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Australian Big Banks are Back!

26 Nov 2021 - Arminius Capital

FY2021 results for ANZ, National Australia and Westpac indicate that the banking sector has mostly recovered from the COVID-19 crisis. But organic growth is hard to find - most of the earnings recovery was due to the writeback of $820m of...

26 Nov 2021 - Australian Big Banks are Back!

By: Arminius Capital

Australian Big Banks are Back!

Arminius Capital

17 November 2021

The three banks with September financial years - ANZ, NAB and Westpac - are almost back to normal. Cash profits and return on equity are still below FY19 levels, but it is clear that the COVID-19 crisis has not left any scars on the banking system. Most importantly, the banks' capital positions are once again "unquestionably strong": an average Common Equity Tier 1 (CET1) ratio of 12.7%, up from 11.4% in FY20, means that all the banks can afford share buybacks.

So far, however, organic growth is modest. Most of the recovery in cash earnings came from the $820m writeback of provisions built up last year. The banks are still paying "customer remediation costs" for their crimes of fees for no service and other horrors revealed by the Hayne Royal Commission, but these should end in FY22. The ratio of operating costs to income is still too high, and the banks will need another two to three years to achieve their cost reduction targets.

The fundamental problem is that banking is no longer as profitable as it used to be, thanks to increased competition, tighter regulation, and higher capital requirements. The KPMG chart below shows how the banks' average net interest margin (NIM) has slid steadily downward, from 3.0% two decades ago to only 1.86% now.

In order to preserve their margins, the banks need to simultaneously cut their operating costs and increase their capital spending to improve their processes. CBA is leading the pack in both of these objectives, which is why it is the only one of the Big Four to have returned to its 2016 share price. Shareholders of the other three banks are well aware of the size of their capital losses over the last five years. This is also why CBA's dividend yield is less than 4.0% while the other three yield between 4.5% and 5.0%.

FY22 results are likely to be similar to this year - modest organic growth, with profits buoyed by provision writebacks. But there will be complications. The first is that wholesale funding costs will increase as US and Australian interest rates rise, and the banks will lose some of the deposit inflow which was triggered by the COVID-19 panic. The second is that the Australian regulators will probably impose macroprudential controls to slow the pace of house price rises and to discourage borrowers from taking on excessive debt. The third is that the rise in CPI inflation will affect different sectors of the Australian economy in different ways, and may put an end to the improvement in loan delinquency rates.

Our analysis suggests that the banks are fairly priced at present, as a sector with low earnings growth but also low risk. In the long run, the recent changes in industry structure will mean that bank earnings will grow more slowly than most companies in the S&P/ASX200 Index, making the banks attractive for income rather than capital growth.

ANZ's cash profit of $6.2bn (218c per share) slightly exceeded market expectations, because stronger markets income offset a 4% increase in costs as well as ongoing customer remediation costs. The full-year dividend of 142c was higher than 60c in FY20 but still below 160c in FY19. During the latest half-year, ANZ's residential loan book declined by 1% against system growth of 4%. This disparity highlights the inadequacies of ANZ's mortgage processing systems, which the bank has acknowledged and is devoting capex to improving. FY22 earnings and dividends are expected to be flat, but ANZ is trading on a lower P/E than the other three, so the medium term may see some price gains through re-rating.

Commonwealth Bank's trading update for the September quarter disappointed the market, with the CBA share price falling 8%. Despite above-system loan growth, cash profit for the quarter was flat at $2.2bn and net interest margin fell significantly. A single quarter is not necessarily an indicator of the 2022 result, but it does reinforce our view that the banks face a difficult competitive environment.

NAB reported a $6.6bn cash profit (199c per share) and lifted its full-year dividend to 127c (a 64% payout ratio), which was better than 60c in FY20 but still below 166c in FY19. The result was free of notable items and other one-offs. Management indicated that future dividends would be 65% to 75% of cash earnings. During the half-year, NAB grew its gross loans and advances (GLA) as fast as system growth or faster. The bank has simplified and automated its mortgage approval process: 30% of Simple Home Loans are expected to be approved in one hour, and 60% within one day.

Westpac is lagging behind the other three big banks. FY21 cash earnings of $5.4bn (146c per share) are equivalent to a return on equity of 7.6%, well behind the Big Four average of 9.9%. Westpac's cash earnings suffered from a notable items charge of $1.6bn, and the September 2021 half year was disappointing, with expenses rising and margins falling. The FY22 dividend of 118c (an 81% payout ratio) was better than 31c in FY20 but well below 174c in FY19. The share price has fallen 9% since the result - the market clearly does not believe that Westpac will achieve its announced cost reduction targets on time.

Funds operated by this manager:

Arminius Capital ALPS Fund, Arminius Capital GMMA Fund

The Long and The Short: The tide of inflation

25 Nov 2021 - Kardinia Capital

Six months ago, we wrote that inflation was on the horizon. We continue to field questions on the topic, so are revisiting it with our current thoughts.

25 Nov 2021 - The Long and The Short: The tide of inflation

By: Kardinia Capital

The Long and The Short: The tide of inflation

Kardinia Capital

08 November 2021

Kardinia

Inflation looking less transitory

Signs continue to indicate that inflation is creeping into the system.

Central and global banks don't tend to agree, but we think the tone will shift. In the face of a constant inflation rhetoric, the global consensus continues to push back on the structural shift in inflation. However, evidence of price inflation and supply chain disruptions are now showing up at every corner.

Volvo has slashed the size of its IPO in the face of soaring energy costs and persistent supply chain delays.
Nike's first quarter sales missed Wall Street expectations by 7% due to production and shipping delays.
Swiss food giant Nestle has increased prices in 2021 and will increase prices a further 2% in the final quarter and in 2022 to offset input costs of more than 4%.
Unilever, which sells more than 400 brands into around 190 countries, announced that it will be raising prices of all its goods by 4.1% in the third quarter to pass on higher production costs.
The price for durum wheat, the key ingredient in pasta, is up 60% this year.
Delta Airlines just logged its steepest one-day drop (-6%) in a year, after warning that rising fuel costs could lead to an operating loss this quarter despite a lift in travel demand.

The Fed still sees inflation as temporary, with upticks in inflation explained away as simply the economy normalising after the pandemic shock and supply chain bottlenecks causing temporary disruption. But our US contacts note that those bottlenecks could last until 2022 or later. US Transportation Secretary, Pete Buttigieg, suggested in a recent interview that US supply chain issues may last 'years and years'[1]. Both Dubai Ports and Singapore-based Ocean Network Express, which carries more than 6% of the world's containerised freight, have suggested an easing in supply chain disruption may not come until as late as 2023.

Listening to the key metrics

Let's take a look at what prices have been doing in the key categories of food, energy and wages.

The UN's Food Price Index is up 33% year on year. The index measures the global monthly price change in a basket of five food commodities, with vegetable oils up 61%, sugar up 53%, cereals up 27%, meat up 26% and dairy up 15%.

Rising fears about supply and energy security have also pushed Brent to above US$80/bbl, up 40%, and spot Asian LNG prices to US$35mmbtu, up 600% since 2019

Source: Refinitiv, Jarden

Meanwhile, the USA labor market is already tightening. The drop in unemployment to 4.8%, and rapid 0.6% month on month wage growth, is indicative of a structural shortage of workers.

We expect the US experience to be repeated in Australia as our two largest economies emerge from lockdowns. We're paying close attention to wage inflation in this country, given the Reserve Bank of Australia has indicated it is unlikely to raise interest rates while this metric remains subdued.

Is history repeating itself?

If higher inflation becomes entrenched, like turning the Titanic it takes time to reverse. We saw this phenomenon in the late 1970s, when three Fed Chairmen tried to stuff the genie back into the bottle - with only Paul Volcker, the last of the three, delivering the silver bullet.

We believe what we're seeing today is remarkably similar to the experience in the 1970s. Back then, food and energy supply 'shocks' led the decade's inflationary surprises. Firstly, bad weather saw CPI for food up 20% in 1973 and 12% in 1974; then came the Middle East conflict in 1973, which drove a rapid spike in the oil price.

History may not repeat itself, but it can rhyme. Today it is fuel prices, unfavourable weather and the impact of coronavirus on supply chains leading to food inflation. For the oil market, it's the rapid move towards 'green' renewable energy (coupled with strong demand as the world emerges from the ravages of coronavirus) and freight costs that has led to a 70% surge in global oil prices this year.

Why does it matter?

In the 1970s, inflation had a critical effect on pushing rates higher, further entrenching inflationary expectations. According to the RBA, the 3 month Bank Bill rate was 6.6% in 1971 and 9.3% in 1974, which then jumped to 16.2% by early 1982.

Today, as inflationary pressures continue to build, several advanced economies have already increased rates, including the Norges Bank, the Reserve Bank of New Zealand and the Monetary Authority of Singapore, with the Bank of England potentially moving shortly.

The recent Australian quarterly CPI release (3.0% year on year) has ensured that inflation will remain a heated debate into 2022. At the very least: if inflation expectations build, interest rates launch sooner and bond prices continue to fall, then we should expect higher volatility in equities. Individual sector returns will diverge with winners and losers.

Equity returns historically beat inflation, within which commodities and energy sectors tend to do well. Banks and sectors which exhibit monopolistic pricing powers and hard assets, such as property, also perform strongly; whereas rate-sensitive sectors such as IT and loss-making stocks tend to underperform. We have seen this before and have positioned the Kardinia portfolio accordingly.

Funds operated by this manager:

Bennelong Kardinia Absolute Return Fund

[1] Buttigieg: Some Supply Chain Issues May Last 'Years and Years', Bloomberg, 8 October 2021

How wholesale investors find fund managers that get them returns

24 Nov 2021 - Wealthlander Active Investment Specialist

Experience in the industry has shown that many Australians are often stuck with sub-optimal investments and institutions managing their money, often without knowing why or what else to do. They routinely don't invest with the better fund...

24 Nov 2021 - How wholesale investors find fund managers that get them returns

By: Wealthlander Active Investment Specialist

How wholesale investors find fund managers that get them returns

Wealthlander Active Investment Specialist

24 November 2021

Introduction
Experience in the industry has shown that many Australians are often stuck with sub-optimal investments and institutions managing their money, often without knowing why or what else to do. They routinely don't invest with the better fund managers and investments and the investment industry and regulatory setup - far from helping them, is actually restraining them. When it is your money, you deserve to know there is a better alternative.

Routinely the industry including super funds, advisers, researchers and investors produce subpar performance by restricting their clients to sub-optimal investment solutions or simply chasing past great performance, pushing money in to an asset or fund manager at the wrong time and after they've done well and are at high risk of mean reverting. I'm sure that's happened to you too, either of your own volition or on the encouragement of a wayward advisor or institution (comments welcome).

Investors then complain that active management doesn't work for them, when actually what doesn't work is the system and people they're using. In fact, active management can and should routinely work extremely well if you access the best parts of the investment architecture and a better investment process, and the better aligned and more experienced and authentic people rather than the professional marketers and sales firms.

While I could write an article about all the industry incentives that fail investors and why the system won't improve any time soon (in fact, it's getting worse), this article will hone in on just a couple of key and common mistakes investors make. It is by no means comprehensive and is not investment advice, but it potentially gives you a better chance of investing much more effectively and informs you about where you might be going wrong.

PROBLEM 1 - Institution Versus Boutique
Large corporates and institutions often don't invest money well. Why? They have a different culture, incentives and motivations than you do which means they aren't as well aligned as they should be with you and your interests. For example, often they are focused on asset gathering and are marketing led rather than investment led, when you just want someone to perform well and act in your interests and not just in theirs. Frequently they are too big, and investing a lot of money really well is more difficult for numerous reasons. Large organisations have a focus on empire building, short term shareholder returns and the retention of their assets rather than industry best practice and adapting to a changing world. Very commonly organisations simply talk the talk rather than walk the walk. Organisational culture and nature also often mean that while they may temporarily employ good people that want the big names on their CV while they're young and inexperienced, the best people will often be looking to move on and elsewhere as soon as they can.

SOLUTION 1: Don't simply blindly invest with large corporates and institutions unless you have a strong reason to, because this stacks the odds against you.
Instead follow what the most authentic and performance orientated people do and prioritise boutique fund managers. Boutique managers are routinely much better aligned with investors. They are often investing their own friends' and family money, are more aligned with performance rather than simply asset gathering, and routinely have an investment culture instead of a marketing and sales culture.

Furthermore, they don't need to waste time in managing up to be promoted, or on internal corporate meetings, and often are more experienced and investment savvy. They often leverage a broad industry network (and are part of a large more diverse virtual organisation rather than a restricted corporate one) and can cherry pick the best people to align with to produce a successful performance culture.

Ultimately most boutiques can only thrive and survive if they add value to investors, because they operate in a competitive industry when their money is not captured or static in the system like it is with large super funds, corporates and institutions. Boutiques can add value in numerous ways directly aligned with investors interest, such as being truly active and overweighting great assets and investments rather than being beholden to other influences or suffering "death by committee" or management meetings. Boutique managers hence stack the odds more in your favour. Early-stage boutique managers are often even better as they are super motivated to perform and won't have excessive assets or competing interests to manage.

PROBLEM 2 - Retail versus Wholesale
Common retail investment solutions such as large superannuation funds and retail funds - those readily and widely available to retail clients, are routinely sub-optimal.

Retail managers are weighed down by an increasingly heavy-handed regulatory regime which can distract from or preclude entirely the main game of good investing. They are more beholden to numerous intermediaries including regulators, researchers, platforms and commercial interests and often need to "slot in" to narrow ideas of what a fund manager should be - including sometimes being very restricted in how they invest or what they can invest in, to the point when they can be structurally relatively ineffective. For example, the new regulatory regime affecting super funds will in future strongly encourage an even more benchmark-based investment approach rather than a more client centric outcome-based investing approach. This creates strong asset class dependency on long only public equities and more binary type outcomes for your investments, not what you probably really want for your hard-earned capital.

Ironically, much of the compliance and restrictions are implemented in the name of "investor protection"; however, this can be thought as being protection from diversity and a better investment return! No wonder retail investors complain they don't have access to the best investments; because quite simply they don't.

SOLUTION 2: Look for good wholesale funds who are aligned with your interests and obviously investment orientated rather than being asset gatherers.
If you qualify as a wholesale client under the Corporations Act such as having $250,000 annual salary over the last two years or $2.5 million net assets, it is generally not a great idea to invest your funds the same way as retail client funds. Avoid advisers and institutions that want to invest you this way for their convenience, when they should be doing so much better for you by treating you appropriately if you are a wholesale client and taking advantage of the large benefits this offers.

There is a good reason why the wealthiest and most successful run their own SMSFs rather than invest with mainstream superannuation funds. This way they can invest in the best investment solutions out there, rather than be restricted to the more constrained and mediocre ones, although sometimes they don't know how to fully take advantage of this.

There are many ways wholesale funds can demonstrate that they are capable and aligned with investors, and the more they can demonstrate this the better…

Ways to Assess Fund Manager Alignment with Optimal Investor Outcomes
Proof of better fund manager alignment can be found in many ways. Some of these include:

Fees

1. Charging low base fees with the fund manager making their money from performance fees (rather than high management fees and continual asset gathering to increase fee collection, irrespective of investor returns and volatility).

2. The manager only charges performance fees if they make you a positive return, as charging performance fees over a benchmark that doesn't matter to your goals and that goes backwards isn't great alignment if investment markets turn down.

Nimble Managers

3. Having low funds under management and strict capacity limits on the funds under management that the manager will manage across different investment offerings.

4. Having few or only one investment fund in which the fund manager substantively invests their own family and friends and which you too can invest alongside them.

Track Record and Clear Articulation

5. A history of valuable work experience and previous strong and consistent performance in other roles, and no question mark about the manager's authenticity or focus on what matters to you.

6. The ability to explain to investors how they will add value and have added valued in the past, and how they have learnt from markets and their mistakes and won't make these again.

Superior Risk Management

7. Superior risk management through genuine diversification and other methods such as using options for hedging risk. Good managers can be, but don't necessarily need to be higher risk and may in fact demonstrate or target lower risks than the average, which better aligns with investor goals for capital preservation.

Culture

8. A recognition that the fund manager's approach is not the only good way to manage money and that the manager doesn't suffer from hubris. For example, the fund manager may be humble enough to invest with other fund managers for diversification and value added rather than pretending they have all the answers with their in-house solutions across every asset class (given this is unrealistic).

Conclusion
Take Advantage of a Wonderful Environment for Great Active Management

These are exciting times right now for good active investing across multiple asset classes and strategies. The opportunity set is huge and there are gains to be made and important risks that need to be managed. We continue to search for new active boutique fund managers to invest with that can demonstrate to us that they offer specialist expertise and are a sophisticated value-adding operator, and importantly are aligned with investors in our fund.

If you haven't had a great experience so far in what has been a spectacularly positive investment environment, look for a better alternative. Hopefully, this article will help you with some suggestions about how you can approach this challenge and invest more effectively in future. Your comments and feedback are welcome and we're happy to discuss further as required.

Funds operated by this manager:

WealthLander Diversified Alternative Fund

New Funds on Fundmonitors.com

24 Nov 2021 - Australian Fund Monitors

Here are some of the latest additions to our database. Follow the links to view each fund's profile, where you'll have access to their offer documents, monthly reports, historical returns, performance analytics, rankings, research,...

24 Nov 2021 - New Funds on Fundmonitors.com

By: Australian Fund Monitors

New Funds on Fundmonitors.com

Below are some of the funds we've recently added to our database. Follow the links to view each fund's profile, where you'll have access to their offer documents, monthly reports, historical returns, performance analytics, rankings, research, platform availability, and news & insights.

WealthLander Diversified Alternative Fund

Inception date:	February 2021	Minimum initial investment:	AU$100,000
Strategy:	Multi Strategy	Distributions:	Annually
Geographic mandate:	Global	Management fee:	0.50%
Investor type:	Wholesale	Performance fee:	15.00%

View Profile

CIPAM Credit Income Fund

Inception date:	October 2020	Minimum initial investment:	AU$10,000
Strategy:	Fixed Income	Distributions:	Quarterly
Geographic mandate:	Australia/NZ	Management fee:	0.60%
Investor type:	Wholesale & Retail	Performance fee:	Nil

View Profile

Harbour Income Fund

Inception date:	October 2015	Minimum initial investment:	AU$
Strategy:	Multi Strategy	Distributions:	Monthly
Geographic mandate:	Global	Management fee :	0.00%
Investor type:	Wholesale & Retail	Performance fee:	Nil

View Profile

ASCF High Yield Fund

Inception date:	March 2017	Minimum initial investment:	AU$50,000
Strategy:	Private Debt	Distributions:	Monthly
Geographic mandate:	Australia	Management fee:	0.00%
Investor type:	Retail	Performance fee:	Nil

View Profile

ASCF Select Income Fund

Inception date:	March 2017	Minimum initial investment:	AU$25,000
Strategy:	Private Debt	Distributions:	Monthly
Geographic mandate:	Australia	Management fee:	0.00%
Investor type:	Retail	Performance fee:	Nil

View Profile

ASCF Premium Capital Fund

Inception date:	March 2020	Minimum initial investment:	AU$10,000
Strategy:	Private Debt	Distributions:	Monthly
Geographic mandate:	Australia	Management fee:	0.00%
Investor type:	Retail	Performance fee:	Nil

View Profile

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Investment Perspectives: Is long WALE really low risk?

23 Nov 2021 - Quay Global Investors

In this article we analyse the data from the US REIT industry during the past two (very different) economic disruptions - the great financial crisis (2008-2009) and the great virus crisis (2020-2021) - and determine whether long WALE...

23 Nov 2021 - Investment Perspectives: Is long WALE really low risk?

By: Quay Global Investors

Investment Perspectives: Is long WALE really low risk?

Quay Global Investors

04 November 2021

One of the many accepted truisms in real estate is properties with a long WALE (weighted average lease expiry) tend to be lower risk.The rationale is that during times of economic disruption, long-term in place contracted leases ensure a property's ability to maintain cashflow, and presumably retain value.

But is that true?

What the data tells us
To test the narrative, we collected data from the US REIT industry across several sectors for the last two significant economic dislocations: the great financial crisis (2008-2009) and the great virus crisis (2020-2021). Then we grouped the sectors into two sub-groups:

Short lease duration (short WALE) - including residential, storage, lodging, healthcare (typically 0-1 year leases)
Long lease duration (long WALE) - including retail, office, industrial and triple net leasing / diversified (typically 5-10 year leases)

The following charts highlight the results for each sector during the great financial crisis, measuring both return and standard deviation (a proxy for risk). The colours of the bars reflect long WALE (blue) and short WALE (orange). The data was measured peak-to-trough for both series.

The immediate observation is there does not seem to be much difference in returns between long and short WALE - although if we are removing lodging, short duration appears to perform better. In terms of standard deviation (right chart), short WALE performed better. However, after excluding industrial, the risk appears similar.

In summary, being long WALE probably did not help much during the financial crisis - either for return or for risk.

Next are the results for the great virus (COVID) crisis. The data was again measured peak-to-trough - however, for standard deviation we used 12 months for the COVID period to ensure we had enough monthly data and to capture the volatility around the virus and the vaccine.

The data during the COVID crisis paints a similar picture, although with some interesting variations. Again, being long WALE does not appear to either help or hinder the returns or the standard deviation during the crisis. However, industrial property performed significantly better during COVID in terms of return and risk compared to the financial crisis. Conversely, healthcare (a star performer during the GFC) suffered disproportionately during COVID.

Why is there limited capital protection from long WALE assets?

One could argue that assessing equity risk and return grouped by WALE is fraught with distortions - as management decisions, operating and financial leverage all impact equity returns - and we agree! There are so many other important factors that drive equity returns than WALE. We believe focusing on the other qualities of companies to be more fruitful.

In this respect, we remind our readers of our overall real estate philosophy - that is, the best way to manage risk is to buy value (below replacement cost where appropriate), buy quality (companies with higher barriers and high return on capital), buy low leverage, and bias sectors benefiting from some cyclical or secular tailwind.

When thinking about risk, we never think about WALE. In fact, since inception through to today, Quay's portfolio tends to be very low on lease duration. Self-storage, single family housing, senior housing, apartments, manufactured housing and student accommodation (all with leases less than 1 year) historically account for ~60% of the portfolio. Notably, over this timeframe we have generally been underweight longer duration asset classes (office and industrial).

Despite our short portfolio WALE, since inception (July 2014) Quay's concentrated 20-30 stock portfolio standard deviation of returns has been 15.3%, compared to 15.3% for the +300 stock FSTE/EPRA NAREIT global index. Why?

Notwithstanding the points made above about buying property companies vs actual assets, we believe the idea that long WALE equals low risk can be challenged on a number of fronts.

Most real estate valuers and investors deeply understand the issue of reversion - this is the measure of how 'out of the market' current lease rates are compared to market. Good investors and valuers price this reversion into their valuation well before leases expire.
Large tenants with long leases are a natural target for developers seeking to find an anchor tenant for new developments - usually a pre-requisite for funding. The long lead time to build (say, office) allows developers to target tenants with still-reasonable lease duration.
Very long leases prevent landlords from managing leasing risk proactively. Few tenants wish to discuss new lease terms with +5 years still remaining.
Very long leases (WALE) alter the nature of the investment from a classic real estate exposure (short leases) to a credit exposure (long leases). This is because with long leases most of the 'net present value' is embedded in the lease rather than the end value (residual).

This final point is worth discussing in more detail. The diagram below conceptually shows the changing nature of real estate as lease duration increases. Advocates of long WALE argue the security of income from long leases protects investor cashflows over the cycle and therefore carries less risk. And having credit risk during times of distress is preferable to residual risk.

While it may sound reasonable to have credit risk rather than residual risk during a downturn, one aspect always lost on real estate investors - and never lost on bankers - is that credit is dynamic. For example, a 2020 study by Standard and Poors found that between 1981 and 2020, 51% of investment grade credit (BBB) was non-investment grade or unrated after ten years. Also, almost a third (32%) of AA rated credit became non-investment grade or not rated over the same timeframe[1].

The lesson for long WALE investors is: the credit you begin with may not be the credit you end with, and therefore your residual risk may be greater than you think.

All of which seems to be verified by the data.

Concluding thoughts

At Quay, we manage relatively concentrated portfolios (historically 20-30 securities) and as such we need to ensure we manage risk as well as generate acceptable total returns. We fundamentally believe the best way to manage risk is to intensively understand and research our investees, which is much easier to accomplish with a concentrated portfolio. Along with our usual risk mitigants listed above, we also avoid heavy capital recycling businesses (property developers) and businesses with lumpy returns (real estate managers).

What we do not do is spend much time thinking about average lease duration (WALE). The data and our track record suggest we are right to do so.

Funds operated by this manager:

Quay Global Real Estate Fund

The content contained in this article represents the opinions of the authors. The authors may hold either long or short positions in securities of various companies discussed in the article. The commentary in this article in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader.

This information is issued by Bennelong Funds Management Ltd (ABN 39 111 214 085, AFSL 296806) (BFML) in relation to the Quay Global Real Estate Fund. The Fund is managed by Quay Global Investors, a Bennelong boutique. This is general information only, and does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units in any fund of which BFML is the Trustee or Responsible Entity (Bennelong Fund). This information has been prepared without taking account of your objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Information Memorandum (IM) and or Product Disclosure Statement (PDS) which is available on the BFML website, bennelongfunds.com, or by phoning 1800 895 388 (AU) or 0800 442 304 (NZ). Information about the Target Market Determinations (TMDs) for the Bennelong Funds is available on the BFML website. BFML may receive management and or performance fees from the Bennelong Funds, details of which are also set out in the current IM and or PDS. BFML and the Bennelong Funds, their affiliates and associates accept no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. All investments carry risks. There can be no assurance that any Bennelong Fund will achieve its targeted rate of return and no guarantee against loss resulting from an investment in any Bennelong Fund. Past fund performance is not indicative of future performance. Information is current as at the date of this document. Quay Global Investors Pty Ltd (ABN 98 163 911 859) is a Corporate Authorised Representative of BFML.

PharmaFun: Broad Strokes, Covid-19 & Revisiting Pfizer

22 Nov 2021 - TAMIM Asset Management

This week we begin a new series centred around the global pharmaceutical sector with a particular eye to ascertaining where the opportunities and risks may be. Going back to our broader macro views, in particular around inflation, this...

22 Nov 2021 - PharmaFun: Broad Strokes, Covid-19 & Revisiting Pfizer

By: TAMIM Asset Management

PharmaFun: Broad Strokes, Covid-19 & Revisiting Pfizer

TAMIM Asset Management

10 November 2021

Before proceeding further, a disclaimer. We are experts in neither the field of medicine, pharmacology nor epidemiology. As such, what follows is simply an investors quest to understand and find opportunities. Moreover, throughout this piece a great degree of data is ascertained from the International Federation of Pharmaceutical Manufacturers & Associations (IFPMA), given the lack of nuance (in this author's view) provided vis-a-vis theoretically independent agencies such as the World Health Organization (WHO) and our very own Therapeutic Goods Administration (TGA). Nevertheless, we shall try and keep the argument as impartial as possible.

Background & Context

For the history buffs among you like myself, this is one sector whose evolution has never ceased to fascinate and tells the story of human ingenuity and enterprise. What began with local apothecaries, expanding their traditional role distributing botanical drugs, turned first into wholesale manufacture, not least aided by discoveries in morphine and quinine, to now becoming a sophisticated global industry central to modern economies (as was illustrated in our most recent global pandemic). My own fascination came about from reading into the prolific use of Laudanum for the most mundane of problems in the Regency Period to the opioid wars that led to the handover of Hong Kong to the British Empire. That particular tangent aside, let's look at the nature and structure of the modern pharmaceutical industry.

It may come as no surprise that it can be quite difficult to disentangle the structure of the industry and the regulatory framework from its evolution in the USA. From its rudimentary form of oversight starting as a result of early outbreaks of tetanus and distribution of contaminated smallpox vaccines (though even here we have seen instances of regulatory capture arguably as recently as the Nixon administration's War on Drugs) and passage of acts such as the Biologics Act of 1902; the modern regulatory framework has evolved to create a diverse range of actors both private and public with national bodies, such as the FDA in the US and TGA domestically, becoming the final and peak arbiters. With that, lets look broadly at the process of firstly bringing new drugs/treatments to market.

Source: IFPMA

The above figure shows the process by which a new drug/medication is brought to market. To sum up some numbers that may be truly eye-opening, here are some key points:

2.5% - 5%: The success rate of compounds passing through the screening process to proceed to pre-clinical trials.
Chances of Success: <0.01% in pre-clinical, 57% in Phase 1, 39% in Phase II, 68% in Phase III
9.5 - 15 years: The average time it takes for a new treatment to go from initial screening to market.
US $2.6bn: The average cost of bringing a successful medicine to market. Some more context: this was US $179m in the 1970s...

More concerning than the above numbers, is the graph below. It showcases the exponential declines in IRR (Internal Rate of Return) from pharmaceutical innovation over time for a cohort of the twelve largest biopharmaceutical companies by 2009 R&D spending. It shows that returns have declined from about 10% in 2010 to just 1.8% as of 2019. Little wonder then for the rather extraordinary underperformance of the sector for shareholders in recent years.

Source: IFPMA

So, that brings us to the question why has this been the case? Especially given the per capita expenditure on healthcare across most of the developed world. To answer that question, let's look at a similar graph which rather prominently shows the disconnect from overall expenditure on healthcare amongst OECD nations. It shows that while overall expenditure increased significantly, the expenditure on biopharmaceuticals has remained broadly constant.

Source: IPFMA

It is perhaps not that particularly difficult to fathom why. Given the likelihood of success in R&D combined with declining IRR, firms are by extension incentivised to increase profitability of existing products (before patent expiration) as opposed to take on the risk of bringing new products. So, on to the next question, why are IRRs declining?

In a world saturated with conspiracy theories, pharma PR debacles and general pushback against the industry, it may not be a popular opinion but the increased regulatory requirements which, although well intentioned, also had the effect of stifling new innovation and increased consolidation of the space. This is the flipside of regulation, creating high barriers to entry most prominently seen within the financial services sector. Across the planet we have increasingly stringent testing requirements and the cumbersome process of receiving regulatory approvals, national health authorities also require companies to track and report patients' experiences while reporting requirements also substantially raise investment cost (for the duration of time that the medicine is marketed). To put it simply, we remain of the view that the investment and regulatory landscape has swung too far. But, what's at stake here?

Quickly, for those that think that Covid-19 was a outlier event in terms of the overall impact upon the global economy. $500bn is the estimated yearly cost of pandemic influenza to global GDP. $3tn is the estimated loss worldwide due to antimicrobial resistance, in the form of superbugs, to the global economy per annum in worst case scenario modelling. By 2030 it is estimated that the cost of tuberculosis every year will be $1tn USD.

Current Landscape

With that context, let us actually get to the current reality of the global biopharmaceutical industry. While overall R&D has seemingly declined (and in our view still remains woefully underwhelming given the centrality of global efforts to the overall economy), the sector still remains an outlier in terms of the amounts spent on R&D, 7.3x greater than aerospace and defence and 1.5x that of software and computer services. Great numbers, aside from the massive cost increases involved in the process over the last four decades.

Conversely however, there have been ways in which the pharma industry has evolved in order to tackle the often prohibitive costs associated. New and novel collaborations through joint ventures, including with non-corporate entities such as academia, and cross sector collaborations are just some of the more recent trends. The most recent and obvious example of this has been the global effort to bring Covid-19 vaccines to market in record time; AstraZeneca's collaboration with Oxford or the creation of the global COVAX initiative alongside public sector organisations such as the WHO, the Coalition for Epidemic Preparedness Innovations (CEPI), and UNICEF (i.e. for delivery) is a prime illustration of the changes that have taken place.

This unique and complex landscape has also led to certain dislocations. For the truly global investor, we are certain at least some may have taken advantage of the growth in generics in emerging markets such as India. That particular country now accounts for close to 50% of global vaccine manufacturing capacity, 40% of generic medicine demand in the US and 25% of the same in the UK. Combine that with a domestic market that has grown in the high double digits for the last two decades, likely to go 3x over the next two, and equities investors in the overall sector would have seen on average return of close to 15x over the last two decades. The growth in the generics market has been the second trend and the centrality of India is the third that remains crucial to understanding the global market.

No longer is the market characterised by blockbusters being bought to market and the exceptional cashflows generated re-used to generate further blockbusters. We have a truly global supply chain, one which many may have become painfully aware of when India's own bipolar policy response to Covid put the entire global vaccination program at risk. Increased capex is required while patent expiration for existing medicines combined with competition from generics provides massive headwinds to the market. Combine that with an aging population and future growth coming from emerging markets such as India (which require different pricing), for the non-discerning investor, it is a nightmare to sift through.

On the question of pricing, let's use a simple and quite recent example: the introduction of the first oral treatment for Covid-19 by Merck (MRK.NYSE) which has ascertained regulatory approval (before you get excited, it is not a cure but simply reduces the chance of hospitalisation by 50% if administered within three days of onset). The actual pricing and distribution of the product is likely to be tiered with developed markets such as the US, which has already agreed to buy US $1bn worth of product, being used to subsidize distribution in poorer or emerging markets. This is done through licensing deals with generics manufacturers, though in the instance of Merck they have decided to distribute it for free. Call me a cynic but we are quite certain that, as they bring to market newer versions and are no longer in the limelight, we will see nice little margins ascertained over the next decade or so (not to mention the PR bump in the short term). The development of the drug itself, to illustrate the other point of collaborations, was done in conjunction with Ridgeback Biotheraputics.

Not to be left behind, Pfizer (PFE.NYSE) has also seemingly come up with its own antiviral pill that is 85% effective (compared to Merck's 50%) if administered within five days of onset (compared to Merck's three days). Both work in slightly different ways, with Pfizer being a protease inhibitor (blocks the enzyme and multiplication) while Merck's is a nucleoside analogue (introduces errors into the genetic code of the virus). Pfizer's own mRNA vaccine and Covid-19 pill is, by the way, a collaboration with German company BioNTech (BNTX.NASDAQ).

The above example of the Covid-19 anti-viral pill illustrates another example of the modern context. Merck effectively giving away its own IP stands in contrast to Moderna and Pfizer's ongoing refusal to transfer technology to mRNA vaccine producers in Africa, LATAM and Asia. As mentioned, we have a feeling that Merck's strategy could be a PR coup which we believe puts them in a better place in those particular growth markets for monetization later. For now however, Pfizer has been the frontrunner in terms of its vaccine efficacy as well as in Covid-related research to date.

With that let us finally get to the first security we like and one which we own in the TAMIM Fund: Global High Conviction portfolio, Pfizer.

Pfizer (PFE.NYSE): Investment Case

We originally bought Pfizer years ago, trading out in early 2016 due to the potential merger between the company and Allergan Plc, which was at the time a potentially lucrative windfall due to tax inversion (i.e. shifting headquarters to Ireland).

"So, if the regulators and governments allow the merger to proceed, it is our view that Pfizer may have just bitten off more than they can chew...doing something for tax reasons alone is seldom a good reason."

- Robert Swift, 'Stock Review - Our Investment in Pfizer', 2 March 2016

Unfortunately for the company, the US Treasury (at the time under the Obama administration) issued new rules to effectively prevent the deal (though it was not pointed out). There was a US $150m breakup fee and somewhat lacklustre performance since.

We bought back into the stock in 2019. Why?

For one we feel the company is often misunderstood. Even before their Covid-19 vaccine, they had a strong pipeline of drugs which fit in perfectly amidst an aging and increasingly obese population. Although mature, Lipitor (cholesterol), Viagra and Celebrex (anti-inflammatory) are three core products. This is combined with prudent acquisitions throughout the 2000s (i.e. effectively ensure stable cash flows for the foreseeable future). With the advent of Covid-19 however, we feel that the company has hit a new period of potential growth. Granted, given the global environment and an increasingly confrontational approach to the sector in the presence of vaccine shortages (yes, this is an issue for a vast majority of the global population despite it not being the case in the West), we will see incremental monetisation going forward. As Covid-19 continues to evolve in the presence of vaccines (superbugs are all but guaranteed) and we see continued rounds of yearly vaccinations globally, this will potentially remain a sticky revenue stream. Believe it or not, the real money is likely not made now when there is a great degree of immediate necessity and potential PR nightmares, we expect increased margins over time as the world learns to live with it.

Arriving at the numbers, revenues for the company grew at a stellar 130%. Even stripping out Comirnaty (their Covid-19 vaccine), the company continued to meet expectations with 7% growth. That second aspect is important given that the flipside of Covid has been a decline in OTC medications and healthcare expenditures. We believe that this is due to Pfizer's unique product line, aside from lockdowns providing a tailwind for Viagra sales, there has been consistent growth across product lines such as Vyndamax (heart failure - transthyretin-mediated amyloidosis), Ibrance (Breast Cancer) and Eliquis (blood clots), all three of which have grown at high double digit rates. On the negative, cost of sales increased close to 41% (granted, a result of vaccine distribution requirements). What is more concerning however is the 5% increase in Selling, Informational & Administrative Expenses (SI&A), this goes back to our point about the increased expense burden across the sector.

What is more interesting, in our humble opinion, is the all important R&D metric, that is the success rate of the drug pipeline. Across all three phases, Pfizer stands out in having a rate approximately 20-30% higher than industry averages; Phase 3, for example, at 85%. Using simpler metrics, PE at 16.2x (compared with the S&P500 at 29.51x) and a dividend yield of 3.3% (don't use Australian standards, this is reasonably attractive for US equities) with a payout ratio of 52.45%, we expect this to go sequentially higher over the coming two year period.

Over the coming weeks we will continue to explore the pharmaceutical sector. Given the events of last couple of years, it is easy to have Covid-blinkers on when looking at the space but we will look to explore some of the other dislocations and interesting vaccines/treatments currently in development and the opportunities that these present.

Funds operated by this manager:

TAMIM Fund: Credit, TAMIM Fund: Small Cap Income

Crypto Revolution in Gaming

19 Nov 2021 - Frazis Capital Partners

Part 2 of a series on Web3 exploring the impact on highly disparate aspects of the human experience: art, music, science, crime, capital, business, payments and, of course, investment opportunities.

19 Nov 2021 - Crypto Revolution in Gaming

By: Frazis Capital Partners

Crypto Revolution in Gaming

Michael Frazis, Frazis Capital Partners

02 November 2021

Part 2 of a series on Web3¹ exploring the impact on highly disparate aspects of the human experience: art, music, science, crime, capital, business, payments and, of course, investment opportunities.

Crypto Revolution in Gaming

As with art and music, crypto is formalising and dramatically enhancing nascent human behaviour in gaming.

Long before Web3, there were people with plenty of time but no money, building characters in games for people with money but no time.

Countless hours were sunk into games like Runescape, where characters wander around a richly developed world doing quests, mining for ores, smelting that ore into metal, then forging that into weapons to be sold for in game currency, or used in battle in the wild regions.

Those that died in battle lost everything they held, and characters with any kind of credibility represented years of play time.

A Runescape village, where you might smelt some ore, deposit goods in the bank, or shop.

World of Warcraft had an even richer world and a wealthier audience. Players in poorer countries spent huge amounts of time building valuable characters and selling them: on an hourly rate, it was competitive with whatever else was on offer.

The problem with all this is that these worlds are under the firm control of companies who made this activity illegal. Interestingly, the centralised control of traditional gaming was a key motivator for the then-teenage Vitalik Buterin to create Ethereum, after Blizzard disabled hard-earned abilities on his World of Warcraft character.

And there was plenty of fraud and skullduggery that made transacting a minefield for all involved.

Most importantly, in all these traditional games, players have no actual ownership over anything.

Crypto, of course, welcomes this kind of peer-to-peer behaviour (the transactions, not the skullduggery, but more on that in a later post!), through clear, programmable rules, backed by a distributed computer and open ledger that everyone on the planet can trust and inspect.

People who accrue value in one game can immediately exchange it on extremely liquid marketplaces.

Axie Infinity

The largest NFT² game right now is Axie Infinity. Similar to Pokemon, you can buy, trade and fight with Axies.

Axies can breed, replete with dominant and recessive characteristics, to create new and more valuable characters. Each funny little creature is unique and apparently the game is quite fun.

This cutesy looking game has changed the lives of tens and perhaps hundreds of thousands of people in the Philippines, of whom many earn more playing Axie than the average wage.

Players can earn (relatively) hard currency by developing, fighting, and trading their Axies, and then safely transfer and store that value in crypto wallets - an aspect that was absent from all games prior.

This has taken the Philippines by storm, is something of a gateway drug into crypto. 50% of Axie players had never used crypto before, and 25% didn't have a bank account (according to a founder).

More info and a better explanation of the game here.

Can't you have games like this without crypto?

As with the examples of art and music: yes, but no.

Yes, because earlier games did indeed develop vibrant economies.

But no - you could not easily transfer value in and out, and there was no way for players to capture the value of the community they were building. There was no way to set new players up with secure wallets that could transact in a trusted way with people both in and out of the game.

Companies could and often would squash out the nascent economies that developed.

World of Warcraft's creator, Blizzard, made even the simplest kinds of transactions illegal. Human nature being what it is, a black economy developed anyway, albeit in a strained, risky, and hacky kind of way.

All the value created by those endless years of gameplay was ultimately captured by the companies, not the players. The chance to change this is the real revolution.

So how big is this use case, really?

One of the beautiful things about crypto is that you can see every transaction. Every dollar of revenue is on chain and searchable.

Imagine if you could do that in public markets, see day-by-day revenue of every company, and invest accordingly. We certainly wouldn't have to stress about reporting seasons in the same way.

That is exactly what happens in crypto, which may partly explain why things move so fast.

We can say with some certainty that Ethereum generated over $1 billion over the last 30 days in transaction fees, paid directly to the validator nodes.

Axie Infinity generated $190 million, a greater than $2 billion run rate.

Which means there is a veritable monthly fortune on offer for players in the Philippines and countries like Nigeria, Venezuela, and Ghana.

Unsurprisingly, Blizzard, Steam, Apple, all the game publishers and developers aren't so keen on these kinds of value transfers to players, and have all actively banned games that incorporate NFTs and crypto, missing an extraordinary opportunity.

They are stuck in one of those innovation dilemmas, too concerned about their existing business model to redirect their talent.

Well-designed economies in Web3 ensure that communities receive much of the value they create, and outsiders can participate.

And on top of an explosive growth in price, the whimsically glorious $SLP token (Secret Love Potion) pays a 126% APR, which if reinvested at the current rates, equates to a 252% annual yield.

Early users and adopters become hyper-engaged financial stakeholders in a way that conventional corporations never allowed, which is one reason why people in Web3 are so obsessed with their chosen communities.

Sandbox

Sandbox (left) and Minecraft (right)

One of the more surprisingly successful traditional games is Minecraft, which was bought by Microsoft for $2.5 billion in 2014, an absolute steal.

415 million monthly active gamers (2020) have control over a Legoblock world, building increasingly complex structures and environments. Of course, they don't actually own what they build.

Sandbox takes this concept into the crypto Metaverse.

In Sandbox creators can make their own in-game assets and sell them on secure marketplaces. Without that incentive people were already making crazy things like block-by-block replicas of Minas Tirith and castles in Westeros.

Block-by-block creations in Minecraft - imagine what people would make with an economic incentive?

VoxEdit allows players to make and animate (with sounds) their own NFTs in the Sandbox.

Assets are bought and sold using SAND tokens, and if you don't want to create, or buy, but believe in the concept, you can buy the tokens outright.

Sandbox tokens have been on a bit of a run late

And Sandbox has sold real estate on their world for increasingly spectacular sums:

A map of The Sandbox

While the full game is yet to launch (expected early next year), this is a tantalising application of Web3.

And a far better take on the Metaverse than Zuckerberg's depressing virtual corporate offices!

Facebook's Metaverse, as if meetings weren't bad enough already. You're on mute!

Star Atlas

In Star Atlas, also under development, players buy Starcraft NFTs and explore a rich universe with real monetary value up for grabs. Players can discover planets, mine asteroids and accrue real cryptocurrency while playing.

The trailer is worth watching here.

A US$30,000 starship for sale

As with games like Runescape, players can form alliances and leave safe parts of the map, to commit violence on whoever they find in the uncharted wilder regions, again an intensification of existent gaming behaviour.

Only, in the crypto Web3 version, where entry level capital starships are priced in the tens of thousands, the stakes are much higher.

Gaming is about to become a lot more serious, and a lot more fun.

¹Web1, Web2, Web3: three stages of internet growth. Web 1.0 - connecting information and getting on the net. Web 2.0 - connecting people / social participation. Web 3.0 - use of machine learning and artificial intelligence to create more open, connected, and intelligent websites or web applications; includes decentralised apps that run on blockchain.

²A non-fungible token is a unique and non-interchangeable datum stored on a digital ledger. NFTs can be used to represent easily reproducible items such as photos, videos, audio, and other types of digital files as unique items, and use blockchain technology to establish a verified and public proof of ownership.

Funds operated by this manager:

Frazis Fund

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.

Why froth can't burn your tongue

18 Nov 2021 - Spatium Capital

The origin of the term "frothy" - in an investment context - is disputed, but many attribute it to Alan Greenspan. The former Chairman of the US Federal Reserve is believed to have normalised the word in his response to the state of the US...

18 Nov 2021 - Why froth can't burn your tongue

By: Spatium Capital

Why froth can't burn your tongue

Spatium Capital

November 2021

Since the global financial crisis, the use of this word when referring to the markets has been looked upon ominously.

In early 2019, the buzz surrounding the state of the frothy ASX was a lasting discussion.

A frothy market is a state in which markets begin trading well above their tangible asset values, often because investors are ignoring fundamentals and making emotionally driven and speculative decisions (periods of which can endure for many quarters, if not years).

The reason frothy markets are often so topical is historically these periods precede a burst of a market bubble.

At least this was the case for the dotcom bust in 2001 and the housing crash (GFC) of 2007-2008. Given the almost two years since COVID19 first disrupted our lives, perhaps this latest episode is also one for the history books.

The current argument we are seeing is the significant growth and interest in alternative 'asset' classes, mirroring the speculation-style dotcom and housing market catalysts for the two most recent frothy periods that preceded a burst bubble.

With our eyes firmly on equities, we couldn't help but notice that Bitcoin, the most mainstream of the cryptocurrencies, took the quickest time (12 years) to reach $US1 trillion in market capitalisation.

Bitcoin now joins an elite club of trillionaires alongside US household giants Microsoft (44 years), Apple (42 years), Amazon (24 years) and Google (21 years).

Whether cryptocurrency will be the catalyst for the next bubble popping will likely only be realised in hindsight, however at the risk of playing into a false causality (falsely assuming events appear related and therefore causing one another) we prefer to remain impartial and observe.

So are equities frothy right now? When comparing the equity markets amongst peer asset classes, there is some potential explanation to the current upward trend(s) that have occurred.

Considering that many fixed income yields are currently heavily compressed, property rental yields in Australia aren't shifting nearly anywhere as quickly as the capital growth trend line and that bank term deposits are a heartbeat above zero, there is an argument to suggest that the stock market's liquidity, prospective growth profile and risk (in comparison to viable alternatives) is the beneficiary of this struggling peer group.

Further, there is an argument to be made that equities, in contrast to some of these alternatives, might fare better in a rising inflation environment - a topic for another time.

This enduring low yield environment does however shed light as to why some investors have found themselves including cryptocurrency as part of their asset allocation; when looking at the state of asset classes in this current environment the options for return (via speculation or yield) have become suddenly fewer.

The final point we would add goes hand-in-fist with frothy markets; investing at all-time highs. Let's look at the below graph and reference what JP Morgan found when investigating all-time highs.

Source: Ben Carlson, A Wealth of Common Sense, 'Investing in Stocks At All-Time Highs'

As illustrated, it has been more lucrative over the last 30 years to invest at all-time highs, rather than shying away from these points and thereby attempting to market-time.

We feel this is somewhat of an underappreciated phenomenon; whilst the brain naturally seeks out patterns in charts that highlight drop-offs such as the GFC, or the COVID drawdown (and consequently drives feelings of fear aversion and a flight to safety), it fails to identify the many, many times a market reaches an all-time high, and then continues to rise further.

Startlingly, on average, key markets such as the US S&P500 set 16 new all-time highs a year.

Like with all risk assets, including property, fixed income, shares and others, the long-term success of these asset classes has stood the test of time.

The only true certainty is that diversification and patience are your best friends. Further, if diversification and patience are your best friends, conviction likely follows closely behind.

As a fund manager, we approach each trading day with the pursuit of identifying mispriced equities and not trying to time this up or down movement of the broader index.

Nor do we seek to fluctuate our cash weighting by keeping the fund's total assets 98-99% invested at all times.

This approach minimises the human tendency to buy assets when prices are rising (and potentially overpaying) and selling when things get scary (and potentially selling at a discount).

By maintaining a smooth and consistent approach to investing, irrespective of the asset class, one can work against this natural tendency.

In conclusion, whilst the market might be considered frothy right now, we suggest in light of the above information that this might not necessarily be a bad thing.

As Peter Lynch so famously said, "Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves."

Funds operated by this manager:

Spatium Small Companies Fund

Why this market would freak out a Martian

18 Nov 2021 - Montaka Global Investments

Three examples of stocks in the reopening, defensive and mega tech narratives highlight a market that would baffle a rational Martian.

18 Nov 2021 - Why this market would freak out a Martian

By: Montaka Global Investments

Why this market would freak out a Martian

Montaka Global Investments

09 November 2021

If a Martian arrived on planet earth today, the global stock market would freak them out. This market is full of peculiarities. Mr Market - the personified term value investing legend Benjamin Graham used to describe the emotional swings of the market - is currently excited about narrative stocks, particularly 'reopening' and 'defensive' companies, and rewarding them with rich valuation multiples despite questionable fundamentals. At the same time, it is punishing companies with reliably growing profits and cash flows, particularly the world's leading mega techs, because of overblown concerns about inflation and regulation.

On any given day, the market appears to be swept up in the prevailing narrative. What is missing is an objective outside examination of the facts that anchor sound investment decisions and underpin strong, long-term performance.

Three examples of stocks in the reopening, defensive, and mega tech narratives highlight a market that would baffle a rational Martian.

Are 'reopening up' stocks good investments?

The first thing the Martian would see when he arrived on earth is that, as COVID-19 cases subside around the world, 'reopening' stocks are trading at very generous valuations. One is Royal Caribbean Cruises, the Florida-based cruise company that was severely impacted by the pandemic. When 'no sail orders' were introduced last year, its revenue literally fell to zero.

With the reopening, around two-thirds of the company's fleet are now sailing and that should move to 100% over time. But the company's stock price is still one-third lower than pre-pandemic. The 'reopening up' narrative is often persuasive to Mr Market. Surely this investment represents easy money for the taking?

Our Martian would say no.

For a start, the company's balance sheet has become financially stretched: the ratio of net-debt-to-book-equity has more than doubled from 0.9 times to 2.2 times. So while its stock price is below pre-pandemic levels, its enterprise value (EV) - the company's total value including borrowings - has well and truly reflated back to pre-pandemic levels. So the company is not as cheap as one might think.

Royal Caribbean Cruises

Montaka Global Investments

Source: Bloomberg

If our Martian assumed that earnings will return to pre-pandemic levels relatively soon (the company is currently loss-making), they would see that based on its current enterprise value, the company has an EV ratio of 20 times this recovered level of earnings (EBIT).

A rational Martian would be bewildered that the market has put such a high valuation on this company. Why would Mr Market be willing to pay such a high multiple of fully-recovered earnings for a heavily-indebted cruise business that remains years away from pre-pandemic profitability - in an industry that will also expand capacity at double-digit rates over the coming years, adding downward pressure to ticket prices?

All kinds of 'reopening-exposed' businesses, from airlines, travel agents, and live entertainment businesses, have seen their EVs fully-recover to pre-pandemic levels, despite earnings being years away from their fully recovered levels.

Are 'defensive' stocks safe?

Meanwhile, our Martian would also hear a narrative around markets being 'stretched' and observe some investors turning to defensive stocks which have become similarly irrationally overvalued. In California, The Clorox Company, a large producer and marketer of branded household cleaning products has a great, defensive business. Households continually buy their bleach, sanitizer, and stain removers irrespective of the natural ebbs and flows of the economy.

It makes sense to Mr Market, therefore, that if the markets are feeling toppy, hiding out in companies like Clorox provides some safety.

But our Martian would not think this company's stock is particularly safe at all.

Its growth has recently turned negative. During the pandemic, its business grew rapidly when Americans rushed to stock their homes with cleaning products. But today that growth is naturally much harder to come by. It is hitting the inevitable 'air pocket' that follows such a drastic pull-forward in demand.

The Clorox Company - Revenue Growth

Montaka Global Investments

Source: Company Filings

The company is also being hit by higher costs. The rising costs of commodity inputs and transport are materially impacting on profitability. In the company's most recent quarter, for example, its gross margin fell 10 percentage points relative to the same period in the prior year.

Yet Mr Market has awarded the company a valuation that implies strong performance for years to come. Its ratio of EV to next year's earnings (EBIT) is 23 times - a materially higher ratio than even before the pandemic. Our Martian would once again be confused: this hardly feels like a safe investment offering protection from 'stretched' stock prices.

Again, this dynamic is not isolated to Clorox. We are seeing similar dynamics in a wide range of branded consumer packaged goods businesses, as well as utilities - all of which are considered by Mr Market to be 'defensive' today.

Are mega-tech's best days in the past?

While our Martian sees 'reopening up' and 'defensive' stocks trading high, they would also see mega tech companies with great fundamentals being punished amid the 'mega-tech is dead' rotation due to concerns about inflation, regulation or other reasons that seem to justify the narrative

Shenzhen-based Tencent is one example. It owns the most widely used digital communications applications in China. With 1.2 billion members in its mobile community, this business owns a privileged platform for social communication (both personal and professional) as well as gaming, news, music, video, e-commerce, and payments.

Tencent - A Platform of Platforms

Montaka Global Investments

Source: Company Presentation

This company also happens to own China's second-largest cloud computing business. It is rapidly building out leading enterprise applications and platform tools, which are the Chinese equivalent of Salesforce, Shopify, Zoom and Microsoft Office. These are not monetised today and, instead, represent valuable future growth options.

But despite this powerful position, our Martian would see the stock is seriously undervalued. The ratio of enterprise value (excluding a large portfolio of equity investments) to next year's operating earnings (EBIT) is just 16 times.

Unlike the reopening-up and defensive stocks above, our Martian would find this stock very interesting. A business of this quality, growing 15-20% per annum for at least the next five years and beyond, with an attractive collection of large, high-probability future growth options, yet trading at a reasonable price.

And it's not just in China where these disconnects between the valuations of mega techs and their high business quality are occurring. In the US, for example, Mr Market is willing to sell you Facebook at less than 18 times next year's operating earnings.

To our Martian, buying Tencent and Facebook from Mr Market - and selling him Royal Caribbean and Clorox seems logical.

What is an investor to do?

So how should an investor play a market that would baffle a rational Martian?

It depends on your investment time horizon. Investors looking to make money next week, next month, or even next year have their work cut out for them. Anticipating Mr Market's mood swings - which change on a dime - is not easy and may well be impossible to do on a sustainable basis.

But for investors, like us at Montaka, who are seeking to compound capital over the long-term - think ten, 20 years and beyond - the answer is to always let your investment decisions be guided by the facts, such as the strength of business advantages, the long-term growth of industries and the fair mappings of business earnings drivers to present values today.

As Benjamin Graham famously told Warren Buffett:

"In the short run, the market is a voting machine but in the long run it is a weighing machine."

Let the facts liberate you from the short-term mood swings of Mr Market. In the current market that means not getting sucked into short-term reopening and defensive narrative trades and focusing on owning the long-term winning businesses in the world's most attractive markets.

Investing for the long-term by looking through the short-term noise means that your portfolio will perform differently to that of your peers but staying the course - as challenging as that can be - will yield the long-term rewards.

Funds operated by this manager:

Montaka Global 130/30 Fund, Montaka Global Fund, Montaka Global Long Only Fund

Australian Equities Market Update & 2022 Outlook

17 Nov 2021 - Sage Capital

Portfolio Manager, Kelli Meagher and Chief Investment Officer, Sean Fenton provide an update on the Australian equities market and the outlook for 2022.

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Fund Monitors Pty Ltd

News

26 Nov 2021 - Australian Big Banks are Back!

25 Nov 2021 - The Long and The Short: The tide of inflation

24 Nov 2021 - How wholesale investors find fund managers that get them returns

24 Nov 2021 - New Funds on Fundmonitors.com

23 Nov 2021 - Investment Perspectives: Is long WALE really low risk?

22 Nov 2021 - PharmaFun: Broad Strokes, Covid-19 & Revisiting Pfizer

Pfizer (PFE.NYSE): Investment Case

19 Nov 2021 - Crypto Revolution in Gaming

18 Nov 2021 - Why froth can't burn your tongue

18 Nov 2021 - Why this market would freak out a Martian

17 Nov 2021 - Australian Equities Market Update & 2022 Outlook

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