Global sharemarkets changed direction abruptly in mid-November 2021, with the trigger the 'hot' US inflation reading for October - it rose to +6.2% year-over-year, almost guaranteeing the US Federal Reserve would raise rates to prevent the number going higher (which it did).

It got worse. The Russian invasion of Ukraine put upward pressure on commodities: disruptions in oil, grain, fertilisers and some chemicals added new anxiety to a world still recovering from COVID supply shortages. Indeed, Shanghai remained in lockdown until last month. There is good news in the bad news - rising costs and tight supply are pushing prices to unacceptable heights for businesses and consumers, which of itself is slowing the economy and reducing upward pressure on interest rates.

As monetary policy tightened investors bailed out of cashflow-negative, longer-dated growth stocks. These companies, exposed as they are to an intentionally-slowed economy, declined in value materially. Without profitability today, the market is anticipating that such companies will be forced to find new funding with fresh debt or equity - but of course at significantly higher cost to existing shareholders, which is pushing valuations down further. Sharemarket indices dropped by -20% to -30%, but many former sharemarket stars were down by -50% to -90%. There was safety in quality, relatively, with the Loftus Peak portfolio outperforming the "concept" stocks, as the chart below shows.

The market punished companies that were not profitable

Source: Goldman Sachs, Loftus Peak. Data in AUD, indexed to 100 as at 30/06/21

For the 12 months to 30 June 2022, the value of the Fund dropped -23.3%, with most of this confined to the second half. This was underperformance of -14.7% relative to the benchmark MSCI All Countries World Index (net) as expressed in AUD from Bloomberg. The Fund closed out the month down -6.9% net-of-fees, which was underperformance of -2.1% against the benchmark.

Roku and Netflix, also hit in the second half, were among the worst performers, and cut -3.9% and -3.3% from Fund value respectively over the twelve months. Amazon cut -2.2%, Google -2.1% and Microsoft -1.2%, while AMD's negative contribution was -2.1% with Taiwan Semiconductor (-1.5%) and Nvidia (-0.8%) also off. Qualcomm, the Fund's largest position, cut -3.4% from the value of the Fund.

Streamers unspool

Netflix and Roku are two former market darlings needing neither debt or equity capital but which nevertheless were treated as if they did. The streamers, together, were the largest negative for the Fund in the financial year to 30 June 2022.

And yet it is difficult to find any informed industry participant who does not believe that all TV will be streamed by decade's end. Indeed, in 2022 streaming eclipsed cable TV in popularity across the US , as reflected in the chart below.

Source: Roku Company Filing, Nielsen

That streaming companies, which thrived in lockdowns only to stall when restrictions are lifted, has little bearing on pivotal questions around their room for growth at the expense of linear TV. We believe Roku's and Netflix's penetration has not reached saturation with both having differentiated but solid medium- to long-term growth paths.

Chip stocks weak, for now

The Fund has held investments in semiconductor companies including Qualcomm, Nvidia, Xilinx, AMD and Taiwan Semiconductor over a number of years. We invested because these companies are foundational to the disruption economy, though they do not command the same valuations as software-driven companies such as Facebook, Netflix and Google, which, along with many others, have boomed as applications for the networked, streamed economy were turbo-charged by the smartphone.

But in this tougher economic environment, when growth multiples are under pressure, the semiconductor stocks have provided significant shelter, while the outlook for them has materially improved as their usage, across virtually all industries (either directly or indirectly) increases.

For example, one very important announcement barely noted by financial markets was that Apple had failed to meet the deadline for the 2023 rollout of its own 5G modems in its newest phones. This is important because Apple's failure was preceded just two years earlier by that of the titan Intel to produce the same part - meaning that Qualcomm will continue to be the 5G supplier through 2023.

Qualcomm's technological superiority, coupled with its financial strength, create a formidable moat ensuring growth for several years for its 5G business. We hold Qualcomm not just for the phone business, but for the significant diversification it has engineered relative to its position a few years ago.

Source: Qualcomm Company Filings

Qualcomm's automotive revenues in the most recent quarter were up +61% on the prior year period, as the performance requirements of and higher demand for automobile intelligence is necessitating a huge increase in chip usage. The company's connected IoT (Internet of Things) business was up +41%. Even Qualcomm's 'mature' smartphone business showed growth of +56% year-over-year, driven by its dominance in 5G.

Another of the Fund's holdings, AMD, also has a sizeable moat - built by besting the incumbent, Intel (which the Fund does not hold) in the area of low power, high performance chips for the most discerning of end markets, data-centres - which, according to McKinsey & Co, represent the single largest and fastest-growing end market for semiconductors globally.

Why does McKinsey say this? Because datacentres are the hardware on which cloud computing runs, an evolving megatrend brimming with promise as the convergence point for the miscellany of remote work, connected supply chains, networks and more. These are areas targeted by Taiwan Semiconductor and Nvidia, which have, unsurprisingly, constructed formidable moats of their own, using deep pools of capital amassed by years of excellence in product execution. This is technology and disruption, to be sure, and not the commoditised kind, either.

The Blue Sky in the Cloud

Megacaps Amazon, Google, Microsoft, Tencent and Alibaba form part of the Fund's cloud exposure. It is possible that these cloud businesses may one day eclipse the legacy businesses of their parent companies (especially true of Amazon and Amazon Web Services). Information technology in business globally is moving to the cloud, but it is only a fraction of the way there. Building a cloud business isn't for the faint of heart - it is a scale game requiring tens of billions of dollars of investment.

This has led to a few large players reaping most of the rewards to date, which we expect to continue given the capital requirements. These companies now represent 73% of the global cloud infrastructure market by revenue. Amazon alone accounted for almost half, while Microsoft had the largest market share growth.

Silicon's cousin - the power semi-conductor

Beyond all this, the roll-out of electric vehicles along with increasing use of wind and solar power are driving the development of new specialised componentry for electrification known as power semis, typically silicon carbide. ON Semiconductor is a major player here, and is critical to the supply of componentry that facilitates this power transfer.

How to grow an Apple

Services - not just products - are a keystone of Apple's future growth. The services business, including Apple TV+, Apple Music, Apple Fitness+, Apple news+ and more notched double the annual revenue growth of the products business in the March quarter. One of these services, Apple Pay, is expanding quickly, and only a few weeks ago moved into the buy-now pay later space. The chart below tells the story of Apple's services businesses now accounting for almost 35% of gross profit, compared with 17% in 2016.

Source: Apple Company Filings

Looking ahead

We understand the market's concerns about recession and what that might mean for consumers and businesses. However disruption and the associated long-term secular trends continue through even the worst periods of recession. It is for this reason, along with the quality of our holdings, that we believe the companies held by the Fund are well positioned for any short-term economic headwinds and more importantly, for the medium and long term.

• Nearly half (46%) of advisers aware of Consumer Duty rules will turn to platform providers for implementation support
• Advisers expect Consumer Duty compliance will require procedural changes (54%), extra resource (46%) and pose new costs (44%)
• Meanwhile, advisers highlight knowledge barrier when it comes to the wider adoption of new regulation
• Nearly half of financial advisers aware of the FCA's Consumer Duty regulations will seek implementation support from their platform provider if the rules are introduced, according to new research from abrdn.

Seven in ten (73%) advisers are aware of the proposed regulations, with a quarter (25%) entirely unaware. Awareness is highest among those working in networked firms (75%), and lowest among those at firms with restricted direct authorisation (69%).

If the rules - a final version of which are expected to be published by the FCA in July - were implemented as proposed, nearly half (46%) of advisers with an understanding of the requirements would turn to their platform provider for support with implementing the new rules.

Just over two in five (44%) would rely on internal resources, while a further two in five (39%) would engage their external compliance provider.

When asked about the anticipated impact of Consumer Duty on their firms' own operations, more than half (54%) of advisers expected their organisation would need to make procedural changes to comply.

Just under half (46%) expected their firms would need to take on additional resource to comply - with those working in directly authorised businesses (50%) most likely to expect the need for further hiring.

Meanwhile, just over two fifths (44%) expected to see overhead costs increase. Those in networked businesses least expected to see a financial impact (35%), rising to more than half (51%) of advisers in directly authorised firms.  

Alastair Black, Head of Industry Change, abrdn, said: "Consumer Duty will be a big step change for advisers when it comes into force next year. It's clear that the majority of advisers are already reviewing what it means for their business, and are anticipating the need to change processes, procedures, and even hire, to ensure they are aligned.

"At its core, Consumer Duty is about good governance, which will touch on all parts of firms' operations. With this in mind, it's encouraging to see that advisers will be turning to a range of sources to aid their compliance efforts, including their third-party partners.

"Consumer Duty is essentially advocating good customer outcomes which is already at the heart of everything an advice firm does. So, while it's encouraging to see firms considering its implications, the change may not be as big as some fear.

"However, there are a number of important steps all firms will need to take. For some this will be similar to implementing the SMCR (Senior Managers and Certification Regime) where there was no clear documentation and rationale to follow. For example, there are some elements that may be new for some advice firms, like documenting how they determine their advice service and charge is good value for money.

"The insight, and support, of suppliers - whether its platform technology, or otherwise - that understand the regulations, and what it might mean for individual businesses, will be hugely valuable to delivering the outcomes the new regulation aims to achieve."

As the publication of the final Consumer Duty rules approaches, abrdn's research also explored where firms saw challenges when it came to the adoption of new regulation in general.

Advisers most frequently pointed to a lack of understanding of new requirements as their biggest hurdle (26%), with a quarter (25%) citing the financial pressure of increased overhead costs.

A further quarter (25%) said they lacked capacity within their business to support new regulation's administrative burden, while just over one in five (23%) said they struggled with implementation deadlines being too tight.  

Alastair Black added: "Regulation needs to evolve to ensure that advisers, and their clients, remains supported and protected. But we know that adapting - particularly to major changes - takes significant amounts of time and resource.

"Working with the right third-party partners, with right experience and expertise, can help advisers move at pace to tackle the knowledge barrier, reduce the cost of implementation and ease capacity pressures - ultimately enabling advisers to spend more of their valuable time on doing more for their clients."

If there's one investing axiom to hang your hat on, it's this: the lower the price you pay, the better your returns over the longer term. With the price-to-earnings (P/E) ratios of many high-quality businesses compressing, I, therefore, think it's time for long-term investors to buy while so many others are fearful.

P/E ratios have compressed materially and quickly. Most of the compression is due of course to rising bond yields, which in turn are a response to inflation concerns. But in some cases, some of the P/E compression can be attributable to rising earnings. Keep the latter point in mind.

Let's talk about a bear market

A bear market is a 20% slide from its peak but at the point of a bear market, investors make a 25% return just from the market returning to its previous high. If the market falls 50%, investors who buy at the trough make 100% just from the market recouping its losses and returning to previous highs. The lower the price one pays, the higher the return.

Looking at every bear market (fall of 20% or more) since WWII, the average length of time it takes for the S&P500 to reach its nadir is 12 months and the average decline is 32.7%. Finally, the average length of time it has taken for the S&P500 to return to its previous high is a further 21 months. At the time of writing, the S&P500 is at 3900 points, down 19% from its high of 4818.63 recorded on 4 January 2022. The index has been as low as 24% below its all-time high. If the market played to the historical averages (unlikely) the S&P500 would fall to 3242 points (down 32.7% from its high, and another 11.5% from its recent low) on 4 January 2023. It would then reacquire its previous high of 4818.62 on 6 October 2024.

While the averages are unlikely to be repeated (the events create the averages not the other way around) what is interesting is an investor who buys the S&P500 index today at 3900 would generate a return of 23.5% over the next two years, three months and eight days. That's equivalent to 9.75% per annum if the market were to follow the averages. And it is also only applicable to the index.

As we aren't in the business of buying indices, rather we seek to own individual companies, the above 'analysis' is only useful in that history offers encouragement the market will reacquire its previous highs, eventually.

Investing in individual companies

Encouraged by the prospect of an eventual broader market recovery we can now examine the arithmetic of investing in individual companies.

First, if I buy a share on 10 times the earnings per share (EPS) of the company ­- a Price to Earnings (P/E) ratio of 10 times - and sell the shares on the same P/E ratio in a future year, and EPS grow at 15%, then my annual return will be 15%, the same as the earnings per share growth rate.

It matters not what the P/E ratio is, if they are the same at the time of acquisition and disposal, my return will equal the EPS growth rate achieved by the company.

Second, as Figure 1 illustrates, the P/E ratio reflects the bipolar nature of markets. Frequently market sentiment swings to reflect popularity for equities, and equally frequently sentiment reverts to being depressed and despondent with P/E ratios correspondingly slumping.

Figure 1. PEs reflect the bipolar nature of market sentiment

Source: Yardeni Research Inc.

P/E ratios are a measure of popularity. The more popular equities are, the higher the multiple of earnings investors are willing to pay and therefore, the higher the P/E ratio. When equities are unpopular, the lower the multiple of earnings investors are willing to pay.

We can take advantage of this bipolar behaviour by focusing buying activity around periods when sentiment, as reflected by P/E ratios, is depressed.

We can also take encouragement, from the reliable bipolar market behaviour, that P/Es will eventually reflect buoyant optimism again.

And further encouragement comes again from the arithmetic of EPS growth and P/E compression and expansion.

I have published Table 1. previously but it is worth dwelling upon again.

Table 1. PE compression v. PE expansion

The vertical axis represents various levels of earnings per share growth. The 15% row assumes the purchase of shares in a company whose earnings per share grows at 15% per annum for five years.

The column headings across the top represent the change in the P/E ratio at the end of the five-year period.

The 15% and the 0% column interest at 15%. Purchasing shares in a company whose earnings per share grows at 15% per annum, will return 15% per year to the investor if the P/E ratio does not change.

The intersection of the 15% row and the -25% column is 9%. Nine per cent is the annual return to the investor, over five years, from buying shares in a company whose earnings per share grow at 15% per annum and the P/E ratio declines by a quarter and fails to recover over the five years.

You will see a 0% return is received where the 15% row intersects with the column representing a P/E contraction of 50%. Buying a share of a company growing its EPS by 15% per annum over five years, produces a nil return when the P/E ratio falls by half and stays there. The investor would also have to hold the shares for the five years to break even.

But a nine per cent return is received, even if the P/E ratio halves when shares are purchased in a company able to grow earnings by 25% per year.

The best chance of attractive returns

It should be apparent by now buying shares in companies able to compound earnings at high rates over a long period, offers the best chance of attractive returns even if the popularity of shares were to collapse and remain in the doldrums.

But as we have previously noted, this is unlikely. PE ratios reflect popularity which swings frequently and reliably.

Figure 2. ASX Cyclically adjusted PE (CAPE) five year forward return (dot plots)

Finally, stockbroker MST has conducted a historical analysis of returns from Australian shares based on the P/E at which the investment was made. It is clear from the data, the axiom referred to earlier - the higher the price one pays, the lower the return and vice versa - holds true. A higher starting P/E produces a lower return.

Regression analysis of historical returns (note my comments about averages) reveals paying today's P/E ratio should result in a return over the subsequent five years of approximately 15% per annum. The range of historical returns at the current P/E however is five per cent to 25% per annum.

In any case, history and math are on the side of the long-term investor brave enough to invest when others are fearful, as they are today.

Author:  Roger Montgomery, Chairman and Chief Investment Officer

Interest rate hikes, inflation, geopolitical tension… Portfolio Manager Anshu Sharma discusses semiconductors (chips) and why we think they are so important over the next three to five years.

As the second quarter ends, investors are licking their wounds from negative asset returns as policy withdrawal corrodes asset values around the world.

Investor sentiment has swung wildly throughout the year but now seems firmly entrenched in Kubler-Ross's famed five stages of grief - denial, anger, bargaining, depression and acceptance.

Make no mistake, things do not look good in the near term for economies as central banks raise rates the world over, lifting interest servicing costs and reducing discretionary spending. Bond markets have already priced in the most substantial and violent rate hiking cycle in generations - far beyond the 2.5 per cent US Federal Reserve rate hiking cycle peak of 2018 that crashed the corporate credit markets (and ultimately the equity market). As investors are entering the bargaining phase of grief, perhaps there is some glimmer of hope emerging, as inflation data and the inventory cycle (the bullwhip effect) can help ease the pathways into 2023.

It is very likely there will be some depression as the markets continue to adjust (illiquid assets need to play rapid catch-up to listed assets) and finally an acceptance that our new geopolitical world order requires a vast recalibration of energy and labour markets that will have far-reaching effects, add risk premia to asset classes in higher volatilities and crimp the lofty growth valuations seen in the last cycle.

Government bonds led asset underperformance, correctly signalling tougher times ahead for the economy as reopening inflation was turbocharged by the Russia-Ukraine conflict and further China lockdowns.

Early in the year, many investors seemed in ''denial'' that markets could fall abruptly, despite the early warning signs from the bond market that funding interest rates would be moving significantly higher, tightening the economy at significant pace despite the economy opening the year in great health.

No doubt significant ''anger'' has been experienced as many risk assets followed the lead of bonds over the second quarter, playing catch-up and slingshot in a spectacular fashion (the US Nasdaq is now down 29 per cent).

The cult of crypto has been forced to stare into the abyss and contemplate life without self-reinforcing feedback loops, amid nasty infighting among the tribal communities. Australian equities have thankfully been well insulated from larger global declines to date, thanks to heavy commodity exposures which have outperformed significantly so far in a supplyconstrained world. This requires some investor consideration should growth fall substantially, as commodities can flip from leader to laggard very quickly despite supply constraints - in the Global Financial Crisis of 2008, oil fell from $140 a barrel to $44 in a matter of months.

Are we somewhere around the ''bargaining'' phase currently - looking for pathways that can deliver a soft economic landing? There are certainly signs that goods inflation has significantly abated in the US - major retailers such and Walmart and Target have reported a surge in inventory accumulation and expect consequential goods discounting as a result. Supply lines are healing, and freight costs have fallen - this is known as the ''bullwhip'' effect, where inventory can flip from deficit to surplus almost instantaneously.

Many businesses perhaps over-order inventory, knowing their order may be scaled back, but as supply lines heal one day the entire order arrives and they find themselves overstocked, leading to poor inventory turnaround times. This may also be the result of changing consumer demand, but either way discounting occurs and inflation pressures ease as a result until the excess inventory is cleared to restore equilibrium.

This should help inflation begin to moderate, along with a more stable energy complex (oil peaked at $US130 after the outbreak of the Russia-Ukraine conflict; now $US106).

However, services inflation is still expected to rise in the near term, leading to an ongoing, volatile series of outcomes in the inflation data. We expect that inflation will moderate over the balance of the year which will help central bankers find a change of narrative towards a ''pause'' of policy from the highly restrictive settings they are currently embarking upon.

Sadly, while this improvement in inflation will help lift the angle of decay, we still have some difficult times to navigate as interest rates rise over the balance of the year, as expected by the bond market which has fully priced these expected outcomes. And so the ''depression'' phase may remain ahead as a ''pause'' of policy may help alleviate the declines, they will not bring back the financial asset lunacy of 2021 (anyone for a digital ape drawing for a few hundred thousand?). Assets are finding new valuation ranges for a post-Covid geopolitical world.

This is probably a world where inflation can oscillate from inflationary (supply disruptions from war) to disinflationary (capitalism solves the problem) as secular forces clash and government policy stimulates or destroys demand, chasing inflation mandates.

Investors must finally find ''acceptance'' that the pandemic uprooted a rule-based system, led to the great resignation, accelerated working from home - essentially it threw the economic and social jigsaw puzzle into the air and pieces have landed all over the place. Incredible government policy saved economies from their stark realities at that time, but the entropy of that volatility has returned and will leave us with a more unstable world.

Part of that acceptance will be to realise that asset allocation is paramount for investors, who will be reminded that some equity is worthless, some dividend policies are best endeavours only, some credit will default, and many boring and and conservative assets play a critical role. In combination, strong and diverse asset allocation will generate good outcomes through the uncertainty we continue to face.

Contractually and legally binding bond coupons from highly rated governments are close to certain for income investors (unless you think the governments will not exist in time to repay you).

They might find growing acceptance in a world where the only certainties are death and taxes.

Market commentary June was a very weak month for equities globally, driven by continued investor concern around the quantum and pace of interest rate increases and a weakening US (and global) economy. Central banks (correctly in our view) appear committed to reducing inflation via aggressively increasing interest rates, even if it means reducing economic growth in the short term. 

In the US, the S&P 500 was down -8.4%, the Nasdaq fell -8.7%, whilst in the UK, the FTSE fell -5.8%. In Australia, the All Ordinaries Accumulation index fell -9.4%, whilst the Small Ordinaries Accumulation index was down -13.1%. On the ASX, the best performing sector was consumer staples, whilst resources was the worst performer, impacted by lower commodity prices and growth concerns regarding the Chinese economy. The underperformance of small/mid cap stocks vs large cap is not a new situation and has indeed occurred in all of the months in the last five years where the ASX has seen large falls. 

Whilst we agree that inflation, interest rate rises and weakening economic growth are all valid current concerns for investors, we also believe the falls in stocks across the board have been quite material and hence from a stock specific basis, there are now some very attractive investment opportunities for investors willing to take a 2-3 year view. 

As always during periods of market stress, it is very important to take a long term view and think about how long the current negative conditions will be in place over the medium term. Whilst concerns around an economic slowdown are warranted currently, we believe in 12-24 months time, this risk is likely to have reduced as central banks are further down the path of interest rate hikes. 

It is also important to remember that on average, bear markets last for 12-15 months, hence the current challenging conditions will not be in place permanently. Also, we would stress over the next 12- 18 months, whether Australia and/or global economies actually have a recession is not the key issue (even though it will generate a lot of media discussion). Rather for investors in the Fund, the key issue is the investment opportunities that are thrown up from the sell-off in equities, that can provide the basis of investment returns over the next 3-5 years. 

It should also be noted that as the stock market is very forward looking, stock prices historically fall well ahead of any economic downturn, in particular small/mid cap stocks on the ASX. 

Revenue multiples have returned to pre-2020 levels for high growth software companies, based on Octahedron's index. The downturn in valuations was accompanied by a 23% year-on-year decline in March quarter VC funding for late-stage and technology growth funding, crunchbase calculated - although it found seed and angel investment held up better, growing 9% year-on-year. The Information found VC firms buying listed tech stocks, meanwhile consensus data from FactSet shows the tech sector is not expected to have been among the strongest growth areas of the S&P 500 in the June quarter - energy and materials stocks have the most expected of them. Kailash Capital shows that price growth for the S&P 500 in the 2017-2021 period has doubled the long-term average return. Finally, Bloomberg charts the rise of self-employment in the US.

Octahedron Growth Software Index (EV / NTM Rev)

Source: Octahedron

Global Venture Dollar Volume by quarter

Source: Crunchbase

Global Seed and Angel Investment by quarter

Source: Crunchbase

VC Firms Buying Publicly Listed Shares

Source: The Information

S&P 500 Revenue Growth Expectations

Source: FactSet

S&P 500 historical average returns

Source: Kailash Capital

Americans increasingly shifting to self-employment

Source: Bloomberg

July Edition