by Clay Smolinski
As we head into the final months of 2022, it’s worth taking a step back and reviewing the past 10 months, particularly given the turn of events, and providing an update on our thinking and key themes within our portfolios.
The investment environment has changed dramatically this year. To understand this change, we need to appreciate where we have come from.
Platinum has been in operation for over 28 years. Over that time, three core principles of our investment process have remained consistent:
1. Price matters – the starting price you pay heavily influences your return.
2. Truly great investment opportunities tend to carry a seed of discomfort when you are making them – they are not obvious. If everyone believes an investment is a sure thing, why would it be mispriced in your favour?
3. You are more likely to find great opportunities or mispricings in areas outside the spotlight.
Over our 28-year history, those principles have generally served us well. However, if we look back over the last five years, the best-performing stocks and parts of the market were almost the inverse of these three principles. These stocks, such as Netflix, NVIDIA, and Amazon, all:
1. Had high starting valuations that moved ever higher.
2. Were comfortable stories with few concerns and consensus on their beauty.
3. Were firmly in the spotlight – being some of the largest and most talked about companies in the world.
From that unusual starting place, post the COVID stimulus, the market evolved into a full-scale speculative bubble, where loss-making business models were encouraged, the ability to grow sales fast was all that mattered, and companies would routinely trade on incredible multiples of 20-50x sales.
This unusual environment was facilitated by an abundance of cheap/easy money, supreme investor confidence in the future, and the belief that interest rates would remain low for a long time.
That was the recent past, but what is happening now?
Since the start of this year, the situation has changed somewhat. During COVID, governments globally created vast sums of new money and gave it to their citizens and businesses to tide them over through forced lockdowns. While a large amount of new money was created, the productive capacity of the economy (e.g. trained workers, plant and equipment, availability of commodities) remained unchanged. As the new money chased real goods, services, and assets, prices adjusted upward with a time lag. Disruptions to supply chains had an impact, but the money printing is the root cause of the inflation we see all around us.
Now, central banks are trying to reverse this situation by aggressively raising rates to incentivise people to pay back debt and consume less, with the likely outcome being higher unemployment. The goal is to lower demand. It goes without saying that an environment of rapid money creation is very supportive of asset prices, while an environment of high rates leads to demand destruction and suppressed asset prices.
The implication of this can be illustrated with an example. In the US, the six-month risk-free interest rate increased from 0% to 4.5% in just 10 months. Blue-chip corporates can now borrow at 5.5%, while weaker-quality corporates are facing borrowing rates of around 8-10%.[1]
This has multiple effects:
– Projects now have a hurdle rate, and companies running loss-making business models have much higher operating costs.
– The financing cost to consumers for new big-ticket items, such as houses, cars, and renovations, is much higher, which will dampen economic activity.
– Investors now have another choice – when rates were very low or zero, equities were the only real choice; now fixed income assets have become more attractive and investors require a higher starting return from equities.
In short, the easy money has been pulled, money now has a real cost, and a sense of healthy investor scepticism is returning to markets. Cash flow, profits, and valuations increasingly matter again.
How is Platinum positioned in this environment?
Coming into this year, there were three big-picture considerations that shaped our portfolios:
1. There was a huge distortion in company earnings. Consumers had been given large amounts of money by governments, and COVID lockdowns changed their spending patterns. Because of this, many companies were at peak levels of profitability, and their true earnings power over the next two to three years was very unclear.
2. We expected rates to be higher. We have long expressed our view in various presentations and investment reports that we expected interest rates to move higher to address the mounting inflation problem. We wanted to own the beneficiaries of that, but also short those companies who would be harmed the most.
3. We maintained our bias towards value. Valuations were high and we wanted to position ourselves in the cheaper, more attractive end of the market.
Key themes across the portfolio were:
– Companies not at their peaks, where we have high confidence that they will have higher earnings in two years’ time. Holdings that fell into these buckets included our oil and gas companies and also travel.
Following an eight-year recession in capital spending and extensive cost-cutting, the oil and gas industry is now seeing a large step-up in investment as countries seek to invest in and develop new sources of supply. From our experience, when you combine a big increase in spending with an extremely lean industry, excellent profit outcomes can follow.
The travel industry went through considerable pain during COVID, and it was a sector that investors did not want to own. However, the desire to travel is innate to human nature, so we were confident it would come back. And we are seeing that now, with travel demand booming, and I’m sure many of our investors have felt the high airfare and hotel prices off the back of that demand.
– Companies that benefit from higher interest rates and inflation. This includes some of our commodity holdings, as well as banks and insurance companies. European banks, for example, have been hurt by negative rates for a decade, and that initial shift from negative to +2% interest rates provides a very meaningful boost to their profits as they benefit from their low-cost deposit franchise.
– Companies in a different economic phase. There is much discussion about the US and Australia entering a recession, while China is already in a deep recession and enduring zero-COVID policy lockdowns. Chinese stocks are down 60% from their February 2021 highs,[2] and any positive news, such as a plan to transition away from the zero-COVID policy, would likely have a positive effect on stock prices. For more on our thoughts on China, please see a recent video by portfolio manager Cameron Robertson.
– Beneficiaries of new marginal investment and the new problems we need to solve. One example of this is the move towards greater electrification. Europe’s desire to decarbonise has been supplanted by the need to achieve more energy independence – and they need to do that quickly. The end result of that will be the need to electrify a wider range of energy uses where it is feasible. A good example is 30% of the European Union’s gas is used for home heating, a process that can be electrified more simply. [3] When you add this to the electrification of passenger vehicles, this will create a wave of demand for batteries, power semiconductors, copper, and electrical transmission and efficiency infrastructure. Other areas include robotics, machine vision, and automation.
– Shorting companies that have unsustainably benefited from either COVID or easy money. COVID lockdowns created a large pull forward in spending on many goods. A great example is leisure goods, such as bikes and fishing gear. These are mature markets where demand would normally grow 2-3% p.a., but during COVID, sales jumped 50%. Once you have bought a new fishing rod and new bike, you don’t need another for a few years. There are many companies like this in furniture, electronics, home renovation, and so on. Additionally, the easy money environment encouraged a wide range of loss-making business models, that are completely reliant on new equity or debt funding to continue. We think this funding will be much harder to come by, and hence, we still see several opportunities to short here.
In summary
The last couple of years were characterised by an environment that was extremely favourable to stock and asset prices, thanks to easy money, low interest rates, positive attitudes towards risk, and strong demand. Today, we have an adverse environment for stock and asset prices, rising inflation, higher interest rates, and concerted efforts by central banks to reduce demand, which may create unemployment.
This new environment calls for a different approach than what has worked in the recent past, and it is an environment that is more suited to Platinum’s approach. While broad markets have fallen 20%, given how wild the party was, we would not be surprised to see broad markets fall further. However, we must also keep in mind the incredible buying opportunities and long-term wealth that can be built if you are willing to invest in these environments. These cycles are nothing new; we just need to understand them and take advantage of them.
In that regard, we will continue to invest in companies that we think will be incremental sources of growth and investment or are already pricing in a recession, and at the same time, endeavour to protect our clients’ money by opportunistically shorting unsustainable areas.
[1] Source: FactSet Research Systems.
[2] Hang Seng China Enterprises Index. Source: FactSet Research Systems.
[3] Source: 2021 Annual Energy Paper, Michael Cembalest, JP Morgan Asset and Wealth Management
DISCLAIMER: This article has been prepared by Platinum Investment Management Limited ABN 25 063 565 006, AFSL 221935, trading as Platinum Asset Management (“Platinum”). While the information in this article has been prepared in good faith and with reasonable care, no representation or warranty, express or implied, is made as to the accuracy, adequacy or reliability of any statements, estimates, opinions or other information contained in the article, and to the extent permitted by law, no liability is accepted by any company of the Platinum Group or their directors, officers or employees for any loss or damage as a result of any reliance on this information. Commentary reflects Platinum’s views and beliefs at the time of preparation, which are subject to change without notice. Commentary may also contain forward looking statements. These forward-looking statements have been made based upon Platinum’s expectations and beliefs. No assurance is given that future developments will be in accordance with Platinum’s expectations. Actual outcomes could differ materially from those expected by Platinum. The information presented in this article is general information only and not intended to be financial product advice. It has not been prepared taking into account any particular investor’s or class of investors’ investment objectives, financial situation or needs, and should not be used as the basis for making investment, financial or other decisions. You should obtain professional advice prior to making any investment decision.
