Finding opportunity in the noise
In any given year, a few dominant market narratives surface, taking up newspaper column inches, broker reports, emails (so many emails!) and internet space. Past such narratives include:
- Amazon is about to destroy Australian bricks and mortar retail (2017)
- US inflation is getting out of hand (late 2018)
- The Federal Reserve’s tightening has gone too far and must now reverse (early 2019)
- The coronavirus pandemic will cause a global solvency crisis (March 2020)
- Value is now set to dramatically outperform growth (mid-2020).
What is clear from the above is that not all narratives are created equally – they don’t always prove to be correct. However in the heat of the moment they can shift markets with their certainty. There are two current market narratives we have observed dominating headlines and thoughts: the ‘reopening trade’ (i.e. sell covid-19 winners and buy covid-19 losers that are set to benefit from a normalisation of activity), and the ‘inflation debate’ (is inflation structural or transitory?)
Why do market narratives emerge? Put simply, this is an industry. People are paid to give their views, and their views must centre around something. So expressed opinions tend to converge on the debate du jour. We do this too. We have participated in panels, discussions, written investor letters (including our most recent annual investor letter) outlining our views on the macro debates or narratives of the day. At times in doing so we have felt inauthentic, worried that we are simply adding our voices to the noise of something that doesn’t actually factor heavily into our day-to-day investing process. So we thought we’d use this investor letter to outline why such narratives don’t typically play a part in our thinking around investing, with one (important) exception.
The reason we don’t position our portfolio to reflect our views on the macro debate of the day is twofold. First, we’re not convinced we’d be any good at it. Macro investing is a separate skillset in our minds to long-term equity investing.
Our investment process focuses on finding the combination of qualities in companies we have found to make the best long-term investments. However, we don’t have a track record (or confidence in) our ability to ‘add value’ through macro calls, such as positioning the portfolio for a period of significant inflation, or shifting to elevated cash levels to reflect a view that the market is overvalued and will fall in the near term. So we focus on stock picking, rather than layering in macro views that we may or may not get right.
The second reason we shy away from positioning the portfolio around market narratives is simply that they rarely matter in the long run. In the short term, it’s hard to predict the direction of a share price: market sentiment, news flow, broker upgrades and downgrades etc. all appear to influence the price. Over the long term, however, we believe only one thing drives the value of a company and that is the returns it generates on the capital invested in the business, so this tends to be our focus.
This isn’t to say we don’t pay attention to the market narratives. We do, for the simple reason that it is often where the valuation opportunities lie. Once something becomes a dominant narrative, it’s usually somewhat in the price. We are reminded of the absolute fire-sale that was Australian listed retailers in 2017, as Amazon prepared to enter the Australian market. JB Hi-fi saw its’ share price fall from A$28 to A$22 over the year, Super Retail from A$10 to A$8, Amazon competitor Booktopia was forced to scrap its A$150m IPO – even the mighty Wesfarmers couldn’t get its IPO of Officeworks away.
Fast forward to today and JB Hi-fi trades at A$46, Super Retail at A$12, Booktopia listed with a A$350 million valuation, and Officeworks EBIT is up 50% from A$144 million in 2017 to A$212 million in FY21.
This didn’t occur because the market ended up being wrong about Amazon entering Australia: it did indeed set up direct operations in 2018. However, we have observed the market is often good at predicting the event that will occur, but not so good at predicting what the impact will be. Interestingly, today Amazon is barely raised in companies’ Q&A sessions with investors. Perhaps now is the time to pay a little more attention to the issue?
In late 2018, the dominant market narrative was one of rising rates in the US to fight inflation: freight costs were ripping, lumber costs spiked, the US 30-year mortgage rate went from about 3% to nearly 5%. All of this was a perfect storm for sentiment on US-exposed building stocks. The James Hardie share price fell from A$21 in August 2018 to A$15 by January 2019. Again, the market correctly anticipated the event that would occur: the Fed was forced to raise rates aggressively from 1.5% to 2.5% over the course of 2018, however it inaccurately predicted the impact – in fact, the sharp tightening in financial conditions caused by the rate rises led to a precipitous drop in demand and roiled markets, such that the Fed was forced to reverse course in December 2018 and begin cutting rates again. This set the scene for a subsequent global market rally. In hindsight, this was an excellent time to buy James Hardie shares, which have recently topped A$50.
Perhaps the starkest example in recent memory of the market getting this event/impact relationship wrong was the March 2020 coronavirus drawdown.
The S&P/ASX 200 fell 30% in 23 days, the fastest ever drawdown of such magnitude. In hindsight, the event the market was anticipating turned out to be entirely correct: a pandemic would lead to the tragic loss of millions of lives, and would cause prolonged global lockdowns, disrupt global travel and supply chains and close international borders. However, the market got the impact wrong. In Australia, rather than economic devastation, the co-ordinated efforts of emergency fiscal and monetary policy drove house prices up over 20% and precipitated among the best economic conditions the nation had seen in decades. It turns out almost every single stock was a buy in March 2020.
So where does this leave us today? While the market narratives (and subsequent mispricing) are not as extreme today as last year, we still consider these as a fertile hunting ground for mispriced assets. At a time where we receive daily emails with lists of ‘reopeners’ to buy, or warnings on what stocks will be ‘hit’ as inflation rises, we are given useful clues as to what consensus narrative is being built into expectations, and therefore stock prices. We own a number of ‘covid-winners’ that such emails would recommend we take profits on, businesses such as Nick Scali, Wesfarmers and Healius. These businesses may have elevated levels of current profit, however this is:
- already arguably well understood (e.g. Nick Scali FY22 EPS is forecast to fall 23%, Wesfarmers by 9% and Healius FY23 by 30%);
- has underpinned significant balance sheet transformation, which gives latent optionality for capital management to smooth any earnings normalisation. Nick Scali is a great example of this: in the last week its share price has risen over 20% on the announcement that it has acquired Plush Sofas, mostly funded through its significant cash reserves.
On the other side of the equation, this year we have entirely sold out of Qantas, as we believe expectations have run ahead of reality. While we anticipate a return to solid cash-flow generation will follow normalised border arrangements, we believe this cash will fund several years of debt paydown, rather than the years of capital returns we enjoyed as shareholders from 2016-2020.
In short, while the narrative of the day can often seem compelling and inevitable, it rarely matters in the long run for businesses. However, the complex and reflexive relationship between expectations, reality and share prices mean we should regularly force ourselves to lean into that debate to find opportunities to buy good businesses at good prices.
Invest where fair value exceeds market price
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