Global equity markets - how do you position during times like this?
Equity markets and asset prices have never faced so many headwinds all at once. Global equity markets have seen a significant fall this year driven by heightened inflation due to covid’s continued impact on supply chains and a war in Ukraine driving energy prices and soft commodity prices up. While the global index is down 11.6% since the start of January to the end of May, our fund is only down 2.1%. Over the past six months our fund has remained flat while the global index has fallen 10.4% This is due to our view last year that certain parts of the US market and the global market were reflecting elevated valuations and our overweight positioning towards Asia, Europe and Australia. We have also protected the portfolio with some shorts and have recently bought some put options against the S&P 500 to further protect the portfolio as we enter a typically weaker part of the year. I get excited during times like this as this is the time when you can buy high quality companies at prices below their intrinsic value.
I attended a Morgan Stanley disruption conference this week and had the pleasure of seeing some innovative companies present as well as some other portfolio managers speak. It was interesting to see how divergent the views have been in the markets over the past few years and how both camps are sticking to their views, but both can’t be right. On the one side of the camp there are the people that buy companies at any price and say don’t worry because this will be a huge opportunity. I will put Cathie Wood and the Ark Innovation Fund in that camp.
Cathie Wood presented at the conference and spoke about how she was invested in Tesla because the total addressable market for electronic vehicles will be huge and Telsa is a leader in that. But I can’t remember a time when one automotive brand ever controlled more than 20% of any given segment of the automotive market.
Cathie spoke about how inflation will drop because Walmart and Target have built up their inventories due to the supply chain problems in the world and will now discount their products. Unfortunately, that’s not how inflation works in a global economy.
Ian MacFarlane addressed the audience explaining the reality of the situation we are in. Ian was the Reserve Bank Governor of Australia for 10 years during the Keating and Howard governments and introduced Australia’s inflation-targeting monetary policy regime.
Central banks over the past decade have unfortunately loosened monetary policy to unnecessarily low levels and are being forced to tighten aggressively now just to get to a normal rate. In the US inflation is running at 8%, while in Australia it is at 5% and rising. Ian said that he expects inflation to remain above the RBA’s targets due to the global supply chain shocks caused by COVID, the war in Ukraine and the level of de-globalisation occurring as a result. The biggest risk now is a wage-price spiral as real incomes are currently falling.
The reason why I had to elaborate on the current state of inflation and monetary policy is that this leads to rising interest rates, which is what we are seeing and leads to the view that Profeta Investments shares with another large part of the investment community.
This is the camp that a lot of global macro hedge funds sit in which include Stanley Druckenmiller and Greg Coffey. Greg presented at the Morgan Stanley conference and is known in the US as the Wizard of Oz. Greg said that you know what will happen to risk assets based on how much liquidity central banks pump into markets or withdraw it.
We're currently witnessing central banks in the US, Australia and even Europe withdrawing liquidity. But in Asia, they are loosening liquidity – in China’s case – or keeping monetary policy accommodative, as is the case in Japan. This is a large part of the reason why we have continued to buy quality mispriced businesses in these regions.
In the western world we are seeing tightening monetary policy. The Reserve Bank of Australia has just increased interest rates by 50 basis points, the largest monthly rise in 22 years.
The US Federal Reserve increased interest rates by 50 basis points in May and another 75bps this month and are expected to continue until they get the cash rate closer to 3.5%, from the current rate of 1.5%-1.75%.
These liquidity squeezes will create tremendous opportunities for nimble investors. We are currently holding circa 16% of the portfolio in cash in order to take advantage of further opportunities as they arise. We have also hedged a portion of our portfolio with shorts and put options.
Warren Buffett recently had his annual general meeting in Omaha in May, which I attended virtually this year and have had the pleasure of attending in person on a number of occasions.
Buffett has always sat in the second camp by virtue of him being a value investor. Warren doesn’t care about the macro economy. He just wants to buy good quality businesses with strong balance sheets at attractive valuations. That is the way we have been brought up to invest at Profeta Investments.
There has been a lot of talk in the press recently of Warren Buffett buying up stocks. That is true but the devil is in the detail. Warren has been accumulating shares in energy companies such as Occidental and Chevron and made a big bet on these companies after the war started in March. He has also continued to accumulate shares in banking stocks and recently purchased Citigroup.
Energy and Banks are two sectors that benefit from elevated inflation and rising interest rates. We have also been accumulating shares in banking stocks and energy and actually purchased some Citigroup shares prior to Berkshire’s announcement. These sectors of the market still look attractive in the US. However, in Asia, every sector is on sale! That’s why we had the recent rally in Chinese technology companies.
Like Charlie Munger, we continue to hold our Alibaba shares as it gives you wonderful exposure to the leader in e-commerce, payments and cloud infrastructure as a service in China at a bargain valuation.
The chart below shows how much valuations have fallen globally over the past year. The average price to earnings ratio (PE) of our fund is only 12.7x, while the US’s S&P500 still sits at 17x and Australia’s All Ordinaries is at 15x. We tend to agree with Morgan Stanley that the US market has further to fall, due to elevated valuations in growth companies and loss-making companies.
However, as you can see in the chart below, Japan’s Topix, Europe and emerging markets are trading at below-average multiples. While there is a risk to weakening economies as interest rates are increased to dampen inflation, we believe that buying high-quality companies at low valuations will deliver strong medium-term results. This is despite volatility remaining high in the short term.
In the current market, small capitalisation stocks are being sold in a manner that appears to be like throwing out the baby with the bathwater. The US’s Russell index dipped below it’s pre-covid high, so the $5 trillion in quantitative easing that the Federal Reserve spent to prop up markets seems to have disappeared for these companies.
It is times like this where the greatest opportunities arise and while the clouds are dark and stormy, we are excited about the opportunities that are emerging and how we are positioning the portfolio to take advantage of them. Be greedy when others are fearful!
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