Damen Purcell, COO of Australian Fund Monitors, speaks with Richard Ivers from Prime Value Asset Management about the Prime Value Emerging Opportunities Fund.

Since inception in October 2015, the Fund has returned 14.86% p.a. against the Index's annualised return over the same period of +9.64%. The Fund's Sortino ratio (since inception) of 1.27 vs the Index's 0.74, in conjunction with the Fund's down-capture ratio (since inception) of 45.74%, highlights its capacity to significantly outperform in falling markets.

Funds operated by manager: Prime Value Emerging Opportunities Fund, Prime Value Equity Income (Imputation) Fund - Class A, Prime Value Growth Fund - Class A, Prime Value Opportunities Fund

Australian Fund Monitors' CEO, Chris Gosselin, speaks with Charlie Aitken from AIM Investment Management about the AIM Global High Conviction Fund's recent and long-term performance.

The AIM Global High Conviction Fund is a long-only fund that invests in a high conviction portfolio of global stocks. The Fund has achieved a down-capture ratio since inception in July 2015 of 81.83%, highlighting its capacity to outperform when market's fall. The Fund has outperformed the Index in 7 out of 10 of the Index's worst months since the Fund's inception, further emphasising its strength in negative markets.

The Case for Asian Equities

Australian Fund Monitors

09 March 2021

Asia represents nearly one-third of global GDP, but Australian investors continue to allocate a relatively small amount towards Asian equities.

We believe there is a case to be made for investing in Asian equities, noting there has been a belief that Asian markets are potentially more volatile and are therefore riskier.

However, for the two years to 31 January 2021, Asian markets performed more strongly than the Australian and global markets. 

AFM's Asia Pacific ex-Japan benchmark returned 16 per cent for the two years compared to 13.5 per cent for the Global Equity benchmark and 9.9 per cent for the ASX 200 Total Return benchmark. 

The standard deviation for the Asian benchmark was also lower than both the global benchmark and the Australian benchmark with volatility of 11 per cent, 12.1 per cent and 20.2 per cent respectively. 

The maximum drawdown for the ASX 200 Total Return benchmark was -26.8 per cent compared to -7.89 per cent for the Asia Pacific ex-Japan benchmark. The maximum drawdown for the global market was also comparably large at -13.2 per cent.

Looking at actively managed Asian equity funds, seven of the 24 Asian equity funds on AFM beat the index. 

On average long-only funds performed marginally better than long/short and market neutral funds over the last two years. However, the absolute return strategies performed better in the last 12 months. 

Funds with a high exposure to India had struggled to add value, versus the overall Asia Pacific ex-Japan index, while the two funds on the AFM database that focus on China returned 24.5 per cent and 2.67 per cent for the two years. 

Asian equity funds have an average correlation of 0.51 to the ASX 200 Total Return benchmark and 0.5 to the Global Equity benchmark, highlighting their potential to provide good diversification.

Damen Purcell, COO of Australian Fund Monitors, speaks with Jonathan Wu, Executive Director at Premium China Funds Management.

Premium China was started their first fund in 2005 and have grown to offer 4 actively managed specialist Asian equity and fixed-income funds to both Australian and New Zealand investors. Their Premium Asia fund, which was started in 2009 has returned 12.97% per annum since inception outperforming the Asia Pacific Ex Japan benchmark by over 8% per annum.

Funds operated by manager: Premium Asia Fund, Premium Asia Income Fund, Premium Asia Property Fund, Premium China Fund

How will the recovery influence risk and returns?

Mark Burgess, Chairman of the Advisory Board at Jamieson Coote Bonds

As the macro risks associated with COVID-19 have loomed over global markets and economies for almost a year now, changing expectations of the shape and strength of the recovery will be important in influencing returns and volatility for 2021. We recently sat down with Mark Burgess, Chairman of the Advisory Board at Jamieson Coote Bonds to discuss this and other important issues on investors' minds.

Navigating the economic recovery

This recovery is unique as we've seen one of the most dramatic interventions in markets in history, to the credit of central banks and governments who took immediate action last year and we are now beginning the see the consequences of that. Will it take traction in the economy? How will the virus develop? These are critical issues which are raising serious question marks about the style and nature of the recovery. Financial markets are looking through this - at some of the beneficial aspects of low rates and at the rising liquidity aspect of central bank intervention. The economic environment is rather unclear, relative to financial markets, which are taking a forward looking view.

Inflation risks on the rise

I'm always reminded of what I believe is the right approach to risk and look to a range of scenarios, such as economic growth. Inflation should be one of those scenarios. How does inflation play out? Is it a rising risk? We're likely to get an uptick in inflation as the year-on-year comparisons turn positive. There are a couple of factors that have helped keep inflation low in the past, such as globalisation, that appear to be changing and therefore the ability to keep inflation at low levels is changing at the margin. On the flip side, we have very slack labour markets, we have an output gap that's quite wide, and at these low interest rates, capacity can be added quite quickly across the world. With this in mind, my expectation is that perhaps inflation will uptick but we're unlikely to get the kind of embedded or serious inflation that we saw say in the 1970s. Competition caused by excess investment as a result of low interest rates could cause deflation in parts of an investor's portfolio, and the inflation-deflation combination should be assessed across the assets that go into a well-diversified portfolio. Watch the video to hear more.

Constructing fixed income allocations - the risk of chasing yield

Yields are going to be low generally and the most important risk is not to chase yield for yield sake. If you're chasing yield with risk attached to it, those risks will be lurking in the background more over the next two to three years than they have in the past. As bond yields are marginally moving back up, they're getting ready to be a defensive asset again. Markets are experiencing this combination where yield is becoming available in some places and in other places there's certainly a lot of competition for yield. Investors should be cautious as risk attached to yield is one of the most important things to watch out for. We've long advocated this; one example is separating corporate credit from high grade sovereign bonds. High grade government bonds provide safety, while corporate credit will have other risk and return characteristics. Most importantly, as we come out of the COVID-19 environment, we'll find out which corporates are safe and which are in good shape as we see that part of the cycle play out.

"The most important risk is not to chase yield for yield sake."

The important role of high grade government bonds in diversifying some of the unknown risks that remain

High grade government bonds were defensive during the downturn, playing the important diversifying role that they have always played in portfolios. As government bonds edge slightly higher again, they will provide that defensive characteristic and diversification within a portfolio. We believe they will always be a good asset to hold. Australian investors haven't held a large position in government bonds historically, and a key lesson from the events of last year proved the diversification characteristics of the asset, at a time where diversification was difficult to find. There are a couple of other places to find diversification, but high grade government bonds are certainly one component of that. Watch the video to hear more.

Why this fuel source could knock battery power off its perch

Matthew Fist, Portfolio Manager, Firetrail Investments

19 February 2021

The hype around hydrogen is heating up. Hydrogen has been used as an alternative energy source since 1807. But higher costs, transportation and storage difficulties have restricted its use over the past 200 years... Until now!

The urgent need to curb climate change, declines in renewable energy pricing, and changes in supply/demand are creating new opportunities for hydrogen as a viable alternative energy source. While the range is high, medium-term forecasts point to hydrogen demand growing around ten-fold. In this monthly insights piece, we discuss the implications for investors and why Fortescue's former CEO Andrew "Twiggy" Forrest (and also Firetrail) are getting excited about the opportunities that will arise for Australian investors over the next decade in alternative energy sources

The hype around hydrogen

Last month, Forrest used his second Boyer Lecture to make the case for green hydrogen as the solution to reaching net-zero emissions. He also highlighted Fortescue's plan for a hydrogen-powered 'green steel' plant in the Pilbara. Elsewhere, US President Joe Biden signed an executive order on his first day in office recommitting the US to the Paris Agreement, and all signs are that he will push ahead with the stated target of 100% clean energy in the US by 2035. Closer to home, Australia's Prime Minister Scott Morrison has shifted his stance, stating that the nation's goal is to "reach net-zero emissions as soon as possible, and preferably by 2050".

Hydrogen is the most common element in existence, making up 75% of the universe by mass. It is almost 1 million-times more abundant than fossil fuels, is highly combustible, and only emits water when burned. 

Perhaps of most interest is the energy density of hydrogen. The combustion of one kilogram of hydrogen produces more than three times as much energy as one kilogram of diesel! In a hydrogen-based economy, so the story goes, "green hydrogen" produced using renewable electricity could be used in place of fossil fuels that currently provide around 80% of global energy and are responsible for the bulk of emissions. But there are drawbacks. Hydrogen is currently expensive to produce and difficult to store and transport.

Back to 1807

The first internal combustion engine that used hydrogen as fuel was constructed as far back as 1807. Similarly, the potential for hydrogen to replace coal as a means of electricity generation emerged in the 1860s. This leads us to the most obvious question - is it really different this time? The case for the 2020s being the decade where hydrogen finally fulfils its long understood potential rests on two key premises:

Curbing climate change. Meeting the climate targets of the Paris Agreement dictate decarbonisation across all areas of economies, not just electricity generation. This includes 'hard to decarbonise' sectors such as shipping and steel production that contribute a significant level (around 11% combined) of global emissions. Due to the chemical properties of hydrogen, it is uniquely suited to provide a solution to many of these sectors. In other words, to curb climate change, hydrogen can be used to decarbonise parts of the energy system that electricity cannot reach.

Falling cost of electricity. Historically, potential use cases for hydrogen have been made impossible by the sheer amount of energy required to produce the gas from water via electrolysis. Recent enthusiasm has, in part, been driven by continuous declines in renewable pricing, with current projections indicating that renewable energy prices of around $10-20/MWh (where hydrogen becomes an attractive proposition) will be common over the next decade. 

Ultimately, for green hydrogen to fulfil its promise, both demand and supply sides of the equation must come together. Supply must be provided in suitable quantities at a cost that competes directly with incumbent technologies and other new green solutions. Similarly, on the demand side, technology must be developed and refined such that green hydrogen can replace current processes.

Supply

The economics of the conversion of energy into green hydrogen depends primarily on:

• the quality of the renewable resource,
• the cost of the renewable generation asset, and
•  the cost of the electrolyser that converts electricity to green hydrogen. 

Solar is an abundant resource when compared to all other forms of both renewable energy and fossil fuels, as can be seen in Figure 3. In Australia, because of our massive share of solar energy and large landmass, just 0.13% of land area would be required to provide enough energy to cover all our energy requirements. Many studies have been undertaken on the likely trajectory of solar and hydrogen production, with most predicting price parity with fossil fuel derived hydrogen gas between 2030 and 2050, broadly equivalent to the current cost of gas in many developed markets and a price that could see uptake across a range of industries. Importantly, Australia is forecast to be one of the lowest-cost producers of hydrogen.

Demand

While the supply side of the hydrogen equation and cost trajectory is relatively well understood, the same cannot be said for demand. Various studies on pathways to decarbonisation suggest hydrogen's long-term share of energy supply could be as high as 30%. Most estimates, such as those forecast by BP and Bloomberg, fall in the order of 15-30% by 2050. 

At an industry level, there is significant debate about the suitability of hydrogen from both an economic and technological perspective. Consider, for example, passenger vehicles. Hyundai and Toyota are both due to start around 20-unit hydrogen fuel-cell fleets in Australia by the end of March. At the same time, Volkswagen concluded last year that "everything speaks in favour of the battery and practically nothing speaks in favour of hydrogen". Elon Musk calls the fuel cell-powered cars "fool cells".

Two areas of consensus on the demand side for hydrogen centre around long-duration backup power for renewable-based grids and the production of steel.

• Power. Hydrogen has a unique ability to provide reliable, long-duration power to stabilise grids reliant on intermittent renewable sources. Hydrogen can play a role in the grid by providing large amounts of energy over long time periods, which is simply not feasible with battery solutions or pumped hydro storage solutions. Green hydrogen is an attractive proposition for storage where excess electricity generation (for example in the middle of the day) is produced at nil marginal cost.
• Steel. For Australian investors, one of the most topical areas is the potential for "green steel" made from hydrogen. Steelmaking generates around 8% of global emissions, and for the most part, the process from which steel has been manufactured has stayed the same for over a century. Iron ore is smelted in a blast furnace with coke, (derived from coal) leaving behind pure metal and emitting carbon dioxide. By contrast, direct reduced iron (DRI) can use hydrogen, rather than coke as the reducing agent, and instead of carbon dioxide, only water is emitted. The Pilbara region of Australia has been slated as a potential green steel and hydrogen export hub given access to iron ore, sunlight, water and Asian customers

The market opportunity for investors

While the range is wide, medium-term forecasts point to hydrogen demand growing around ten-fold. As Forrest put it in his Boyer Lecture, Australia's "characteristic good luck" extends to hydrogen. Given Australia's natural solar resource endowment and proximity to Asian markets, it is only a matter of time before small-cap investment opportunities arise. Australia's 'good luck' is not lost on large corporates - companies such as Woodside (ASX: WPL), Incitec Pivot (ASX: IPL) and APA Group (ASX: APA) are all actively investing and exploring potential opportunities. 

Conclusion 

More than 200 years since it was first used as a source of fuel, the hype around hydrogen is growing. Improving economics and an increasing focus on curbing climate change is creating new opportunities for hydrogen as a viable alternative energy source. On the demand side, medium-term forecasts point to hydrogen demand growing around ten-fold, paving the way for future investment opportunities for Australian companies, entrepreneurs like Andrew Forrest and investors like Firetrail.  

An Extraordinary Scam that is Netting Millions

Romano Sala Tenna, Katana Asset Management

19 February 2021

In 30 years following markets, I've seen a lot of scams. But the current one is the most dangerous yet, and people we know and care about are going to lose money unless we warn them.

Two weeks ago a Melbourne-based friend emailed me. His closest friend's 68-year-old mother, who happens to be disabled from a stroke, had recently inherited $300,000. Using www.compare-investments.com.au, they checked for a rate better than the 0.4% on offer at the bank.

After completing an enquiry form, they were soon emailed a "prospectus" from a global bank. This offered 4.56% for one year, 5.49% for two years right up to 9.21% per annum for 10 years.

My friend asked me what I thought. The 23-page prospectus looked professional and completely consistent with genuine documents from the global bank in question. But as I later discovered, key pieces of information were doctored, including the phone number, email address and of course the bond rates.

As I read the prospectus, my first impression was that the rates looked really good! Good, but not ludicrously high enough to raise my suspicions. And with the apparent backing of a big bank brand, it seemed like an option worth considering.

But timing is everything in the markets. And fortunately for my friend (and unfortunately for the scammers), literally 24 hours beforehand, I had received an email from the head of fixed interest at Bell Potter Securities, warning of high yield bond scams.

An exchange of emails confirmed that this was indeed a scam.

If this unfortunate lady had proceeded, her application form and 100-point identification check would have provided the scammers with all the information they needed to steal her identity. Worse still, if she had transferred money, it would have been directed to a false bank account and then very quickly skimmed off-shore; never to be returned.

I'm not too proud to admit that, if not for that email the day beforehand, I would not have realised this was a scam. And if a professional money manager doesn't immediately recognise an investment scam, what hope is there for the average citizen?

Most Scams Are Easy to Spot...

Such scams usually have one or more of the following traits:

• dubious introduction - often cold calling or spaml
• unbelievable returns
• capital guarantees
• unknown brands and amateur marketing materials (often with poor grammar and typos)
• off-shore contacts - commonly from Hong Kong or Eastern Europe; my favorite one last year was a 'financial adviser' in Estonia offering a special deal only to close associates, to which I was graciously included despite having never met him 
• deadlines - pressure to act quickly or miss out; this last trait is perhaps the most tell-tale of all scams. 

...but not this one

Several factors, alongside the impressive but "realistic" returns - especially over one- and two-year terms - actually further suggested the authenticity of this scam, including:

• The brand was a tier-one globally recognised bank.
• The marketing materials were professional and consistent.
• The pathway to the scam - via a comparison site - appeared legitimate.
• The capital guarantee was in fact there, but not immediately obvious.
• And the contact details were for a Sydney CBD number.

As an aside, when I phoned that number it went through to an after-hours voice recording. But earlier in the week I actually got through to a lady with an Australian accent, who definitely did not work for a tier-1 global bank!

We are in an especially dangerous time for scams, and it is not just because of the pervasive reach of technology. The even bigger issue currently is that because cash rates are so low, many mums and dads - who have often only ever used bank deposits - are now looking elsewhere.

Scammers are becoming increasingly clever and more resourceful, and it has never been quicker or easier to enact a scam than it is today. This scam was certainly deceptive, but you can bet even more sophisticated scams are close behind. We need to ensure that those most vulnerable are not defrauded.

Simple steps to protect savings - yours or others

I think most scams can be avoided if the would-be victim follows three simple steps:

1. Never feel rushed - take your time and independently verify the offer. If you're pressured to act quickly, it's almost certainly a scam
2. Only use a licensed financial adviser - and check every financial decision with them. We are blessed in this country that we have a strong regulatory framework that licenses and monitors financial advisers; you can check to see if someone is registered at https://moneysmart.gov.au/financial-advice/financial-advisers-register.
3. Watch for above-average returns or a capital guarantee - every scam must offer something that you can't get elsewhere, or you won't take the bait. Even this scam offered rates (on the five- and 10-year bonds) that in hindsight were too far above market. It also offered a capital guarantee, which only very specialised institutions can do, and only on low-risk, low-return products.

Further Steps if You Have Time

There are some additional things to look for:

• The ACCC runs the SCAMwatch website, which provides information to consumers and small businesses on how to recognise, avoid and report scams. This website is good if no other reason than it highlights the breadth and depth of scams operating. However, it can take time to update; for example this current scam has been operating for weeks and it is still not listed on the website.

• Check the purported issuer's website to see if there any alerts about imposter scams and check the contact details, branding and current offers. Once gain this should not be solely relied upon.

As a final point, take the time to report any scams to SCAMwatch. The short time it takes to fill out the form may very well save someone else's life savings.

Please Warn Anyone You Care About

I have been following financial markets for 30 years, and this scam passed my radar. If a seasoned market follower can be fooled, then anyone can. Our only defence is to warn those we care about.

The Art of Selling

Lawrence Lam, Lumenary Investment Management

23 February 2021

When we think about investing, we always think about buying. We spend enormous amounts of time forecasting the future, distilling vast stores of information into one single click of a green button. But what is commonly overlooked, is the other side of the equation - selling. It remains the poor cousin of buying, yet it shouldn't be. Selling is as important to investing as braking is to driving. Selling at the right time is just as important as timing on the entry. Yet all too often, investors only know the accelerator and gloss over the analytical framework of selling. In doing so, they give up much of the hard work they have put in to establish the buy thesis.

In this publication I will share my insights from the perspective of a global equities investor who has made misjudgements when selling and what I've learned from the mistakes of others and my own.

Why are institutional investors so bad at selling?

It may surprise you to know institutional investors do not have an edge when it comes to selling. Recent researchers studied the outcomes of selling decisions and determined there was substantial underperformance over the long-term. So bad were the selling decisions they even failed to beat a random selling strategy. These weren't retail investors. The study looked at portfolio managers with an average USD $600 million size. The outcome? They still failed to outperform a simple randomised strategy. 

But why are institutions so bad at selling?

Poor selling hurts returns more than you think

Without an analytical framework for selling, investors use mental shortcuts which are susceptible to behavioural biases and lead to inconsistent results. Poor selling can hurt you in two ways. First, you can sell out of a great company too early. The seed of a Californian redwood tree is only a tiny speck yet it has great potential beyond its appearance. Dispose of those seeds and you end up missing out on a giant.

Second, a weakness in your selling process can lead to prolonging a losing investment far too long. Our cognitive biases can shroud our judgement. We can become committed to a previous decision and fail to see how changing circumstances no longer make an investment worthy of our portfolios.

The psychology of selling

Inspecting my own game, I came to realise the importance of a strong short game to complement my long game. By 'short' I mean selling stocks you own, not short selling (which is selling what you don't own). Most fund managers only focus on their long game and disregard the short (I suspect this is also true of their golf). The research supports this. Professional investors are able to outperform through stock selection and buying, but many underperform when it comes to selling decisions. 

But why? Buying and selling are simply two sides of the same coin. If one can make good buying decisions, why does it differ so much when it comes to selling?

Use heuristics with caution

Recall earlier I introduced the term 'mental shortcuts'. In psychology, these are known as heuristics. They're good for simple decision making, but detrimental when it comes to complex analysis required in investing. Without a system of thought when selling, we gravitate back towards a structureless approach. And this is where it can go wrong for many investors. Even at the institutional level, cognitive biases creep in. Research found the most common being:

• The disposition effect: a reluctance towards selling losers, and inclination to selling winners.
• Overconfidence: assuming you will make the right decision to sell without any factual analysis.
• Narrow bracketing: looking at decisions in isolation without consideration for the broader picture. Analysts who focus on one geographic or sector are most susceptible to this.

This makes sense. Most institutional investors spend less time thinking about their selling framework, they are measured for their efforts in buying. Incentives are centred around investment prowess, not divestment skill. I've written previously about how enterprising investors can outmanoeuvre institutional investors here.

Easy come, easy go

From my own experience, I deploy more capital to those investments that I have greater conviction in. The greater weighting reflects my analysis and the velocity which I think returns can be made. This conviction when entering a stock also translates to better selling performance on exit. Another takeaway from the study shows poor selling decisions tie closely with low conviction investing. Just think about those stocks representing the smallest proportion of your portfolio. These are the stocks you are most likely to make bad sell decisions with.

Knee-jerks that hurt

One of the main reasons institutional investors make bad selling decisions is because they react to price movements. All the fundamental analysis done when deciding to buy is not mirrored when they sell. Instead, sell decisions are either automatically triggered via stop losses or to capture recent gains. Either way, basing selling decisions purely on price is what leads to underperformance. To counter a pure price focus, the questions investors should focus on are:

Have business prospects fundamentally changed for the future?

Are customers migrating away from this industry?

Does the company still retain its competitive edge?

It's that time of year

Following closely behind automated selling strategies are the financial calendar trades which occur when professional fund managers decide to sell for no other reason than to realise taxable losses or crystalise their gains as they massage their financial year end results. Annual bonuses drive selling decisions which are proven to underperform in the long-term. From the portfolio manager's perspective, it may not matter if they are rewarded for these decisions so long as they achieve their end of financial year KPIs.

Knowing these weaknesses is one thing, mitigating them is another. It is only once these issues become known that addressing them becomes possible.

Incentives that create value

The single hardest and simplest correction for most investors is to align your long-term incentives with your selling strategy. If your investment strategy is long-term and you want to compound your investments, then set up a framework that rewards careful, fundamental analysis before selling. I've written about this previously here. The same questions when buying should be applied to selling. Here is where private investors have an in-built advantage over institutions - they innately possess the flexibility and natural incentive to perform over the long-term; ignore the arbitrary financial year end distractions and focus on the real fundamentals.

Institutional managers need to think as if they are the largest investor in their fund.

Investing with conviction matters

Dipping toes in waters is not the optimal way to invest. Concentration leads to outperformance as it encourages deeper analysis. Nothing like a big investment to ward off capriciousness. The benefit isn't only on the buy side. The research shows selling decisions benefit too when concentration is higher. Invest mindfully and with meaning. Underperformance happens when you're selling out of a stock you were never that convinced with in the beginning. Easy come, easy go, but you will pay for it when you sell.

Stress and other suboptimal influences

Have business prospects fundamentally changed for the future?

Are customers migrating away from this industry?

Does the company still retain its competitive edge?

The answers to these questions will inform whether you hold or sell.

But as we have seen recently, when you're facing a 30-40% drop in prices, the stomach will take over the mind. Stress sets in, sometimes even panic. This pressure is even greater for institutions who have to report back to thousands of clients. They become price-reactionary. Heuristics invade the decision-making process when time is pressured. Evidence points to the most severe underperformance on sales coming after extreme price movements. Institutional investors are susceptible to mental shortcuts as they tend to use stop-losses, automatic rebalancing to benchmark weighting, and auto profit-taking triggers to simplify sell decisions.

Sell because of changes in business prospects, not because of stock price movements, even if you're under extreme market pressure.

How to use feedback

Institutions spend less time analysing the selling decision. They will meticulously track buying decisions, but they rarely analyse how selling decisions went. A technique I employ to improve selling decisions is to elucidate myself with iterative feedback. Track the results of selling decisions just as you would with buying decisions. Each iteration of feedback informs how a sell decision can be improved for next time. Without it, investors are blind to their own mistakes.

The dangers of commitment bias

Cognitive biases cloud our judgement and none are worse than our feeling of commitment that encourages us to hold onto investments longer than we should. The sell decision is based on logic and business prospects in the future. Waiting for an eventual turnaround is useless if a company's customer base has fundamentally changed, or if its competitive advantages have been eroded by competition. I have scars to show for this misjudgement. Under-selling can be just as detrimental as over-selling.

The evolution of selling

The evolution of any investor understandably begins with focusing on buying, but sophisticated investors that truly understand when and how to sell, transcend into becoming adaptive investors able to compound wealth in any market condition. Adaptive capital is where you ride each wave as it presents itself. To do that, you need to be skillful at braking, not just accelerating.

Happy compounding.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that invests in the best founder-led companies in the world. We scour the world looking for unique, overlooked companies in markets and industries on the edge of greatness.

Disclaimer

The material in this article is general information only and does not consider any individual's investment objectives. All stocks mentioned have been used for illustrative purposes only and do not represent any buy or sell recommendations.

Should equity investors fear higher bond yields?

Andrew Mitchell, Ophir Asset Management

17 February 2021

Investors have been focused on the bond market in recent weeks because they have seen something unfamiliar - rising bond yields. In the first week of January, the US government 10-year bond yield (the rate of interest the US government borrows at) surpassed the psychological barrier of 1% for the first time since the Covid shock began.

Given lower bond yields have been used to justify higher share market valuations for much of the last decade, rising yields could pose a threat to equities.

Some seasoned and sceptical investors have been arguing for years that equity valuations have become dangerously dependent on the persistence of historically low bond yields.

While we don't believe the rise in bond yields is dangerous yet, or reflects the threat of a sharp acceleration in inflation, rising yields will likely be a headwind in gains for equities. And that means that if investors want to generate strong returns from equities in coming years, they will need to focus on stock picking skills.

Why bond yields have been heading higher

Expectations around economic growth and inflation have driven bond yields higher. The emergence of effective coronavirus vaccines has triggered optimism that the global economy will rebound powerfully in 2021. The US Senate elections in Georgia, which handed Democrats control, has also increased the Democrat's ability to drive through a reflationary economic agenda. Yet even as the pandemic recedes, it appears central banks are set to maintain policy rates at or near zero, further allowing inflation pressures to build. This comes as the US Fed, as well as the Australian RBA, want to now wait longer to see actual inflation heading sustainably higher, rather than expected inflation, before they start lifting interest rates.

How bond yields affect equity valuations

Bond yields are an important determinant of equity valuations. When bond yields go down, share market valuations tend to rise ... and as bond yields go up, share markets tend to falter.

The relationship may not exactly hold in the very short-run, but it becomes more clearly visible over longer time periods as can be seen in the figure below (cyclically-adjusted price-to-earnings ratio used a share market valuation measure).

There are three key and interrelated factors that link bond yields with equity valuations:

1. Firstly, bond yields drive the opportunity cost of equities. If, for example, the 10-year bond is yielding 5% per annum, then equities only become attractive if they can earn well above 5%. In fact, because equities are riskier than bonds, investors will demand a 'risk premium' to justify owning them. The long-term average risk premium on equities is 5%. So a 10% return - the 5% investors could get from bonds + the 5% risk premium -- will act as the opportunity cost for equity. Below a 10% return, it makes less sense for investors to hold equities because they are not being compensated for the additional risk. So as bond yields go up, the opportunity cost of investing in equities also goes up, and equities become less attractive.
2. Bond yields also impact the cost of capital in valuing equities. The yield on bonds is typically used as the risk-free rate when calculating this cost of capital. When bond yields go up, the cost of capital goes up. That means that future cash flows get discounted at a higher rate, meaning a $1 of cash flow received in the future from a company is worth less today. This compresses the valuations of these stocks.
3. Thirdly, bond yields impact financial costs for companies. When bond yields go up, it is a signal that corporates will have to pay a higher interest cost on debt. As debt servicing costs go higher, the risk of bankruptcy and default also increases, typically making highly leveraged companies vulnerable.

Good and bad market volatility

Although bond yields do impact share valuations, investors should be more worried about losses that result from a downward revision of a company's earnings potential, than losses caused by an increase in interest rates (all else equal).

The former suggests a market assessment that there is now a greater chance that the business will fail to deliver its expected earnings growth. While losses from increasing rates indicates the adjustment of the rate of discount, without a revision of market views on the company itself.

Indeed, to achieve long-term success, investors should distinguish between good and bad volatility. This is particularly invaluable for private investors who often regard any loss as bad news, when it may be an opportunity to lock in access to higher future income. For example, a move up in bond yields allows investors to buy and lock in future income at a lower cost. That's good news for anyone saving for a pension or an education endowment. For superannuation savings plans, it means that more future pension income can be bought with each new dollar of saving.

Should investors be worried?

The critical question is whether the current move up in bond yields goes beyond a healthy reflation that reflects the post-pandemic economy, and surges into inflation.

Presently markets are positioned for the former: that is, the economy will recover, but inflation will stay under control, and interest rates will remain low. 

Even under this scenario, investors should still factor in that equity valuations are likely to be pressured over coming years as interest rates trend higher. This means that strong equity returns will have to rely more on actively selecting the stocks that can generate sustainable earnings growth, and less on free kicks from falling bond yields and central banks cutting interest rates.

Or in other words, a greater proportion of returns are likely to come from stock picking skill rather than a rising tide lifting all boats (read: companies) in the market.

Why I don't think we're headed for a correction

Roger Montgomery, Montgomery Investment Management

February 2021

Over the last few months, increased risk-taking by investors has led to ballooning prices for loss-making businesses, IPOs in unprofitable firms, and speculative 'assets' like cryptocurrency. This is usually a signal that the market is too hot, and is due for a correction. Is the market at risk of an imminent collapse? 

There's no doubt pockets of exuberance exist. The recent activity in GameStop, the gold rush in electric vehicle and battery makers, and the surge in bitcoin more recently point to some seriously illogical, if not stupid, behaviour. Even in Australia convincing evidence of euphoria exists. The "buy now, pay later" sector here trades on a combined market capitalisation of $40 billion despite the requirement for dilutive future capital raisings to fund book growth and despite generating an annual loss of $82 million.

US-based billionaire futures trader Paul Tudor Jones, recently observed more US companies are currently priced at greater than 100 times earnings than ever before and the number exceeds, by half, those that traded at more than 100 times earnings during the dotcom bubble.

Bubbles deflating in isolation

Despite the clear evidence of bubbles in certain pockets of the market, however, I believe they can inflate and deflate in isolation. Indeed, we have already seen this occur. Last year, Hertz, Kodak and Nikola all rose between 600 and 1600 per cent in just a few months before crashing between 80 to 90 per cent. The bubbles inflated and burst and yet the broader market was uninterrupted. Similarly, the current bitcoin mania can crash without dragging the equity market down. It's done it before. It crashed - falling from nearly US$20,000 in 2018 to $4000 in 2019 - without any impact on the stock market.

Provided the entire market is not in a bubble, and the bubbling assets themselves are not held on the balance sheet of systemically important financial institutions, these bubbles can burst without wiping out the financial system or the returns for sensible investors who refrain from gambling.

What does a high PE ratio mean?

Speaking of the broader market, Robert Shiller's CAPE (Cyclically Adjusted Price Earnings) ratio for the S&P500 currently sits at its second-highest level in 150 years. The only time the ratio has been higher was during the tech bubble in 1999. Some commentators note that the elevated PE ratio is not only a sign of overvaluation but a warning of an imminent crash.  Robert Shiller himself, however, has noted the ratio is an unreliable tool for the prediction of crashes and prefers it to be used to estimate the average annual return for the forthcoming decade - something it is more reliable at predicting. Its lofty status suggests the next 10 years' average annual return for the S&P500 might be in the low single digits.

Of course, whether the market is overvalued or not depends on which measure you use. On standard PE metrics, the S&P 500 is trading at about 22 times predicted earnings for 2021, higher than the long-term average of about 16, but lower than the 30 it reached before the dotcom bubble turned into DotBomb.

25 per cent of the S&P500 is weighted to just six names

And before concluding the market is at risk of an imminent collapse, one must appreciate the fundamentals supporting the constituent companies, remembering 25 per cent of the S&P500 is weighted to just six names -- Facebook, Apple, Amazon, Microsoft, Google and Tesla - known as the FAAMGT stocks. The FAAMGTs are collectively worth more than $US8.1 trillion ($10.7 trillion), and account for almost one quarter of the $US33.3 trillion S&P 500.

For decades Warren Buffett espoused the importance of owning companies able to sustainably generate high rates of return on equity, noting that such performance could only be driven by the presence of a sustainable competitive advantage. Anyone who understands competitive advantages knows the most valuable is the ability to raise prices without a detrimental impact on unit sales volume. With the arguable exception of Tesla, in these monopoly companies inheres the most valuable of all competitive advantages.

Our own analysis reveals these companies to be incredible wealth creation machines. In almost every case their returns on equity are higher today than when they were smaller enterprises. The bigger they get the more profitable they become. Today's internet giants enjoy the benefit of infrastructure, such as computing power and storage, mobility networks and data speeds, that was inadequate back in 1999 when the first internet boom crashed. And there's a long runway for growth ahead.

Growth companies have simply seen more economic value accrue to them relative to more traditional companies with lower valuations, and unless antitrust legislation stops them, more value will accrue to their owners.

So, while the market does seem overvalued overall, there is merit in the idea that the companies driving the market higher have powerful economic moats and are themselves individually inexpensive -- excepting again perhaps Tesla!

Finally, as we discussed here, based on current bond rates (which of course could change - keep an eye out for a steepening yield curve) the Australian market appears to be fairly valued rather than expensive.

The market might be expensive but it is being driven by a serious weighting to companies with highly desirable and prized characteristics. Pockets of irrational exuberance do exist and they're easy to find but they can inflate and deflate without upsetting the rest of the market. And finally unless bond rates start to ratchet up, the market appears to be about fair value.