Valuations rebased across most asset classes – opportunities starting to present with quality expected to shine going forward
We have discussed for some time now the 40-year deflationary rate cycle that began in 1981 after the US 10yr bond yield peaked at almost 16% and troughed in the depths of COVID in 2020 when the yield reached almost zero. This cycle created a tailwind for long-duration asset prices for more than a generation of investors, culminating in the unsustainable valuations, particularly of ‘tech’ or ‘growth’ stocks, in recent years.
Apart from the fact that rates were approaching zero, the ultimate end of the cycle was in this case brought about by the final onset of inflation, and the unsustainable ballooning of ‘real’ negative interest rates globally. An extended period of ‘money printing’ by central banks, handouts by governments to manage the impact of COVID-19 on domestic economies, and broad-based global supply shortages following COVID-19 and the war in Eastern Europe all combined to form a perfect storm where significantly more amounts of money in the system were chasing significantly fewer amounts of goods and services – the ultimate definition for the onset of inflation.
As we entered the new calendar year, the Fund was positioned strategically to manage our assessment of these risks. As always, there was a large bias towards defensive business models. We held notable positions in financial stocks (including banks), which we had identified as beneficiaries of a rising rate environment, a larger than usual exposure to Resources – primarily Evolution Mining for its gold-linked inflation hedging characteristics, and modest protection from PUT options.
On the stock-specific front, our largest holding in Telstra offered a defensive cash flow supported by an unappreciated inflation hedge via its NBN revenue stream (not to mention the recent announcement of inflation-linked pricing in the mobile division). Our exposure to the Health Insurers (NIB and MPL) offered us an improving industry structure post-COVID-19 and our holdings were beneficiaries of a higher rate environment via their investment floats. A new position in Amcor offered us highly defensive and diversified global cash flows at an attractive entry point, and BHP was trading at very attractive cash yields, offering a substantial (larger than usual) margin of safety to potential movements in the iron ore price. Each of these stocks and strategies ultimately proved to be successful in their resilience to the market correction and were amongst the main positive contributors to performance in the full year.
Unfortunately, their contribution was not enough to offset the broader and almost indiscriminate sell-off that impacted the market, and the Fund, as a whole. Generating a negative performance figure first and foremost is a disappointing outcome. However what disappoints us more is that, in these market conditions, we would normally expect a better performance from the Fund relative to the market. We have reflected upon many lessons learned in the past 12 months, but to summarise, we would make the following observations:
- Compared to previous cycles, our cash holdings were relatively low prior to the market correction. In what is perhaps evidence of our bottom-up approach to the management of our cash holdings, we had simply been able to identify what we considered to be attractive opportunities to deploy cash into the end of the 2021 calendar year and were by and large comfortable with the valuations of existing holdings. Our cash holdings were further depleted by the early January distribution to unit holders. The result was a higher than usual exposure to the subsequent equity market correction.
- Put options in place in the New Year had an unfortunate expiry date days before the onset of the January market correction. We had assessed pricing for new positions to replace them however by that point volatility had already spiked and the cost of new premiums was at a level we considered too expensive. The result was a lack of protection from the market downturn in January/February. We would note that subsequent put options have proven extremely profitable and were a key driver of the Fund’s ‘outperformance’ in the June quarter.
- We experienced elevated levels of volatility from a number of our less liquid small cap positions. Whilst not a significant weighting in the portfolio individually, we did experience a disproportionately negative impact from a number of our less liquid holdings. We remain comfortable with the underlying business models and cash flows of these holdings, which we continue to believe will prevail in the medium to long term, notwithstanding their recent volatility.
- Finally, the Fund’s performance relative to the market suffered materially due to its significant ‘underweight’ position in the materials and energy sectors. Since its inception, the Fund has had minimal exposure to the resources sector on the basis of too many variables and hence higher forecast risk associated with their business models. The energy sector generated a return of +30% in FY22, whilst materials declined by -1.5%, both meaningfully outperforming the market. Combined, these sectors comprise >25% of the ASX300 index, compared to a mid to high single-digit total exposure for the fund (mostly Evolution Mining). As such, these sectors provided a substantially greater positive offset to the market correction than they did for the Fund in the period. Of course, the opposite is true in times where these sectors are out of favour, which to a certain extent has been the case in the opening week of the new financial year.
Looking forward, we continue to plan for an environment where economies globally will be facing the double whammy of having to digest the removal of unprecedented levels of quantitative easing and other stimulus support, whilst at the same time adjusting to the inflection point of a 40 yr downward interest rate cycle, with interest rates globally now rising again at pace. The cost of money is once again going up whilst the availability of money is going down, a troubling formula (to say the least) for investing in long-duration assets.
We continue to position the portfolio with a view to navigate these challenges, ensuring exposure to business models with pricing power and low levels of price elasticity (to combat inflation) as well as those who benefit from a rising interest rate environment. In addition, our cash balance has risen from a low point earlier in the year – predominantly due to high geopolitical risk and uncertainty – and we continue to benefit from our put position in the portfolio, the value of which has risen considerably given the recent market movements.
Despite an elevated level of volatility in markets, we remain as focused as ever on our primary objectives of capital preservation and generating a reasonable real return for our investors. We continue to believe this is best served by a disciplined approach and consistent investment methodology. A variety of good businesses run by honest and competent management teams at the right price will create a well-diversified portfolio of ever-growing cash earnings streams.
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Rhett is the CIO and Fund Manager of the Pengana Australian Equities Fund, and joined Pengana in October 2007, bringing with him over 18 years of experience as an investment professional at the time.