumpet progress in one area while quietly glossing over their lack of interest in one or both of the others.

The solutions to the problems in each of these areas are different too. Driving change on the environmental front is most effective when governments are engaged via regulation and financial incentives. Consumers have more power when it comes to social issues. Investors have long recognised that they may be best placed to encourage progress on governance through engagement, votes or, more crudely, divestment.

Perhaps the real conclusion from all this is that, quite rapidly, ESG investing is becoming just plain investing. Companies that rate highly on the imperfect and inconsistent sustainability measures that we currently have perform well in stock market terms because they are, quite simply, better companies.

It makes sense to work towards common standards for fair comparison, but I suspect there will always be an extensive menu of these, not a single aggregate number for every company. Environmental, social and governance factors are just too varied to be corralled into one framework in the way that a company's income statement and balance sheet have been by the adoption of standardised accounting principles.

While we're working out how to measure sustainability ourselves, perhaps we could do worse than getting the kids from Tower Hamlets in to surprise us.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 ("Fidelity Australia").  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International.

© 2021 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity International and the Fidelity International logo and F symbol are trademarks of FIL Limited.

Fifty years ago, General Property Trust (GPT) listed on the ASX. In so doing, it changed the lives of income investors for good.

Since then, Australia has become a global leader in listed commercial property. Local and offshore investors have been attracted to the relatively high income of AREITs and their competitive, risk-adjusted returns.

Then came Covid and an altogether different environment tailormade to tarnish the sector.

The mighty Westfield had put Australia on the map as a global retail real estate leader but also gave us one of the highest exposures to retail real estate in the world. Within a few days of lockdown, shopping centres were empty with the enforced switch to online seeing several years of growth compressed into a few weeks.

In offices across the country a similar shift was taking place. Having prevaricated for years over the pros and cons of working-from-home, managers and their staff were surprised at how smoothly and quickly the transition occurred.

These factors were the writing on the wall for the AREIT sector. Having reached a high over 64,000 in late February 2020, the ASX300 AREIT accumulation (total return) index fell 37% in March as investors tried to comprehend the implications of the unknown. Shopping centre stocks were amongst the hardest hit, notably the large mall landlords Scentre (down 55%) and Vicinity (down 52%) as investors panicked around whether their shopping centres would ever re-open.

ASX300 (Equities) vs AREIT300 Accumulation Index

Source: APN Property Group, S&P

The forlorn outlook many experts predicted back then hasn't eventuated, with Australia's largely successful control of the pandemic getting much of the credit. Those offshore investors that ran for the hills last March have since turned tail, realising Australia was a better place to invest in a pandemic.

AREITs have since recovered significant ground with the vaccine announcement delivering a further boost. Still, the sector continues to trail the broader Australian equity market recovery (refer above chart) which is an opportunity for investors focusing on the long term.

The structural concerns that first surfaced as the pandemic took hold, along with the absence of international tourists and immigration, explain much of the gap. The Government-mandated Leasing Code of Conduct was also a significant burden (not placed on most businesses) for landlords.

The code removed a tenant's obligation to meet contracted rental payments under the lease contract, meaning landlords were having to support their business partner (tenants) which created great uncertainty for investors. As some support is still being provided, this continues to weigh on the sector's recovery.

Thus far, AREIT landlords have provided more than $1b in support under the Code, with almost all of it ( more than 90%) delivered by owners of retail properties (notably large malls).

The unintended consequence is that those businesses most impacted by the pandemic - namely large mall landlords, Scentre and Vicinity - have provided the highest levels of tenant support. The impact on their bottom lines has been pronounced and prolonged.

Where are the opportunities?

While all AREITs have recovered significantly from their March 2020 lows it is in the dispersion of that performance where opportunities lie. Those AREITs currently trading well below their pre-pandemic 2020 highs include Vicinity (down 40%), Scentre Group (down 34%) and GPT (down 27%) all of whom were burdened with additional Covid impacts (Lockdowns and the leasing Code).  These names will recover, providing solid returns to investors focused on the long term.

However, as always, there's a caveat. AREIT performance is inextricably linked to the Australian economy. On that score, the ongoing recovery will be boosted by six factors:

1. a return to the office will assist struggling CBD retail as foot traffic rises;
2. price growth in residential property and ongoing construction will boost retail, especially DIY and homeware categories and improving consumer confidence. Consumers' willingness to spend, a key plank in the path for a return to pre-Covid life, should gather pace;
3. the vaccine roll-out will further lift business and consumer confidence;
4. the return of international tourism, potentially exceeding prior levels (revenge travel as consumers look to catch-up), should have a similar impact;
5. as will the return of international students, with residential and retail property clearly benefiting. Overseas students can also help us address current labour shortages; and
6. the return of immigration will be a major economic driver and, as with foreign students, residential real estate will be a major beneficiary, with flow on benefits for office/retail and other real estate sectors.

These factors point to AREITs performing well over coming years. Between 2010 and 2019 AREITs returned 11.6% p.a. (mainly from income). According to UBS data, over the past 20 years AREITs have delivered an average return of 9.6% a year, including an average distribution yield of 6.9% p.a. The income investors received is almost 50% higher than equities over this period.

This is a key takeaway for income investors - it is the income component of AREIT returns that is the most predictable. With the recovery underway, investors can again expect to rely on it.

The risks

The major risks to the AREIT sector concern all those factors that may apprehend the economic recovery. Inflationary pressures that may result in higher interest rates, damaging the wealth effect, the continued slow pace of vaccine rollout and more damaging mutations should all be considered. While inflation has become a growing concern across financial markets, it could see more investors turn to commercial real estate which has leases that have inflation linked or fixed rental escalations providing a level of protection that other asset classes cannot provide.

And there remain unknowns in the office and retail sectors, although in our view these are diminishing each day. In sticking to high quality, well-located properties with premium tenants, as APN Property Group likes to do, these risks can generally be offset.

Three major trends

1.  The benefits of funds management earnings to AREIT growth

In recent years, Charter Hall and Goodman Group have grown their funds management operations. Their moves proved prescient. Covid highlighted the reliability of their earnings under significant market stress. As recognised leaders in real estate asset management, the growth in funds management earnings by AREITs is set to continue.

2.  Not all retail is created equal

Large malls with heavy exposure to discretionary retail suffered from lockdowns and reduced foot traffic while non-discretionary convenience centres underpinned by supermarkets thrived. Large format retail (LFR) centres, meanwhile, fed our demand for homewares, electrical, furniture and everyday needs. A recent LFR transaction occurred at a 50% premium to the December 2020 valuation. Post-Covid, most assets will continue to deliver healthy income but investors should remember not all retail is created equal.

3.  Say hello to new commercial property asset classes

Already, there are two listed Childcare (or social infrastructure) REITs with more to come. Hotels (pubs) and primary produce is another sector getting attention from commercial property investors with FY21 seeing a record year of transactions. Service stations assets also deliver bond-like returns but with growing income, underpinned by high quality tenant covenants and strong investor demand (2020 saw a record level of transactions) with the added benefit of alternative use potential (when electric vehicles dominate our roads). The future AREIT index may look more like its US counterpart, where commercial property investors can add healthcare properties, life science and government buildings and even mobile phone towers to their portfolios.

This article has been prepared by APN Funds Management Limited (ACN 080 674 479, AFSL No. 237500) for general information purposes only and without taking your objectives, financial situation or needs into account. You should consider these matters and read the product disclosure statement (PDS) for each of the funds described in this article in its entirety before you make an investment decision. The PDS contains important information about risks, costs and fees associated with an investment in the relevant fund. For a copy of the PDS and more details about a fund and its performance, visit our website at www.apngroup.com.au.

At midnight a couple of days ago the FDA announced the approval Biogen's Alzheimer's drug aducanumab.

Usually when a drug is approved it's cause for celebration, the culmination of perhaps decades of academic and clinical work. The moment is hugely meaningful for patients, doctors, and their families. 

Not in this case. The FDA's independent scientific panel and own statisticians concluded this drug had no measurable effect. 

Aducanumab was tested in two well designed Phase III trials. They were double-blind, placebo-controlled, dose-ranging, and most important of all, with thousands of patients around the world, they were large enough to power a result. If this drug had any significant effect, it had plenty of opportunity to show it.

Instead, the trials were halted early for futility and the drug caused dangerous brain swelling in some 40% of recipients. Which makes the decision all the more surprising. 

When China and Russia announced they had coronavirus vaccines, the world ignored them and looked to the FDA. This is the institution that stood alone against thalidomide. And this week it approved a drug with no evidence of efficacy. 

Biogen tortured the data, mixing patients from one study where the drug had a marginal benefit, with the other, that showed a marginal decline. This sort of post-hoc data mixing to prove a point is a statistical crime.

The FDA didn't approve on this sketchy basis, but rather because the drug cleared amyloid beta plaques. And it was on this, rather than Biogen's shonky data manipulation, that the drug was approved.

Long-time readers will know that we share the increasingly common view that amyloid beta hypothesis is flawed as:
1) every drug that clears amyloid beta fails to show any clinical benefit (there have been many), and
2) many people die naturally with plenty of amyloid beta in their brains, but never get Alzheimer's. 

A hypothesis that actually fits the medical data is that amyloid beta is an effect, not a cause.

The situation is worsened by Biogen's commercial cynicism.

Analysts coalesced around a $10k annual cost estimate for the drug, with the highest at $25k. Biogen has stated they will charge US$56k pa, for a chronic disease that lasts years. 

The FDA asked Biogen to conduct a confirmatory study to prove the drug's effectiveness.

Biogen promptly announced they complete this trial in 2030, giving almost a decade to sell a dangerous, useless drug... and that's before the inevitable delays. We can be sure this study will be done as slowly as possible.

The FDA made a similar call with Sarepta, approving a drug against their own expert advice, on condition of a confirmatory trial. Five years later, the trial has not been done. Why would any company pay money to kill their golden goose?

In another Biogen-friendly curiosity, the FDA approved the drug for all Alzheimer's patients, not just those with early stage disease or with particular biomarkers. There are over 5 million Alzheimer's patients in the US, so the cost of this could exceed US$100 billion a year. That is enough to move the needle on the entire US medical system. This decision could blow back hard onto the pharmaceutical industry.

As one of our advisors put it, it will be quite some time before the full ramifications become clear. 

Recently there has been a flurry of research into alternative theoriers that fit the data, offer new clinical targets, and in early stage trials have demonstrated a clinical effect. We have small investments in two of these. The FDA's decision will starve these alternative approaches of oxygen. The rational move for every company with a failed beta-amyloid drug is now to resurrect it.

Patient advocacy groups, weaponized by Biogen, have something to answer for here.

The correct approach would have been to allow Biogen to conduct a further study, if they so wished, to prove the drug worked. 

It's early days, but this looks like the biggest scandal in pharma since Valeant and Bill Ackman's corporate skullduggery led to the methodical axing of R&D departments several years ago. Three members of the FDA's advisory panel have already resigned in protest. 

In Biogen, a new corporate villain has been born.

Disclaimer

The information in this note has been prepared and issued by Frazis Capital Partners Pty Ltd ABN 16 625 521 986 as a corporate authorised representative (CAR No. 1263393) of Frazis Capital Management Pty Ltd ABN 91 638 965 910 AFSL 521445. The Frazis Fund is open to wholesale investors only, as defined in the Corporations Act 2001 (Cth). The Company is not authorised to provide financial product advice to retail clients and information provided does not constitute financial product advice to retail clients.

The information provided is for general information purposes only, and does not take into account the personal circumstances or needs of investors. The Company and its directors or employees or associates will use their endeavours to ensure that the information is accurate as at the time of its publication.  Notwithstanding this, the Company excludes any representation or warranty as to the accuracy, reliability, or completeness of the information contained on the company website and published documents.​

The past results of the Company's investment strategy do not necessarily guarantee the future performance or profitability of any investment strategies devised or suggested by the Company.​

The Company, and its directors or employees or associates, do not guarantee the performance of any financial product or investment decision made in reliance of any material in this document. The Company does not accept any loss or liability which may be suffered by a reader of this document.

We have seen a range of increasingly interventionist monetary policies unleashed over the last 20 years, and we're now solidly onto the next version. This one will be loose money and loose fiscal. Should be fun, as long as you are prepared for inflation. 

Inflation is now here. It really never went away. Hedonic methods of calculating what was already an imprecise gauge of price changes, have obfuscated, and of course lowered, the official figures. If you wish to see what pre-hedonic calculations would have gauged inflation levels to be today, check out the two charts below on inflation as per the 1990 methodology and the 1980 methodology. Both are by courtesy of shadowstats whose authors provide a plethora of 'real' economic data. www.shadowstats.com

We now actually have an admission of sorts that inflation is here and, woops, higher than promised. Don't wait for any apology. There won't be one.

https://www.zerohedge.com/markets/yellen-admits-inflation-about-soar-says-it-will-be-plus-society

To be fair it's not entirely the current Administration's fault. The asymmetrical approach to interest rates, inflation and sound money in general, started with 'Maestro' and has snowballed since.

Nonetheless a perverse sort of Gresham's Law is applying here - bad policies continue to drive out good. Inflation is the new good thing, and we should welcome it. Yet as Ronald Reagan said in 1978, "Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man."

Memories indeed are short. We are potentially near the end of the liberal era of economic policy with which Regan and Thatcher were associated. Prepare for more government, more rules, and different risks.

Since none of us is going to be in charge of macro-economic policy (at least anytime soon) and we have to invest to maintain our spending power in real terms, against this backdrop of understated inflation and carefully massaged negative real interest rates, how should we proceed?

The answer is to invest in certain equities which are better inflation hedged and which simultaneously provide a better hedge against risk of catastrophic corporate failure.

Do not ignore equities even if you are at an 'advanced age'. Conventional wisdom states that the allocation to fixed interest should rise as you get older. A rule of thumb is that you should have your age as a % in fixed income. So, at 60, you should have 60% in bonds. At current levels of interest rates and inflation, this will almost certainly guarantee an erosion in real purchasing power. Don't do it!

Inflation and corporate failure hedges

Two dimensions should be used to assess which are the better equities to currently overweight if you wish to buy inflation protection. One is Governance as in the 'G' in "ESG" (We think ESG is still improperly used); the other is sector membership and the stability of revenue growth and asset base. Both have an impact on returns, downside protection and survivability.

Below we show how and why better Governed companies have a better survival rate and thus should have a lower discount rate applied to their dividends. These companies are still currently undervalued.

We then show that in the last 40 years, the risk of catastrophic loss in certain USA sectors has been much greater in some than others. Any investor with a time horizon beyond 5 minutes should thus weight their equity exposure to companies in these sectors.

We have written before on ESG and why we think G is relevant as a risk factor but not necessarily as an alpha factor. We show again below the wide range of ESG cores from different ESG ratings agencies, courtesy of Northfield. No alignment here which implies there is no single ESG standard that can be applied.

This article provides a recent assessment of ESG scores and how they are barely useful. https://www.ipe.com/viewpoint-why-companies-and-investors-must-leave-esg-ratings-behind/10053120.article

Nonetheless, good G as measured by its impact on corporate financials, IS useful. Sensible leverage, correct levels of re-investment, and staff retention are all part of any Fundamental or Qualitative assessment in deriving the correct discount rate to apply to a companies' future earnings. Good G can justify lower discount rates through higher survival rates, and thus lower risk.

Below is some analysis of the performance of high G companies in a crisis. Think of it as built-in downside protection to favour high G companies.

Sector membership matters too with respect to survival rates. Most companies do not last. Many companies fail and will continue to fail. Go back and watch any sporting event from 40 years ago. How many of the companies on the advertising billboards are still around today?

What really hurts compounding of returns is a catastrophic loss of capital; it only takes a few stocks to seriously fall for the poorly designed portfolio to suffer serious damage. So how to avoid this risk, and not expose your wealth to risk of failure? Check out the table below drawn from Factset and Refinitiv data.

So, a 70% decline in price aka catastrophic loss, hurts 40% of all listed USA stocks. However, some sectors have historically seen more casualties than others.

If you wish to be safer, especially at this juncture, then look within Utilities, Consumer Staples, Financials Materials and Industrials. By market cap these comprise much less than half of the stock market so active management will prove its worth here.

Companies meeting these two criteria of good G and sector membership, are priced and behave as "index linked corporate bonds". In this regard they are unique. They provide a decent yield compared to the pitifully low or even negative rate on 'safe' government bonds and the current yield on index linked bonds, which of course is negative; AND they offer a measure of hedge against inflation since equities are a claim on nominal growth which conventional bonds are not. Index Linked bonds do provide a hedge against inflation but with negative yields, they are expensive. Buying an index linked bond with a negative yield of 1.5% and not a utility company with a dividend yield of 4% is giving up annually, a 5.5% return.

Equities we own which meet these criteria are in the Global Listed Infrastructure Strategy and the Global Equity Strategy. They include AES, Quanta Services, Johnson Controls, OneOK, Enbridge, Terna, ENEL, Rubis, General Mills, Kroger, Iron Mountain, ENN, Hydro One and Verizon.

We view this as getting a yield in line with corporate bonds, AND the index linking of an inflation proof bond. These companies will have a greater chance of survival in the long run if history is a guide.

The chances of a macro policy misstep are now high, so this is the time to be thinking about survivor strategies.

Here is a slide of returns over the last 18 years accruing to equities, government bonds, infrastructure equities and blends of each. Even during this period of 'growth' equity excitement, one didn't lose out too much by having exposure to defensive stocks in sectors with high chances of surviving a shock.

Currently therefore we are overweight Utilities, Infrastructure and Industrials. Given their superior survival characteristics, their lower P/E multiples and higher dividend yields they look attractive. Add in the likely buying frenzy to be unleashed as other investors scramble to get behind the newly discovered infrastructure spending plans in the USA and Europe, the best place to have risk would appear to be in these companies rather than the now very vulnerable to regulation, non-tax paying, non-voting share class issuing, expensive stocks of yesteryear.

The great thing about the stock market is that complacency, one trick ponies, and luck, get found out over time. Betting on price momentum with an absence of thoughtful, rigorous, analysis on valuations, risks, and portfolio construction tools and without any knowledge of long-term history, is a disaster waiting to happen.