Last year, we endured some major shifts in the market. Just 23 trading days resulted in the S&P 500 falling -34%. By June it had topped +40% (from its 23 March low). It can be disturbing when this happens in such a short timeframe, especially with the media going ballistic with doom and sensationalism. Is this usual?

Yes, it is. Large ups-and-downs occur all the time - though not for the past 10 years. So it feels unusual and can be tempting to time moves or cash out until things feel okay again. Here are the seven biggest market events over the last 90 years:

1. The 1929 Great Depression Crash lasted well into the 1930s. It's still by far the craziest ride in history. The market was up +32% in '29 until peaking in September. Then it fell -45% in two months. Then it rose +28%. Overall, the year was down just 8.3%. By four months into the next year the market was up +22%. It didn't last, as the next eight months would see a -44% drop. By December it was still down -25%.
2. 1931 had stocks rising in two months by +19%. It then flipped, closing around -57% by mid-December. That year is the worst year on record, finishing -44%. Would you have stayed invested? Another -51% drop over the next five months of 1932 would really test you! (This was THE bottom as it turned out.) Without warning or good news, markets rallied +112% in only 12 weeks. The S&P still fell again another -32% to settle for the entire year at -8.6%. Selling didn't subside in 1933 as there was another fall of -25%. After that, investors enjoyed a staggering +121% in July (and a bump of -29%) to finish the entire year +50% - one of the best years ever. 1934 saw another rise of +21% (and a fall of -29%). 
3. The '73/'74 oil crisis marked another rollercoaster of returns. Stocks fell -37% before bottoming in October, then rallied +21% the next month, ending the year at -26%.
4. 1980 saw stocks falling -17% only to rise +43%. The market was up +32% by year's end. 1982 witnessed a similar event with -17% followed by a +40% jump. Year-end stocks were up +20%.
5. The Black Monday crash of '87 saw the market falling -34% in only a week. It had risen +40% beforehand and ended the year almost +6% (after the worst one-day crash in history). 
6. The late '90s asset bubble had a +20% gain for five years straight up until 1999; yet in '98 it had a -9.3% fall before increasing +34% ending the last year of last century at +28%. As the dot-com bubble burst nudged by 9/11, three big 7. price swings occurred in 2001. Stocks fell -19% before rising +19%; then there was a -26% crash to close the year around -12%.
7. The 2009 GFC bottomed in early-March '09 at peak gloom but not before being slammed at -28% from 1 January. Prices then leapt +67%, closing the year at +26%.

What would you have done as an investor in response to each of these market events? Hindsight is a wonderful thing...

Three demographic discoveries that affect investments

To understand the drivers of the structural down-shift, we need to first look at the reality of the globe's demographic make-up. Our white paper discusses three demographic discoveries - and at least one of them will challenge long-held beliefs!

Discovery 1: The world population will grow for the next 30 years and there's not much that can be done to stop this. 

Discovery 2: World population will then decline and there is little that can be done to stop this if societies behave as they have done for millennia. 

Discovery 3: 'Peak Child' occured in 2011. There will never be a year in our lifetimes where more children are born. This has profound economic growth implications.

Learn more in our demographics White Paper: The GDP Downshift - Preserving Equity Returns

Disclaimer
Equity Trustees Limited ("EQT") (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Insync Global Quality Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) ("Insync"), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

Recently, there's been a lot of discussion about whether the significant government stimulus, combined with record low interest rates and unconventional monetary policy such as Quantitative Easing (QE) will finally result in rising inflation, something markets have not experienced for some time. After a number of false starts, it appears that almost every central bank is committed to these measures until they achieve their objective of realised inflation.

It's a risk of which investors should be aware. On a practical level, it means taking a look to see whether the assets in your portfolio are still match-fit in an environment of rising inflation. We have previously written on the critical role of the attacking defender as it relates to private debt illustrated through soccer, so we'll extend this soccer team analogy to explore this dynamic and the role private debt can play to help investors navigate an environment of rising inflation.

Moving market dynamics

Long-duration assets like government bonds, infrastructure, property, and high-growth equities benefit when interest rates fall by lowering the discount rate applied to all their future cashflows.  These are the first assets selected in your team when rates are falling. We have seen these champion investments perform exceptionally well over the bull market of the last 40-years, when interest rates have dropped from double digits to near-zero levels.

With the potential for rates to rise from zero and with the prospect of inflation, it's time for the coach and team manager - in markets, the portfolio manager - to make some difficult decisions about whether champion players in the twilight years of their career - for example sovereign bonds - should still be on the field, at least for the whole match. It may be time to re-evaluate whether your best past players are really your top choices going into a new season, or whether they should be retired, rested, or spend less time on the pitch because they've lost a yard of pace.

When inflation expectations rise, interest rates tend to increase, and the yield curve steepens. In these conditions, it's an opportunity to reconsider whether some of the long duration assets that have been tried and tested players in the portfolio are still fit for purpose. It might be time for short duration asset classes such as private debt to step into their role in the team.

In a rising interest rate environment, the value of long-duration assets like fixed rate corporate and sovereign bonds, fall in value because their future cashflows are discounted further than before. This isn't the case with private debt, which is short duration and senior secured debt, and in a rising interest rate environment does not fall in value, giving true diversification benefit.

Australian & New Zealand Private Debt: Appeal in a rising rate environment

The chart below illustrates various credit and fixed income investments with differing levels of duration. The longer the duration, the more sensitive the investment valuation will be to interest rate changes.   

     Source: Revolution Asset Management and Bloomberg. 'Aust & NZ Private Debt' is based on realised investment experience of the Revolution private debt strategy from December 2018 to May 2021.

In fact, the overall yield of private debt rises in line with interest rate movements upwards because the total interest earned on the assets is the floating rate benchmark plus the credit margin, instead of a fixed rate coupon. This is one of the most compelling reasons to consider an allocation to private debt in your current portfolio. The trade-off is that investors need to be comfortable with increased credit risk and the illiquidity that comes along when investing in private debt.

Like any soccer team, sometimes the coach or manager needs to bench certain assets because they don't suit the playing conditions. But when conditions turn, it could be time to bring them back into the team. Gold is a good example, which has historically served as a store of value when inflation rises. Perhaps it's also time to have an eye to the future and consider whether to promote up-and-coming players from the youth team. In this example, the coach or portfolio manager might examine whether an allocation to crypto currencies may add diversification to your portfolio in a QE world, but we'll leave it to others to continue this debate.

Re-positioning for the times

Overall, what's important is to have the right balance of attacking and defensive assets in a portfolio for the current conditions. You pick a different team when the game is played in rain and snow compared to when the conditions are fine. When it comes to investing, what's important is to choose the right assets for the prevailing economic and market environment.

Think of private debt as the attacking defender or wingback in the team, it provides the right balance in a portfolio because it produces uncorrelated returns to other assets, as we demonstrated in our previous article. It's an investment that's first and foremost a defender that aims to preserve capital, but at the same time, it can contribute to the attack and goals in the form of regular income that can either be spent or used to re-balance. Just as with soccer players, consistency is the key to selecting a fund manager that has the form for managing a portfolio through different conditions. At the same time, a good fund manager - and good players - will be well-balanced, durable and without weaknesses.

Private debt as an asset class is an especially attractive option, particularly when inflation is rising, something with which markets have not had to grapple for some time. Revolution Asset Management's goal is to be the attacking defender in investor portfolios by providing that winning and balanced combination of attack in the form of potential income, and defence in the form of aiming to provide capital preservation through all market cycles.

This article is for institutional and professional investors only and has been prepared by Revolution Asset Management Pty Ltd ACN 623 140 607 AFSL 507353 ('Revolution') who is the appointed investment manager of the Revolution Private Debt Fund I, the Revolution Private Debt Fund II and the Revolution Wholesale Private Debt Fund II (together 'the Funds'). Channel Investment Management Limited ACN 163 234 240 AFSL 439007 ('CIML') is the Trustee and issuer of units for the Funds. Channel Capital Pty Ltd ACN 162 591 568 AR No. 001274413 ('Channel') provides investment infrastructure services to Revolution and Channel and is the holding company of CIML. None of CIML, Channel or Revolution, their officers, or employees make any representations or warranties, express or implied as to the accuracy, reliability or completeness of the information, including forecast information, contained in this document and nothing contained in this document is or shall be relied upon as a promise or representation, whether as to the past or the future. Past performance is not a reliable indication of future performance. All investments contain risk. This information is given in summary form and does not purport to be complete. To the extent that information in this document is considered advice or a recommendation to investors or potential investors in relation to holding, purchasing or selling units in the Funds please note that it does not take into account your particular investment objectives, financial situation or needs. Before acting on any information you should consider the appropriateness of the information having regard to these matters, any relevant offer document and in particular, you should seek independent financial advice. For further information and before investing, please read the relevant Information Memorandum available on request.

IPOs can give you wonderful returns if you get them right, but burn your money if you don't. And that's clearly shown in the trajectories of the companies that have listed since the COVID-induced market lows in March 2020. Because, while there were some big winners - like Cettire (ASX:CTT), Aussie Broadband (ASX:ABB) and Universal Stores (ASX:UNI), there were also some clear losers.

Our process at the Montgomery Small Companies Fund is designed to seek out companies with an under-appreciated or undiscovered competitive advantage with capable management teams that are early in their value creation journey. The IPO market can be a good place to look. So what's been happening in this area of the market since the market's COVID lows and what did we do?

The IPO market since COVID 

The first IPO out of the blocks in the COVID market depths was a $30 million raise for Atomo Diagnostics (ASX:AT1) at 20c a share. AT1 listed with an agreement already in place to provide COVID diagnostic kits to needy European Government type customers. It seems that whatever solace the market is looking for at any given moment in time, there is an IPO for that! Day 1 turned out to be AT1's best day (so far) - trading at over 50c, but it's been downhill ever since, with the stock now trading 20 per cent below issue price at 16c or so today. Quite a journey. There is a message in the AT1 story.

The valuation regime of an IPO is an unknown, brokers do a good job to select IPOs that they can "get away" essentially giving the investor crowd what its craving, the flavour of the month. And brokers work hard to whip up demand, this can result in extreme pricing dislocation events. Our job is to be on the right side of that event. Picking those businesses that can go on to create that value for our investors in the Fund. The ones that go up and stay up.

There are many IPO events - we go through the stats below - so our process involves an initial screen, to see if the IPO candidate likely has the characteristics that we are looking for in the portfolio, before selecting which ones to spend the time and effort doing proper due diligence on.  Doing the work at IPO helps get an understanding of a company that can pay dividends down the track, even if we don't decide to invest on IPO, we try to do the work on as many as we can.

The stats: By our count there have been 110 IPOs since the market COVID lows in March 2020. 39 of these have been resource exploration plays, all but 2 have been sub $50 million market cap. Microcap resource exploration plays is not an area of the market the Fund goes hunting in. Too speculative. We don't look at those.

There have been 71 non-resource exploration IPOs that have listed since the COVID lows, 44 of these have had a market cap on IPO of greater than $50 million. That's our investible universe. Of these 44 listings, the median return since IPO is -3 per cent. 21 are above IPO price, 23 are under. The data says IPOs are not a one way bet, but the chart below also shows that if you get them right there are good returns available.

Distribution of IPO Returns post March 2020: IPO price to date

Source: Montgomery, Iress, Listings 1/4/21 onwards, ex Resource exploration with Market Cap > $50mn

Characteristics of IPO losers

One of the most common IPO errors observed in recent times is investors look to play "hot themes" of the moment.  Remember if you want it, there is an IPO banking team that has got the deal for you and during COVID times this was meal kits, e-commerce and buy-now-pay-later, amongst other things. An IPO on a "hot theme" can look good in the short run, but can come with longer term pain, as the hot money that chases these "hot" deals does what it does best and moves on to the next shiny thing. Consequently, most if not all of these types of new issues don't find a real investor base anywhere near their IPO price and end up firmly under water.

Youfoodz (ASX:YFZ), tried to capitalise on the market's appetite for meal kit delivery that boomed during COVID. Its IPO was "priced" at $1.50, it never traded within cooee of that, best print was $1.32. One way traffic since then. It's 71 per cent down, trading at 44c on my screen as I write, and takes the award for the worst post COVID IPO (to date anyway). My Food Bag (NXZ:MFB), New Zealand's "Youfoodz" provides further illustration of hot theme/hot money loser and is trading 28 per cent below its issue price.

Another that looked to cash in on the "moment" was internet retailer Adore Beauty (ASX:ABY). The business was listed on a high valuation, after being acquired by private equity for a much, much lower price only a short time before. At best you could say this was opportunistic. Nevertheless "investors" fluttered like moths around the e-commerce flame when it IPOd at $6.75 in October 2020. That did slightly better than YFZ, however like many moths the "upside" there didn't last long, ABY closed above issue on its first day, but never since and is now down 32 per cent on that IPO price. ABY is arguably now an illiquid micro-cap with a lot to do to re-build its reputation with investors after its warning that it's not growing at the rate investors expected. A downgrade in expectations before it even delivered its first set of full year financials as a listed company is a sin not easily forgiven by institutional investors.

A blog on IPOs wouldn't be complete without reference to Nuix (AX:NXL), but given the AFR has done such a good job of disclosure there (better than the prospectus it appears...), we don't feel the need to explain. Caveat Emptor.

We didn't do the work on any of the above.  Screened out early.

The Winners

IPOs can be lucrative too, as just as the price discovery process can be difficult for investors, that's the case for the IPO brokers and advisers too, and the business can be sold too cheaply at IPO. IPOs that have performed well include Cettire (ASX:CTT), Aussie Broadband (ASX:ABB), Maas Group (ASX:MGH) and Universal Stores (ASX:UNI). We didn't look at CTT (we thought the e-commerce model was just a child of the times and would quickly slow, time will tell) or ABB (sometimes we miss things). We looked at MGH but thought it was expensive, it's up 150 per cent so I suppose you'd classify that as getting it wrong! We invested in UNI.

Of the bottom 10 IPO stocks, 9 of those were "hot theme" stocks, only Harmoney probably doesn't manage to fit that description, although arguably it may have been pitched as such. On the flip side of the top 10 performing IPOs only 2 of them could be considered to be "hot themes" and 1 is a bio-tech (tough to value), the rest have proven business models, some with competitive advantage, many are well run by talented management teams.  That's what you need to look for.

Montgomery Small Companies Fund IPO report card

Of the 44 non-resource exploration IPOs since COVID with a market cap of greater than $50 million, we have looked at 23 of them, the rest we screened out, for one reason or another. We also looked at one sub that market cap level as we thought it could be interesting - a total of 24 active IPO investment decisions were made. We decided to invest in 8, of the 24 we reviewed.

Of the 8 we invested in, we made money in 6 of them, sometimes with very good returns.  As an aggregate across those 8 we have made 25 per cent return on total capital deployed, with the median return being 48 per cent. It's worth pointing out that only a small fraction of the Fund at any one time is committed to IPOs, for instance of the 8 IPOs we invested in, 5 have been sold, and we hold 3 which are collectively circa 2 per cent of the portfolio. Risk management is always important, especially with IPOs. Early stage companies have higher risk, so we size these in the portfolio so that if they go right we make good returns (see chart below), but if they don't work you won't see us telling you we have underperformed because an IPO didn't go the way we planned.  We acknowledge the work done by the advisors and brokers who partner with us, in bringing these companies to market, for the good ones that is, you can keep the bad ones!

What about our losers? Of the two IPOs we invested in that didn't work, we made minor losses on one, the other is Cashrewards (ASX:CRW), which hasn't worked (so far) but we continue to hold. We certainly don't get them all right.

Montgomery Small Companies Fund IPO report card: 75 per cent hit rate

Source:  Montgomery, Iress, Listings 1/4/21 onwards, ex Resource exploration with Market Cap > $50mn

Of the other 16 decisions where we looked but decided not to invest, 10 of those are under water, 6 made money, although 3 only just. We did miss 3 good opportunities that we did the due diligence on but for various reasons we didn't get over the line. Next time.

And we think that there will be a next time for quite some time. IPO banking teams at the banks and brokers report many IPOs in their pipeline, all looking for the right time to come to market. Whilst it's clear to us that investor appetite has moderated, particularly for loss making businesses, we see that as some "heat" coming out of the market. That's healthy and we expect a steady flow of IPOs for us to scrutinise over the coming months.

Why we invested

The cannabis theme first caught our attention in December, when a United Nations (UN) commission voted to remove cannabis from Schedule IV of the 1961 Single Convention on Narcotic Drugs. The decision removed it from being in the company of more dangerous and addictive substances like heroin and cocaine. Many investors around the world looked at this move and saw it as a major step to normalising the substance. Immediately after this announcement, prices of cannabis-related stocks began to climb. 

While the change had no immediate material effect on the space, it was seen as a symbolic victory and a sign to nations that it was acceptable to reconsider punitive criminalision policies. Days later, the US House of Representatives passed the Marijuana Opportunity Reinvestment and Expungement Act (MORE) which decriminalised cannabis on a federal level. 

In January 2021, some states in America began renewed efforts to legalise cannabis locally. Lawmakers in New Mexico, New York, and Connecticut all made overtures to either medicinal or recreational legalisation. A strong first day of legal sales in Illinois also spurred the belief the industry was profitable. 

In February, a group of German researchers published a study demonstrating the benefits of medicinal cannabis on patients with Parkinson's disease. 

By this time, the continued stream of positive news flow had reached equity markets - from the start of November to the 10th February, AdvisorShares Pure Cannabis ETF had appreciated approximately 183%. 

We began to initiate investments in the theme during the month of December and continued to build positions in companies such as Creso Pharma (ASX:CPH), ECS Botanics Holdings (ASX:ECS) and Elixinol Wellness (ASX:EXL) throughout January.

Towards the end of January, it became clear Joe Biden would enter the White House with a Democratic House and Senate. In theory, this would make it easier to pass legislative priorities which strengthened thematic tailwinds and confirmed our view that immanent short-term volatility would present opportunities.

Why we exited

We have since exited our investments in the cannabis theme for multiple reasons. 

After significant runs into March, we saw most businesses in the sector become over valued without any real shift in company fundamentals. We also saw a slowing of progress from a governmental and legislation perspective. When it became apparent further legal developments in the industry would be delayed by Congress, prices began to return to more normalized levels, though still inflated. 

In February, companies issued their half-yearly reports and financial statements. The general market reaction was negative, as business fundamentals could not justify current trading levels across the board.

As companies within the sector saw their share price continue to decline in late February and early March, it became apparent the theme required further developments to be in play once again. We subsequently exited our investments.

What we want to see next

To begin reaccumulating investments in the cannabis sector, we would like to see several developments. 

The most important is legalisation, not just in the United States but around the world where there are significant markets for medicinal and recreational cannabis. 

In the United States, legalisation of cannabis would break the regulatory shackles that has been holding the industry back. It would open access to funding from federally registered banks and allow companies who sell cannabis to trade on national stock exchanges (thereby providing easier access to capital). 

Further developments in the medicinal space would also be beneficial for the theme. If positive research continues to be published around the globe, we expect to see renewed investor interest. 

Mergers or acquisitions in the sector would also be positive - this would allow larger companies to gain access to better distribution channels and expand market access. Ultimately the objective is to improve business profits and margins, which will make the companies more attractive investments.

Laureola Australian Feeder Fund

Approximately nine months ago, we provided a review of our investment case for Nike in 'A Marathon, Not A Sprint'. With the benefit of time, vaccines, additional data points illuminating how consumer behaviour has shifted as a result of the pandemic, and further clarity on Nike's operational performance, it is a good time to take stock and revisit the business again.

The slide below is taken from our investor update presented in October 2020, and summarizes the key points underpinning our initial investment thesis for Nike back in August of 2019.

Source: AIM

While the narrative around Nike for much of the last 18 months has been 'work-from-and-stay-at-home-winner', our view was always that this misses a much more pertinent fact: that the company is undergoing a structural change in its business model that would mean its margin profile would materially increase over the next three to five years. From our October 2020 note:

Prior to our initial investment, we estimated that the sale of a Nike product through its direct-to-consumer (DTC) channel is substantially more profitable than through the traditional wholesale channel. Management have subsequently confirmed this, stating that the sale of an incremental unit through its owned digital channels generate roughly twice the revenue (due to Nike not having to provide a wholesale discount). In the [September 2020] result, management further quantified the margin impact of digital sales: roughly 10% higher gross margins, translating to roughly twice the operating profit of products sold through the wholesale channel.

Sales through Nike's digital channels accounted for ~30% of all revenues in the most recent quarter [ended August 2020]. With management indicating they expect this to increase to between 40% and 50% (and possibly higher) over time, it implies that Nike's historical gross margin profile (in the low-to-mid 40% range) will likely move closer to 50% over the medium term. Nike also plans to modestly expand its own physical retail channel by investing in smaller stores that effectively operate as an extension of the digital channel, allowing for customers to order online and pickup in-store, order in-store for home delivery, or simply function as a small-footprint showroom for consumers wanting to try before they buy.

Combined with increased insight derived from 'owning' the consumer relationship through its own stores and digital channels, we also think there are efficiencies to be gained in general operating and (in particular) marketing expenses over time. All told, we believe it is not inconceivable for Nike to expand operating margins somewhere between 4% to 6% over the next several years due to a combination of mix shift towards DTC channels and revenue growth.

The valuation impact of this margin uplift is material. In theory, by simply shifting the destination where consumers choose to purchase goods from Nike, the business could end up selling the same number of products at the same retail price but end up dramatically increasing profits. By vertically integrating its distribution to be more in-house, Nike is effectively reclaiming margin back from the wholesale channel.

Pulling Ahead of the Pack

Last week, Nike reported quarterly results for the period ended 31 May 2021, where management discussed many of the key drivers of performance for the businesses over the next several years. We were happy to hear that an increased focus on Women's shoes and apparel is bearing fruit, as this was a market Nike has historically underserved. (Turns out there's money to be made in specifically catering to the needs of ~50% of the population!) As this trend matures, we expect it to drive faster organic revenue growth for several years, underpinning market share gains.

Of further interest was the fact that Nike sees the changing positive attitude towards healthier lifestyles coming out of the pandemic as an opportunity to grow the overall market by promoting sports participation, particularly among younger consumers. The combination of greater insight into consumer preferences is driving not only more targeted product development, but also more targeted (and effective) marketing spend.

The interaction of these factors (a structural shift towards healthier lifestyles, expanding into underserved market segments, the shift towards a DTC-business model, and other efficiency gains from investing in technology over the past several years) lead to management issuing the following medium-term (2025) guidance:

• Revenue growth ranging between high-single-digit to low-double-digit, driven by the material opportunities in Women's, apparel, the Jordan brand, digital channels, and international markets. This is several percentage points higher than the average mid-single-digit revenue growth rate of the past few years.
• NIKE DTC will represent approximately 60% of total revenues by FY2025 (from ~40% currently), led by the growth in digital channels.
• NIKE-owned digital will represent approximately 40% of the business by FY2025. Partnered digital channels (large wholesale partners such as Footlocker, JD Sports, etc.) will make up a further 10% of revenues, for an overall digital channel mix of 50%.
• Driven by the mix shift towards Nike's DTC sales channels, gross margins will reach a 'high-40%' number by FY2025 (from a low-to-mid 40% range historically).
• Greater efficiency on operating costs will see the operating margin reach a high-teens percentage by FY2025 (from a 12% to 13% range over the last decade).
• The combination of all the above should lead to earnings per share growth of mid- to high teens out to FY2025.
• Importantly for us, capital expenditures are not guided to materially increase to fund these initiatives, meaning the free cash flow conversion of the above accounting earnings growth should be strong.
• Lastly, this means that returns on invested capital will end up being higher than the previously guided 'low-30%' range, meaning that Nike will continue to create enormous value for its owners.

Of late, the market has been focused on short-term issues, such as port disruptions in the US (meaning inventory was not able to be timeously distributed to consumers for a period), or a consumer boycott of Nike product in China (which seems to be dissipating already). Historically, such short-term 'glitches' are when long-term investors have the opportunity to purchase great businesses with a margin of safety. (Our initial investment in August 2019 was made at the height of the US/China trade war rhetoric; buying a US brand with a meaningful percentage of sales into China was not exactly the flavour of the month.)

By focusing on the longer-term developments that were not yet obvious in the reported numbers - specifically, the change in profitability enabled by the channel mix shift - and understanding the benefits of Nike's 'portfolio' approach to its business (across regions, categories, brands, and sporting codes), the long-term investor would have found much to like. As the margin uplift driven by the DTC shift is now better understood by the market at large, the market valuation has begun to reflect this; in fact, it rallied by nearly 15% on the day following its most recent result as the market capitalised the long-term margin structure into the valuation today. To us, Nike is a case in point where short-term market volatility can benefit the patient investor in buying a quality business at a margin of safety.

While we are sure there are still many unforeseen and unexpected challenges Nike will have to navigate out to 2025, the combination of its strong competitive advantages in brand (and, we believe, in execution), strong cash generation, a conservative balance sheet and a high-quality management team steering the ship gives us comfort that the business is a high-quality compounder, and will be for many years to come.

One of the most useful measurements investors and advisors can use when assessing a manager's past performance is up capture and down capture ratios. These measurements can tell a lot about how a manager has a generated their performance and can indicate whether they are a suitable investment for your portfolios. Up and down capture ratios also are a great indicator of whether a fund is delivering on its philosophy and process.

The up capture ratio shows the percentage of market gains the fund has captured in the months that the market provided positive returns. The higher the up capture ratio the better the manager has done when the market has been doing well. Ultimately, you should expect a long only fund to have an up capture ratio of greater than 100% indicating that the fund performed better than the market in the months the market was positive.

As you would expect the down capture ratio shows the percentage of market losses the fund captured during the months when the market lost money. The lower the down capture the better the fund has performed when markets are down. You would expect a long/short fund to have a down capture ratio significantly lower than 100%, indicating that the fund has protected against the downside.

Isolating up and down capture data provides interesting insights into how active funds have delivered returns over the past 3 and 5 years.

Isolating Global Equity Funds including Long Only and Long/Short Funds over 3 years, to the end of May 2021, the market was positive for 23 months and negative for 13 months:

• The best performer in the peer group had the highest up capture (151%) and the 5^th lowest down capture (57%).
• The 14 funds in the top quintile for performance were all 1^st and 2^nd quintile for up capture and 1^st, 2^nd or 3^rd quintile for down capture.
• As expected, long/short funds had a lower average up capture ratio of 82%. But surprisingly they produced an average down capture of 86%. Of the 17 funds in the long/short peer group, 6 funds had a down capture of greater than 100% and didn't protect on the downside.

Looking at a 5-year time horizon where the market was up for 37 months and down for 23 months:

• The best performer in the peer group had the 2^nd highest up capture (148%) and the 6^th lowest down capture (70%).
• Long only funds proved that they can protect against down markets. The average down capture for long only funds was 87% and only 8 of the 43 funds in the peer group had a down capture greater than 100%.

Having a strong understanding of how a fund performs during different market cycles provides investors and advisors with broader insight into how a fund might fit into a portfolio and provides a unique benchmarking tool to allow them to assess that managers performance.

Detailed information on Up and Down Capture Ratios for over 600 actively managed funds can be accessed via Australian Fund Monitors.

In recent engagements with our investors, the topic that has come up most frequently is fears of higher inflation.

Concerns on inflation are valid. We have essentially had an entire generation of consumers never having had to live through a high-inflation period. Historically, inflation peaked in the early '80s in the US, meaning that a person would have to be in their mid-to-late 40's (at the very least) to even remember it, and more likely in their 60's to have felt the experience of seeing their purchasing power erode at double-digit rates year-over-year. As such, the risk of inflation is top of mind for us as an investment team, and has been since last year.

We think a number of topics around the potential effects of inflation (both near term and long term) on the Fund are worth highlighting, not the least of which is what we as your investment team are doing about it.

Firstly, we distinguish between what could be called 'transitory' inflation (which is affecting near-term sentiment and making news headlines on an almost-daily basis) and potential 'structural' inflation (i.e. where prices go up, and then keep going higher).

If we go back 15 months to when the COVID outbreak began to materially impact economic data, demand for goods and services were artificially depressed, as many consumers were confined to their homes for long periods of time. What we are seeing now is that the reopening of the global economy and the related pent-up demand for goods and services (i.e. the demand-side of the inflation equation) has to an extent overwhelmed the pace at which the supply-side can respond and normalise by producing/delivering a sufficient quantity of goods/services. This demand/supply imbalance has resulted in temporarily higher inflation as there are relatively more people chasing the same (or fewer) amount of goods and services. We expect that as supply chains work through the disconnections (typically it takes several months to ramp up production capacity) and the imbalances normalise, this type of 'demand-pull' inflation will moderate. At present, the combination of 'demand-pull' inflation and a relatively weak comparative base for the period March to July 2020 is pushing up the reported inflation numbers, which is what you are seeing in the headlines on a day-to-day basis.

More of our focus as an investment team is spent on whether or not these temporary inflation trends can become more structural in nature. By way of example, in May, McDonalds in the US announced that they would be increasing the wages of over 36,000 workers by 10% over the next several months. Similarly, Amazon is offering $1000 sign-on bonuses to new employees at starting salaries higher than minimum wage rates (and what would likely have been the going hourly rate otherwise). To us, these are indicators that the labour shortages in the US may manifest in structurally higher wages in time. Given the strong demand levels for goods and services in the near-term, we would expect them to get passed through to the end consumer in higher prices. Essentially, once McDonalds has increased staff wages, we would expect wages to remain at those levels and not to revert lower. The risk here is that this type of wage increase leads to an upwards adjustment in the cost of production/services, leading to cost-push inflation. This dynamic could lead to inflation taking a step-change higher and not be merely 'transitory' in nature (though in time it could be offset by greater automation). As you might suspect, we are watching developments on the wage front closely.

Actions taken in the Fund

Importantly, while the nature of inflation (transitory or structural) and the rate of inflationary increases remain uncertain at present, we have worked to position the Fund to take advantage of this current environment. We have invested in businesses with strong balance sheets and considerable pricing power. By and large, our businesses have utilized the past year to remove costs from their operations without sacrificing the capacity to service their customers. We expect this will translate into sustainably higher margins over the medium term, a point that seems to be ignored by the broader market at present (which seems fixated on the inflation print from now to December 2021). Given the nature of the unique products they sell/services they deliver and their strong market position, our businesses are using the current inflationary environment to not only pass on rising input costs, but in many instances raise prices above inflation. In short, these businesses prefer to operate in the current environment where demand for their goods is strong and they can more easily pass on price increases. We expect this inflationary period to be a tailwind for the businesses in the Fund.

However, business fundamentals are often not reflected in the market (at least, in the short run). Should the inflationary outlook result in central banks globally raising interest rates materially, this will likely negatively impact valuations across all asset classes (equities, bonds & property) as the 'risk-free' rate of return (achieved through owning a government bond or placing money on deposit) will move higher, meaning investors' will reassess how much risk they need to take to generate a specific level of return. Stated more simply, if interest rates are 0% (and inflation remains contained), you'd pay up a lot more for a business that can grow earnings at 15% p.a. for the next five years than if interest rates were 5% and inflation at 4%, (at which point you might well consider having some money on cash deposit). If inflation REALLY takes off, prices might need to come down quite a bit for a period of time. Stocks at the hyper-growth end of the market (think very, very expensive tech names with no demonstrable cash flows) will be disproportionately hurt in such a scenario, which is why we have reduced our overall tech weight since September 2020.

One common theme shared by our businesses is that they are run by management teams who have a demonstrated ability to allocate capital wisely; combined with the fact that they understand how to generate shareholder value (return on capital > cost of capital) the same way we do, they are very sensitive to the acquisition price paid. We believe owning a portfolio of cashed-up businesses with good capital allocators, strong cash flows and little debt is exactly what one would want to do in such a scenario, as it would give CEO's such as Mark Leonard (Constellation), Messrs. Buffet and Munger (Berkshire), the Mendelson family (HEICO), etc. the opportunity to finally deploy their balance sheets in a meaningful way. Seen in this light, we would argue our ability to actively back superior capital allocators places us at an advantage to the major indices (& the ETFs that track them) through such a period, as our businesses have the ability to 'create' value in a shareholder friendly manner (whereas our opinion of the capital allocation skills of the average business in the index is not nearly as benign.)

There is a school of thought that says commodities and commodity producers are a good inflation hedge. This may work for a period of time, but in the long run, doesn't actually hold true. To quote from the 1983 letter to Berkshire Hathaway shareholders (written just as inflation was subsiding):

Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom - long on tradition, short on wisdom - held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn't work that way. Asset-heavy businesses generally earn low rates of return - rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment - yet its franchises have endured. During inflation, Goodwill [intangibles] is the gift that keeps giving.

The whole piece written by Mr. Buffett on the type of business to own during periods of inflation is worth reading, though it is quite lengthy. (Those readers who are interested can find it here: https://www.berkshirehathaway.com/letters/1983.html - simply search for the phrase 'Goodwill and its Amortization: The Rules and The Realities' to skip to the relevant part.)

We are grateful for the interactions we have and feedback we receive from our investors. We view ourselves as a long-term partner rather than simply a fund manager, and would encourage any investor (or prospective investor) to reach out to us with any questions. As an investment team, we are committed to responding personally (and promptly) to these kinds of queries.

While the uncertainties around inflation in the near term persist, we believe the Fund is well positioned to capitalise on a range of outcomes that may unfold in future.