2022 Q2 Newsletter
“ Time is on my side, yes it is
You’re searching for good times
But just wait and see”
Time Is On My Side - The Rolling Stones, 1964;
(Songwriters: Ragovoy, Norman)
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We are opening this quarter’s newsletter with great news: we have completed the acquisition of MitonOptimal Portfolio Management (CI) Limited and welcomed its Guernsey-based office, which includes Simon Sharrott, Shaun McDade and Blair Campbell, to our discretionary team at the beginning of April.
In this quarter’s newsletter, Shaun, who has been in the industry for over 30 years, has set the scene for updates from each of our strategies, along with a deep dive into a new stock that has entered our Global Blue Chip portfolios. We hope that the commentary provides insight into portfolio adjustments as well as reassurance and comfort that your portfolios are being actively managed during what has been a difficult period in markets.
At the risk of stating the obvious, financial markets have been unusually challenging of late. The repricing of assets in response to a rapidly changing inflationary environment has been unrelenting and the breadth of the sell-off has left investors with precious few places to hide.
Since inflation rates at the levels we are currently experiencing have not been seen in developed economies for decades, many (most?) market participants - including central bankers - find themselves in unfamiliar and uncomfortable territory. To what extent this has contributed to the deterioration in investor sentiment and resulting market volatility is difficult to quantify, but our sense is that it is not insignificant. It is likely, therefore, that the period during which the fabled Mr Market’s mindset adjusts to the new regime will last a while longer.
Given that expectation, why, then, are we not advocating at least a partial retreat to the side-lines and the raising of portfolios’ cash levels by a meaningful degree? The simple answer to this perfectly reasonable question is that history and experience suggest success in market timing isn’t just difficult, but nigh-on impossible to achieve with any degree of consistency.
With a small number of notable exceptions (Mario Draghi’s “whatever it takes” speech and the announcement of the Federal Reserve’s Covid-19 stimulus package spring to mind), turning points in markets and the trigger for them are invariably clear only with the benefit of hindsight. As such, trading the market purely on news flow is, at the very least, a questionable pursuit. Moreover, since textbooks tell us that markets are a discounting mechanism for future corporate earnings and/or interest rates, it stands to reason that the drawdowns in equity and bond benchmarks that we have seen already reflect at least some (most? all?) of the softer economic conditions that are anticipated over the coming quarters.
History also suggests that some of the biggest daily gains in markets occur around inflection points at which markets are often at their most chaotic and sentiment at its most fragile. As a consequence, and as we have alluded to above, these are notoriously tricky to identify. Accordingly, it’s worth reminding ourselves of the impact on long-term investment returns from missing out on those gains.
According to figures published by BlackRock, missing being invested in the S&P 500’s ten best days in the 20-year period between 1st January 2002 and 31st December 2021 reduces the annualised 9.52% (USD) return to 5.33% per annum and cuts the cumulative value of a notional $100,000 initial investment from $616,317 to $282,358 (corresponding figures for other markets are similarly conclusive). (1)
An improbable scenario? Perhaps. Nonetheless, it serves to support the view that it is time in the market, rather than timing of the market that is key to long-term investment and the benefits from compounded returns that go with it.
That said, we are active managers and always carefully consider the environment into which we are investing. Where required, we will adapt the construction of our portfolios to suit. This newsletter addresses that changing environment, the changes we are making in the portfolios and the new opportunities we are encountering.
Cautious Portfolios:
Lower Risk
By Robert Tannahill
Objective: The Cautious portfolio’s objective is to increase its value by predominantly allocating capital to fixed-income investments. The portfolio can also invest into global blue-chip equities with strong cash-flows and progressive dividend policies. A neutral position would be a 75% bond/25% equity split and the maximum equity-weighting of approximately 35%. The cash generated can be re-invested to provide capital or taken as an income stream.
This year has been a painful one for all investors and we are conscious that it has been particularly bruising for cautious investors thanks to one of the weakest periods for bonds markets in decades (or even centuries by some measures!). In this update we thought we would try and cut through the noise and tackle head-on some of the questions investors are asking. We hope you find it helpful and, as always, the team is at your service.
Why have cautious portfolios struggled this year?
Nutshell: The unexpected surge in inflation compounded by shocks such as the invasion of Ukraine.
At the end of 2021 we were in a world where we were exiting the Covid-19 pandemic and digesting the supply and demand imbalances that it had created. We were preparing for a temporary pickup in inflation and reasonable economic growth. Then in the first quarter of this year, the Russian invasion of Ukraine, which was notably more aggressive than even those closely involved were expecting, significantly changed that outlook. As a result, the prices of nearly all investments fell.
The combination of the war, the resulting sanctions and the potential long term geopolitical repercussions, disrupted the world’s third largest oil producer, just over 7% of global wheat supply and global supply chains, leading to a significant and potentially long-lasting rise in inflation. This was compounded by China attempting to maintain an unrealistic zero-Covid policy in the face of the highly contagious Omicron variant causing widespread lockdowns in the world’s major production hub.
Then inflation surged – and is expected to peak at over 10% in the UK (CPI) before starting to fall back. This left central banks with a difficult decision, support their fragile economies by keeping rates low, or defend their credibility on combating inflation by hiking aggressively. They chose the latter and executed an abrupt U-turn in policy which saw the US Federal Reserve raising interest rates by 0.75% (2) in a single meeting, a move not seen in nearly 30 years.
This sudden change in the outlook for interest rates, which are a factor in the prices of nearly all investments, caused a major shock in markets. This shock to both equity and bonds created a very unusual situation where global equities are down -11.3% (3) and global bonds –14.2% (4) so far this year, leaving the Income strategy down -9.3% (5) as the end of Q2 2022 (5).
Why wasn’t my portfolio better set-up to handle inflation?
Nutshell: We had made changes over recent years that helped; however, the rate at which inflation increased was much faster than we anticipated.
Over the last few years, we have been thinking about what changes in the long-term direction of inflation and interest rates would mean for portfolios. On the back of this, we made several changes to the strategy, designed to help it weather a potentially painful turning point. In summary, these actions helped reduce losses so far this year and we believe they will help us recover from this period. Some examples include:
• In 2020 we switched our defensive government bond positions to US Treasury Inflation Protected Securities.
• In 2021 we added exposure to infrastructure via KBI’s Global Sustainable Infrastructure fund, which has links between profits and inflation rates.
• By the end of 2021 we had moved nearly a third of the strategy into short-dated bonds, which are better positioned to weather rising interest-rate environments.
• In early March 2022 we added an Asian income fund, which we see as well positioned to produce returns in an environment of higher inflation.
Each of these changes helped, although in a year with very few places to hide in markets, it was generally a matter of reducing losses as opposed to delivering gains (other than our Asian fund, which is up since purchase).
This process continues with the aim of further increasing the strategy’s durability in case inflation becomes a recurrent concern over the next few years. The next target is our core corporate bond funds. We are looking at the possibility of moving to managers with a more flexible remit, who, if we can find the right fund, could be better positioned to navigate continuing volatility in bond markets.
Am I going to get my money back?
Nutshell: Absolutely, provided you can give markets time to recover. The harder question, given the current backdrop, is how long that recovery will take.
Whilst unsettling, unfortunately nobody knows when markets will change direction. It is worth bearing in mind that, at times like these, large drops in markets happen fairly regularly and this is not even the largest peak to trough drop in the cautious strategy’s history. During the Covid-19 crisis in 2020, the strategy fell -12.4% (6) from its high point in February to its low point in March. While the dynamics of this sell-off suggest a longer recovery time than the blistering rebound we saw in 2020, it is good to remember that markets have recovered from such falls many times in the past. The largest of these in recent years was the 2008 Global Financial Crisis where the average cautious fund in the UK sector fell -17% (7); however, even that drop was recovered in less than two years.
Looking at the Income strategy today, the upside of the fall this year is that we have some very healthy income streams to help recoup our losses (however that income is variable and not guaranteed). If markets were to stabilise here and accept that lower share prices and higher interest rates were the new long-term reality, then looking at the potential returns on offer from the different assets in the portfolio, we should be able to recoup our losses in a similar timeframe to the recovery of 2009/2010.
In order to help this process we are also actively reviewing the portfolio to ensure we are tilted towards the best opportunities to help ensure that, when markets do stabilise, we can regain this lost ground as fast as possible.
Do I need to do anything?
Nutshell: Not unless your personal circumstances have materially changed since you invested.
While the urge to “do something” can be hard to resist when markets are falling, often the best course of action is to be patient. While a carefully constructed portfolio gives you good odds of achieving respectable returns over the long-term, markets can be extremely unpredictable in the short term. Trying to time your way in and out of markets is extremely challenging and markets often confound expectations by doing the opposite of the obvious.
The dramatic rally we saw in April 2020, despite the pandemic raging around us, stands testament to the damage that can be done to portfolios by missing an unexpected rally – as Shaun touches on in the introduction. So, unless your circumstances have changed (you need, say, to withdraw a material sum from your portfolio in the near future) the best thing is to try hard to do nothing while we work hard on your behalf.
Balanced Portfolios:
Medium Risk
By David Le Cornu
Objective: The Balanced Portfolio’s objective is to provide capital appreciation through a balance of fixed income and global equities. A neutral position is a 50% bond/50% equity split and the maximum equity weighting is 60%. The cash generated can be re-invested to provide capital or taken as an income stream.
The second quarter of 2022 has rhymed with the first. Investment markets have remained challenged by inflation, aggressive messaging from Central Bankers, the ongoing military conflict in Ukraine and Covid-related supply chain disruptions. There has also been an increasingly negative narrative around slowing economic growth, earnings downgrades, and the rising probability of recession. If this were not reason enough to be downbeat, those living in the UK have had to put up with train and tube strikes and airlines’ “fly maybe” policies.
To put things in context, despite a rally late in June, the drawdown in global equity markets this year ranks within the 10 largest corrections in equity markets in the last 50 years. We managed to avoid the areas of investment markets that have been hardest hit, such as non-profitable technology and cryptocurrency which are typically down -50% to -90%, but we have been impacted by the broad-based sell-off in global equity markets.
At the same time, bond markets are having an annus horribilis; this is the worst year they have had since 1978. Whilst, it has been a torrid year for bond investors, we must remind ourselves that unless a bond defaults, if held until maturity, you will get the return that was indicated when you initially invested. Furthermore, as bonds mature, investors are now able to reinvest the proceeds at more attractive yields than have been available for many years. It feels like we are at a point where further potential downside in bond markets is starting to look limited, whilst returns in coming years, as the asset class recovers, appear attractive.
At the time of writing, year-to-date, the Balanced strategy has reduced in value 10.9% (8) which compares to a return of -9.4% (9) from the IA Mixed (20-60%) Sector, -14.2% (10) from the Global Aggregate Bond Index and -11.3% (11) from the MSCI World Index (all in sterling terms). We understand that any retracement in value is uncomfortable for investors, but hope you will recognise that the breadth of the sell-off in investment markets has been such that there have been very few places to hide.
Unsurprisingly, our actions this quarter have also rhymed with those of the last. We have continued to rotate the equity content of the portfolio as part of our navigation strategy with the aim of further diversifying the equity content and bringing cashflows forward, making the equity content of the portfolio less sensitive to high and volatile inflation.
Portfolio actions during the quarter have included selling the Arisaig Global Emerging Consumer fund (within the offshore strategy) and Morgan Stanley Global Emerging Leaders fund (within the onshore strategy), as well as reducing Fundsmith Global Equity and Polar Capital Global Technology to 3% positions. The sale of Arisaig Global Emerging Consumer was undertaken to reduce exposure to economically sensitive Emerging Markets that often struggle when the US dollar is strong and are sensitive to slowing global growth. It was therefore deemed sensible to move the Fund to the side-lines for now. The reduction of Fundsmith Global Equity and Polar Global Technology was to raise cash to fund investment in other equity funds.
In contrast, the Prusik Asian Equity Income and KBI Global Sustainable Infrastructure funds were topped up to 4% and 5% positions. These funds benefit from attractive dividends and some of the underlying cashflows of the businesses they invest in are inflation linked. The final action of the quarter was to introduce a new holding, Lazard Global Thematic Inflation Opportunities as a 3% position.
We have been discussing the new fund with Lazard for many months and it was launched in June. Since we are part of the contingent of seed investors, we gain access to a class of units with an ultra-low management fee. The Fund has also been introduced into our growth strategy and, rather than duplicate commentary, further details on the Fund and their investment process can be found within the growth strategy commentary in this publication.
We wish we had a crystal ball and could tell our clients exactly when investment markets will settle down and how long it will take to recover from the first half of this year. The truth is no one knows, but we are firm believers that capitalism is not broken and that we are simply going through a price reset: better times are ahead and ultimately long-term investors will be rewarded for the risks that they embrace.
At present, it seems like inflation is the key agitator of investment markets, so, until a peak in inflation is evident, investment markets are likely to remain jittery. This encourages us to continue to embrace a defensive mindset for now and to continue our search for investment nirvana. This would be an equity fund that provides exposure to the shares of reasonably-valued companies, largely immune to inflation, not cyclical and not subject to the whim of discretionary consumer expenditure. It sounds like a lot to ask for, but we happen to be looking closely at a fund that may just fit the bill.
It is imperative during unsettling times such as these that we are communicating openly and regularly with our clients. Please contact your Ravenscroft representative if you would like to discuss investment markets or the performance of our Balanced strategy in more detail.
Growth Portfolio:
Higher Risk
By Samantha Dovey
Objective: The Growth Portfolio’s objective is to provide long-term capital appreciation by investing predominantly into global equities. A neutral position is a 25% bond/75% equity split and the maximum equity weighting is approximately 85%.
And just like that we are halfway through the year and the days are getting shorter; 2022 seems to be passing extremely quickly…perhaps that is because I hit half a century this year. Maybe great in cricketing terms, but I am as yet undecided!
This year has been difficult for everyone, both inside and outside the investment world. The atrocities committed by Russia against Ukraine have had huge implications across the world as energy and food prices have shot up; we are definitely feeling the pain in our pockets on a day-to- day basis.
Inflation
Most of us in the office have never lived through high inflation. My parents and many of our clients lived through it in the 70’s and early 80’s, when inflation moved from 3.4% to 12.2%, back to 4.8%, and up to 13.4% – peaking in 1980 at 18.0% (12). During this period, interest rates started at 7.2%, by 1974 were 9.2%, and reached 17.0% in 1979 (in order to combat inflation) (13).
2022 has seen inflation numbers hit the figures my mum and dad saw in the 70’s, the print we saw mid-June for the UK hit 9.1% (equal to 1974) (14), the Monetary Policy Committee are expecting this will hit 11% (15) by the autumn, and interest rates will have to rise accordingly.
Inflation has occurred for several reasons, but has been attributed primarily to supply shortages caused by the Covid-19 pandemic and the Russian invasion of Ukraine. This, coupled with strong consumer demand, driven by historically robust job and wage growth as the pandemic receded, and the fact that the FED stepped in on the 23 March 2020 and flooded the market with liquidity, which created its own hubris.
All of this tends to make markets and investors worry, increasing volatility in listed markets such as fixed income and bonds; we have felt this as a growth investor.
How are we positioned?
We have been asked a number of times “how robust are the portfolios with regard to inflation?” We feel the underlying companies that we invest into via our various funds can weather the inflation storm. They have excellent management, high return on invested capital, low capex, low leverage and solid free cash flow, all of which makes them financially robust. On the whole, these companies are market leaders and can pass through costs to the end user, keeping margins intact – or not suffering as much as others that cannot – or those that have poor “quality” metrics.
Lazard Global Thematic Inflation Opportunities (GTIO)
Unsurprisingly, the investment management world is currently very focused on the spectre of inflation and looking forwards. Lazards has recently brought a new product to market that specifically targets the inflationary environment.
Although a new fund, the team had been thinking about investing for inflation and writing papers on it since 2019. We met Steve Wreford, managing director and portfolio manager/analyst of GTIO, first over Zoom in February and eventually face to face in May; both encounters went very well.
GTIO is a long-only equity fund that has been designed to invest in companies that benefit from structurally higher inflation. They have identified multiple “inflation” themes that should benefit should inflation prove to be more structural in nature.
The team believes that there is an increasing need for strategies that are designed to help clients mitigate the risks and capture the potential opportunities of a structural shift in inflation. The Fund will have somewhere between five to eight inflation themes; there are currently six listed below, along with a couple of company examples to give you some colour:
Consumer Price Capture, these businesses tend to exhibit high pricing power, subscription models/cashflows or coupon clipping – Coca-Cola, Mastercard and Sysco
Intangible Assets, these show brand resilience, and premium brands as well as being oligopolistic which supports pricing power – Diageo, L’Oréal and Richemont
Industrial Pass-Thru, certain long cycle industries have pricing structures with a relatively high ability to pass through rising input costs – they tend to dominate and cannot be easily replaced – Caterpillar, Norfolk Southern and Waste Management
Housing and Finance, if we look at banks, they should benefit from higher property prices through refinancing and home equity loans – Bank of America, CME Group and Home Depot
Scarce Resources, these companies tend to have exposure to commodities and long-life physical assets, during supply constraints they can offer upside asymmetry – Anglo American, Arcelor Mittal and Newmont
Energy Policy, we know from our work on Global Solutions that Government policies are now irreversibly committed to a low carbon transition, companies such as BP and Shell form part of that transition, as they have deep pockets and have to adapt – BP, Linde and Vestas.
Some of these names you will recognise as being held within our quality global funds. As for the more cyclical names we do not own – we took the view if we are going to hold them, then let’s hold the best.
What did we do?
Once due diligence was completed it was decided to put 5% to work in GTIO in the last week of June, so you will see it on the factsheet. The Growth Strategy posted -7.3% (16) for the quarter, versus the IA Mixed (60-85%) Sector of -7.4% (17), bring the year to date -11.7% (18) and -10.8% (19) respectively.
Global Blue Chip Portfolios:
Higher Risk
By Ben Byrom
Objective: The Global Blue Chip portfolio invests into approximately 25-30 global blue chips that are in line with our long-term investment themes. The aim is to invest into such companies at an attractive valuation and hold them for the long term. The cash generated can be reinvested to provide capital growth or taken as an income stream.
The second quarter of 2022 has been a somewhat challenging period for equity investors. Inflation remained the primary concern and we saw the first 75 basis point (0.75%) rate hike by the Federal Reserve, the biggest since November 1994 (20) with the promise of more to come if future inflation figures refuse to come down. Whispers of a looming recession are starting to get louder too, as evidence of a slowdown in real estate and fading consumer confidence start to appear through lending and official consumer survey data sets.
This was not lost on the equity market which reacted accordingly to the unfolding data. Higher rates clearly damaged the tech sector and tech heavy business models, whilst dwindling confidence in economic growth weighed on the more cyclical areas of the market with Consumer Discretionary bearing the brunt, as can be seen in the charts below.
The Global Blue Chip strategy navigated another quarter of uncertainty well on a relative basis with a decline of 7.4% (21) against the broader MSCI World which fell 9.1% (22). What worked and what did not for both strategy and market, can be seen in the Contribution by Sector chart (below, right) which is the product of our positioning to each sector (below, left) and the collective performance of our holdings (below, middle).
Healthcare, which was a positive contributor to performance last quarter, detracted from performance ever so slightly this quarter as our large overweight accentuated a very small negative performance into a 20 basis point (0.2%) negative contribution – whilst negative it is neither a terrible disaster! Positive returns from pharmaceutical holdings Sanofi and GSK, and life science business Waters Corporation were offset particularly by Illumina, as investor concerns over its acquisition of GRAIL, and the threat of credible competition entering its market, weighed on shares.
After many quarters of lacklustre performance, our Consumer Staples collective delivered a positive return and our overweight position to these stocks helped contribute to performance by over 1%. Colgate showed good relative strength despite a mediocre earnings release where top and bottom lines more or less met expectations, but it was the lowering of 2022 guidance that left investors in no doubt that the trading outlook was hardening due to rising input and operating costs from raw material inflation and continued logistical challenges.
Within the Industrial and Information Technology sectors our stock selection outperformed and our underweight to these sectors meant that the negative impact was far less. Companies with technology-based business models have borne the brunt of the market sell-off due to their sensitivity to interest rates.
A few reside in the Consumer Discretionary sector, where we have now, over the past few quarters, built an overweight position relative to the broader market. One area we have been particularly active in is e-commerce, where uncertainty around consumption has created an opportunity to buy companies in an area where we believe the longer-term future looks bright.
Amazon, the world’s largest online retailer amongst other things, was one of our worst performers as it rubbed salt into the wounds of a deteriorating macroeconomic environment by reflecting the slowdown in its own reported earnings and subsequent guidance for even lower growth being reported following the second quarter.
Netflix, was the portfolio’s worst performer during the quarter after it announced that it expects to lose over 2m subscribers after hiking its prices. This put the brakes on the subscription-based growth narrative around online streaming, which had a dramatic impact on other streamers, particularly portfolio holding Disney. Together, these two stocks were responsible for over 2% of the portfolio’s negative performance over the quarter and underperformance relative to the Telecommunication sector. Nonetheless, we remain positive on the industry and the companies we own, due to the quality of their content, management teams and valuations.
With growth looking vulnerable, it was back to normal service for much of the deeper cyclical areas of the market where we have no exposure, which was accretive to performance on a relative basis. Whilst Energy showed some follow-through from last quarter’s strong performance, the relative strength clearly waned as the underlying commodity price retreated from the March highs of $129 p/b, settling around $105 p/b at the time of writing.
The majority of this commentary was written a few days before the end of the quarter, a time when many were hoping for an equity relief rally into the quarter end. Unfortunately, this rally showed hope but promptly faded and has subsequently failed to materialise, an ominous sign as investors were quick to sell into any strength. However, it is not unusual to see strong rallies of 10% or more in falling markets, there are many instances where rallies have lasted many weeks, even months and climbed 20% or more within a longer-term down trend.
Will one of these materialise anytime soon? Well, there is a chance that we may see a potent deflationary force flow though markets – a phenomenon known as the bullwhip effect - where a flagging consumer results in the build-up in inventory and a fast decline in prices. If such a phenomenon materialises the FED may choose to ease its current policy response to inflation. Markets are currently expecting the FED funds rate to finish the year at 3.5% (about double from where we are right now), but if the Fed pulls back by not doing another 75 basis points (0.75%) hike preferring 0.25% or 0.50% this may revise down year end expectations prompting a repricing of equities providing the foundations for a decent rally - we will see.
Global Solutions
Higher Risk
By Shannon Lancaster
Objective: To generate capital growth over the long term (over 5-10 years). The strategy invests into 10-20 carefully selected third party equity funds; following the same, stringent investment process as the other multi-manager portfolios in our range. It is a highly focused portfolio which invests in companies providing goods and services dedicated to finding solutions to the challenges the world faces today.
The 30th of June, or Q2 2022, marks the first three months since the launch of Ravenscroft Global Solutions. The opening quarter of 2022 was fraught with volatility as markets and investors lurched from greed to fear as we witnessed the Ukraine invasion along with rising inflation and interest rates; Q2 provided little relief.
Markets continued to be volatile and there were very few places to hide. The Global Solutions strategy posted -7.1% (23) for the quarter versus the MSCI All Countries World Index of 8.6% (24). For those who enjoy a podcast, the team has produced an update on the strategy’s performance since launch; it is available on the Ravenscroft website.
https://www.ravenscroftgroup.com/news-insights/2022/june/global-solutions-two-month-update/
Over the past three months, we have enjoyed meeting face-to-face once again as investment managers have returned to their offices, in one form or other. As part of our fund due diligence process, we prefer to speak to investment management teams face-to-face but the pandemic meant video calls had to suffice for the small number of fund managers we had not met in person.
Why do we like to meet our managers in person? Despite the lengthy list of useful characteristics of Zoom or Teams, there is nothing quite like shaking a person’s hand (or maybe just a fist bump in this post-Covid world!). We like a proper conversation, which includes all of the nonverbal cues we miss out on over virtual calls, whilst also avoiding common miscommunication issues that may arise online. We find it usually leads to a higher quality meeting which can help us to build lasting relationships with our fund managers.
In preparation for these meetings, we work extensively to create an agenda that covers questions we need to cover. Most meetings will have a set of broad themes or questions we want to cover; this year it has been inflation and navigating market volatility. We are pleased to report that all the managers answered in detail as to their thoughts and actions and we left the meetings reassured and confident that the teams would be able to navigate these turbulent times.
Below are a couple of highlights from some of these meetings which will hopefully provide some more colour on the underlying funds within the strategy.
Aikya Global Emerging Markets (which is a 5% position):
While the name may not be familiar, the team were already very well known to us due to their impressive track record at Stewart Investors. It was a pleasure to meet Ashish, the lead manager, and the rest of the team. Most analysts spend a lot of time on near-term financial results and fail to see the links between good stewardship and franchise strength. They believe they can add value through assessing the quality of stewardship which they believe is seldom priced correctly by the market. Our meeting covered lots of ground, but our key takeaways were:
• The importance of experience at a time like this in Emerging Markets.
• Volatility and double-digit inflation have been common characteristics of investing in Emerging Markets for decades, so, the current market environment is nothing new for them to navigate.
Impax Asian Environment (which is a 5% position):
Fund manager, David Li, managed to escape Australia for the first time in three years and met us to discuss the Fund. The Covid situation in Asia has made it a challenging start to the year for the fund as the economic impact of lockdown continued to be felt across many regions. The portfolio benefitted from not owning the more consumer-focused end markets in China and has exposure to industrials, materials, and utilities.
David explained these holdings benefit from the secular trend of electrification and automation and many are core suppliers of those technologies, not only around Asia, but much of the world. They have been taking advantage of market volatility to selectively add to attractive positions.
KBI Global Sustainable Infrastructure (which is a 10% position):
We made our first team journey to Dublin to meet the team at KBI. We have been talking to the Global Infrastructure KBI team for a few years and we were pleased to meet them in person.
Since we have invested, the Fund has grown in popularity bolstered by favourable regulation, increased government support for the underlying investments, and increased awareness of the increased need for clean energy transition. In terms of performance this year, they are outperforming the broader equity market and delivering downside protection. They explained to us that most of their companies have what they refer to as “inflation escalators” built into business models and they are confident that they can continue to produce strong durable cash flows and pay healthy dividends.
What Next?
For us, it will largely be business as usual. We will continue to monitor all the funds, carry on meeting the fund managers, ensure all investments are behaving as we would expect them to and doing the job they are supposed to within the portfolio.
We are not making any predictions about the future and are mindful of what the well-known investor Peter Lynch once said, “far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
Whilst it is easy to feel overwhelmed by all that is going on around us and the various negative headlines we are bombarded with daily, we believe we are positioned well for the future and the outlook for our investment themes is still very strong.
Stock in Focus:
Oracle
By Oliver Tostevin
We have yet to cover Oracle in Stock in Focus despite buying it over three years and a global pandemic ago! As the investment scene has changed, we thought we’d update investors on why we continue to hold this stock as a top weight in the fund.
At the heart of our investment case of this mature database Company was the thought that Oracle would gradually be able to convert the majority of its legacy “on premise” software customers to its newer and improved cloud offerings, and in doing so receive a significant uplift in revenue. Since then, there have been two further notable developments.
1) First, we never assumed that Oracle would become a major competitor in hyperscale cloud infrastructure, but as of today it’s looking increasingly clear to us that Oracle has secured a place among only three other hyperscalers in this gigantic industry (after Amazon, Microsoft and Alphabet – all owned in the fund too). Even if Oracle remains only the fourth largest player, that’s still a great deal of business coming its way.
2) Second, we didn’t envisage Oracle’s aggressive move to roll up the healthcare IT space through its recent acquisition of Cerner. The latter will probably warrant an additional note all to itself at some stage, but we view this development as potentially very exciting if management can execute on their stated strategy.
These developments are resulting in an acceleration in revenue growth as the revenue mix shifts more towards faster growth segments and the legacy parts of the business become less of a dead weight.
However, oracle’s valuation has not moved materially to reflect the changing dynamics of the Company’s revenue profile and future growth. The sell-side (professional investment analysis provided by investment banks) remains lukewarm at best on the stock citing a number of perceived concerns that we believe, for the most part, are being misunderstood. Nevertheless, in our experience, when many investors look at Oracle, they see something like this:
Evidently, Oracle’s business has barely grown in the last 10 years; and low growth businesses should usually carry low valuations. Fair enough - it’s difficult to argue with this logic.
We have mentioned before that our best ‘edge’ is the fact that we have more time than a number of other market operators to allow an investment thesis to play out. The ‘sell-side’ is generally geared to sell research to big market operators such as hedge funds who have little time for multi-year investment theses. But in the world of investment advice nobody thanks you for a compelling idea that could take years to show results. By the time Oracle starts to deliver in the areas of most concern you can bet your bottom dollar that the price and valuation will have moved to reflect this reality - being early is one of the surest ways (other than being lucky) to get in at an attractive price and extract the maximum value. This takes a certain approach which we discuss in the second part of our investor series that we released in June and can be accessed here for your ease of reference.
Building on the previous chart, when we look at Oracle, we see something a bit more like this:
For several years we’ve likened Oracle to the metaphorical duck: calm on the surface but furiously paddling beneath the water line. There’s lots going on at Oracle, but you’re likely to miss it unless you take a good look beneath the surface. While it’s certainly true that revenue hasn’t grown a great deal, there have been some really rather interesting things occurring within its makeup. Here is not the place to drill down on the various goings-on and associated strategy, but if there’s one key takeaway - it’s cloud. Oracle’s cloud business is now approaching 30% of revenue and, according to management, will further accelerate its rate of growth in the current financial year (that’s “2023” in the chart) beyond 30% - we would call this an inflection point, beyond which, cloud will apply increasing upwards pressure on the top line. Our metaphorical duck is about to start flapping its wings.
The broader investment environment has also changed for infrastructure as a service (IaaS) and software as a service (SaaS) investors as they grapple with an investment climate complicated by rising inflation, higher interest rates, tighter liquidity, and an unravelling of geopolitical tensions that has pitched East against West in a damaging trade war and at least one land war in Eastern Europe.
The collapse in market multiples for many IaaS/SaaS stocks has been terrible as the pandemic trends give way to the ‘new world’. Whilst Oracle hasn’t been immune the relatively low multiple going into the valuation collapse and its steady onward progress has helped shield investors from the worst of it.
As we highlighted in the addendum to our 3-part investor series the best stocks to have owned during the volatile 70’s were businesses trading on low multiples. Whilst we do not know what the future holds, a more volatile outlook in terms of inflation, central bank responses, and geopolitics will create uncertainty. It is our intention to navigate this uncertainty, in part, by holding quality businesses, with modest valuations and promising outlooks.
Overall, we remain optimistic in IaaS/SaaS technologies as inflationary pressures will continue to force their adoption as companies seek efficiency gains to keep a lid on rising cost pressures. This, coupled with a non-consensus view, and a compelling valuation is why Oracle holds a top weight in the strategy.
Boscher's (Not So Bite-Sized) Big Picture
Recession or inflation - which poses the biggest threat
By Kevin Boscher
As we approach the half-year point, markets have become increasingly agitated as sentiment has swung wildly between the prospect of inflation staying higher for much longer versus the threat of a significant global economic slowdown – or even a recession. This has been a very tough few months for investors. Both bonds and equities have fallen significantly, due largely to rising inflation, tightening monetary policy, the uncertainty and spike in energy and food prices created by the tragic war in Ukraine and China’s extraordinary policy of zero-Covid. There have been very few hiding places for investors over the past two quarters.
There is little doubt that economic growth is slowing, and that the risk of recession is growing, especially in Europe, the UK and the US. The US consumer is key, since it accounts for approximately 70% of the economy, with similar trends in the UK and Europe. Consumers are being hit hard by the combination of rising food and energy costs, persistent goods and services inflation, higher financing costs and falling real disposable incomes. So far, the US consumer has been resilient thanks to the combination of excessive savings built up during the pandemic, a tight labour market and buoyant house prices. However, consumer spending could downshift quickly as savings decline, Fed tightening really kicks in and unemployment starts rising, which is inevitable given the Fed’s hawkish stance. With the Fed also draining liquidity from the system, it is almost inevitable that the US will enter a recession within the next 6-12 months. Taken together with China’s struggle and elevated recession risk in Europe and the UK, the threat of a global slowdown is material.
A contributory factor to the gloomier growth and market outlook has been a big increase in investors’ expectations for where interest rates are likely to peak in this cycle. This is largely due to inflation appearing to be even more entrenched than previously thought and the subsequent shift in central bank policy towards a more hawkish stance. Central banks, led by the Fed, seem determined to bring inflation under control through a quicker and steeper rise in rates, even if this results in a recession and higher unemployment. The Fed has changed its view of late due to the broadening of inflation indicators and rising longer-term inflation expectations. Whilst the Fed is acutely aware that it can do little to address rising food and energy costs, it believes that excess demand across the economy could result in more persistent wage and price increases and a change in the psychology and behaviours of both consumers and companies.
The longer-term outlook for inflation continues to be the single most important factor for the global economy and financial markets. Opinion remains divided as to whether the current spike in inflation will gradually ease and return to its pre-pandemic disinflationary trend or, instead, become more entrenched, resulting in a longer-term higher range, more like the 1970’s. The main argument in favour of the cyclical view is that the powerful forces that have been putting downward pressure on both growth potential and inflation remain intact. These include an ageing demographic, technological disruption, and the benefits of globalisation. In addition, high global debt levels tend to dampen growth and increase savings. Those who believe that higher inflation will prevail for much longer point to the fact that the huge monetary and fiscal stimulus injected during the pandemic has led to unusually high demand at the same time as supply has been constrained due to Covid related shutdowns, logistical bottlenecks, and a shortage of labour.
These factors have put upward pressure on inflation, which is becoming more persistent as the shrinking workforce in many developed nations leads to higher wages and a shift in inflation psychology. They also argue that globalisation has peaked and is going into reverse as the US and China battle for supremacy amid elevated geo-political tensions. High energy prices present an additional complicating factor since they add to inflationary pressures in the short term but tend to be disinflationary longer term.
It is possible to make a strong case either way and the truth is that nobody knows – including central banks, governments and economic forecasters. The world has never been through a pandemic followed by war and then a complete China shutdown. Nor do we know what impact Quantitative Tightening (QT) will have on economic activity and markets. Also, it is very rare for the global economy to be facing the threat of inflation whilst equally worried about the risk of a recession. There is simply no economic model that can predict what comes next. Against this backdrop, it makes investment sense to keep an open mind, plan for a range of potential outcomes, stay flexible and adapt where required.
The most likely scenario over the next year or so is that inflationary pressures gradually ease as economic activity falls, commodity prices decline, goods shortages and supply problems diminish, and labour market pressures subside. However, much will depend on whether central banks follow through with their intentions or, instead, pivot at the first signs of economic or financial stress. The key upside risk is that tight labour markets, high commodity prices and rising inflation expectations will trigger persistently high wage-growth and a subsequent shift in consumer and corporate behaviour. Longer-term, central banks will probably find it very difficult to raise rates to the intended levels given the threat that presented by weaker growth, rising unemployment and a potential market or financial crisis. The global economy and markets are also likely to be very sensitive to higher rates given the record high debt levels. In addition, governments seem intent on addressing numerous challenges through higher spending, including income and wealth inequality, an underinvestment in healthcare, climate change and now energy, food and defence security. Central banks will need to enforce financial repression to keep financing costs low and print money to finance this government spending. Such a policy could sow the seeds for a much bigger inflation problem further out.
Central banks face a very difficult dilemma as they attempt to soften demand sufficiently to ease inflationary concerns whilst seeking to avoid a serious recession or a financial crisis. History suggests that a “soft” landing will be nearly impossible to achieve. There are several potential scenarios that could temper their hawkishness, such as the impact of rising unemployment on consumer spending, financial and market stress, falling oil prices and clear evidence that inflation expectations are easing.
What does this mean for financial markets? For now, the tough Fed stance and stubborn inflation could extend the rare combination of falling stock prices and rising bond yields a while longer. However, as growth slows, the risk of recession and/or financial stress increases, and the profit outlook worsens, I expect government bonds to rally well in advance of stocks. Also, yields on US Treasuries, and UK Gilts to a lesser extent, are looking more attractive after the recent sell-off, which has seen the worst drawdown for Treasuries in over 40 years. At the same time, sovereign bonds are very unloved, under-owned and massively oversold from a technical perspective. Another inflationary shock, such as higher energy prices or an escalation in the war, could see sovereign bond yields rise further. However, in the absence of this, it is more likely that sovereign yields will fall from these levels over the next few months, thus providing an attractive hedge against slowing global growth or an unforecastable financial accident.
Credit markets have also had a tough time over recent months with significant losses for both Investment Grade and High Yield bonds. The combination of slowing growth, a weaker profit outlook, hawkish central banks, higher rates and rising default rates is bearish for the sector, especially High Yield. Having said that, a lot of bad news has already been discounted in both equity and credit markets. In addition, assuming that the Fed turns more dovish at the first sign of economic or financial stress, then any slowdown/recession could prove quite mild and falling sovereign yields would be supportive for risk assets generally. Finally, many companies are in a relatively strong financial position at present, having been through a tough test in 2020 and thanks to the subsequent and extremely generous monetary and fiscal support, which has enabled a strong economic and profits rebound.
The bear market in equities is advanced, but the conditions are not yet in place for a durable trough and recovery. Equities need 3 strong “pillars” to do well: reasonable growth, plentiful liquidity and attractive valuations. Over recent months, equities have been in a sour spot with central banks tightening policy materially in the face of higher inflation and draining liquidity out of the system. Valuations have fallen significantly, especially for growth stocks, which are negatively impacted by higher discount rates and were previously trading on very expensive multiples. Equities continue to face several headwinds and are likely to stay volatile for the next few months, with further downside possible. Central banks are likely to continue hiking rates, which will result in slower growth and/or recession. Earnings will come under pressure as growth stalls and costs continue to rise, especially as analyst estimates are still too optimistic. Whilst valuations have moved lower, they remain expensive in some areas. The duration and depth of this bear market will almost certainly be determined by the path of inflation and central bank policy. If the Fed becomes less hawkish, then equities will rally hard as interest rates and bond yields fall. Also, a significant change in Chinese policy towards either Covid or an aggressive monetary/fiscal stimulus would boost global growth prospects and support equities. Any fall in energy costs, especially if accompanied by a resolution in Ukraine would also be very helpful.
Given this background, it makes sense to stick with a diversified and defensive equity strategy, which combines quality growth companies with value and favours large cap over smaller companies and more defensive stocks over cyclicals. At some point, it will make sense to become more optimistic about equities and increase weightings. Assuming that the Fed eventually pivots towards a more accommodative policy, then we may see a rotation into growth stocks, which are more sensitive to interest rates than to economic prospects. However, given that growth stocks are still expensive versus value stocks, the longevity of any such rotation will depend critically on the future path of inflation and interest rates. In the meantime, some very attractive investment opportunities are starting to appear in areas such as emerging markets, where valuations look cheap.
The US Dollar has been very strong over the past year due to a hawkish Fed, higher Dollar Bond yields, a significant decline in US money supply and a stronger relative US economy. Many of these factors remain supportive for the Dollar and I expect further appreciation over the next few months, but this could change if the Fed changes its stance and interest rate expectations move lower. Slower growth will likely cause a cyclical pullback in commodities, but the secular trend should stay bullish. The post-pandemic surge in commodities seems predominantly to be driven by supply factors, capacity constraints due to underinvestment over many years and more recently, the Russia-Ukraine war. The world has very little spare capacity to boost oil output, despite high prices. Gold remains in a long-term bull market given the extremely challenging and uncertain macro environment.
These are unprecedented times for the global economy, financial markets and geo-politics. Although it is feasible to envisage a few potential outcomes, it is almost impossible to have much conviction about how things will evolve. Much will depend on whether the current inflation spike proves to be the start of a longer-term trend and how policy makers respond. A more defensive stance remains appropriate for now as we seek to protect capital for our clients and as we navigate our way through the uncertainty. However, markets have already discounted a lot of bad news and opportunities are starting to emerge across a range of assets, most notably equities. It is also reassuring to remind ourselves that even if we are returning to an environment more akin to the inflationary 1970’s, some assets did very well in this period including some specific equity sectors. We will stay cautious and patient for now and will be monitoring the direction of growth, inflation, and central bank policy over the next few months. We remain optimistic that better times lie ahead but have a contingency plan in case things take a turn for the worst.