End of Year Review
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Look how far we’ve come
As this will be the last article of 2021, I thought it would be a good time to review the portfolio and reminisce on how far we have come since the COVID crash of March 2020. I am also going to share my thoughts on where I believe markets and the economy are heading during 2022.
Since the COVID crash, we have seen a boom in technology, cannabis, renewables, and other similar exciting long-term opportunities which benefitted specifically from the work from home environment. This happened in tandem with Gold rising to new all-time highs. Then, as vaccine news broke in November 2020, there was a huge momentum crash, as many of the unformidable growth stocks dropped and the reflation trade began. This led to an explosion in commodities and other cyclical areas of the market which started to outperform, and this has continued into 2021. Through 2021 we have seen the rise of Reddit meme stocks, continued strength in the stock market, as well as the rise of cryptocurrencies. Alongside this, we have seen sustained increases in inflation rates around the world, reaching multi-decade highs. This all came alongside (and as a result of) 0% interest rates and a never-ending supply of money courtesy of each country’s respective central bank.
I began The Spark’s journey with my view that the Delta variant’s dangers were being over-exaggerated and therefore my first purchase was a recovery stock in Dave & Busters PLC (PLAY). I then continued to construct the portfolio across asset classes and sectors, including energy, healthcare, and precious metals. My thesis when I began The Spark was that the recovery from the pandemic would continue as businesses reopen. This would then lead to increased personal spending and a growing economy (expansionary phase). I also believed that inflation was not as transitory as the central banks suggested and that supply chain/labour issues would persist. This has played out as I thought, however, I did not forecast the hawkish shift of the Federal Reserve (And Bank of England) which has occurred this week. The Fed decided to accelerate the reduction in its bond-buying, from $15bn to $30bn a month, meaning quantitative easing (QE) will end in March 2022, and the BoE has raised interest rates to 0.25%. This, among other factors, has changed my view.
Warning shots
As I have mentioned previously, major economies bond yields are falling (see below). This comes in conjunction with rising yields on more risky bonds, such as the Greek 10-year bond. This shows that investors are becoming more defensive, selling down risky assets, and moving to safe havens (bond prices move down because people are selling them, leading to a rise in yields). The bond market is now pricing in slower growth. Alongside this, inflation continues to rise (5.1% in the UK this week), as does the US Dollar. As I have written about before, a rising dollar hurts foreign markets as their bonds are priced in Dollars, making their repayments higher. The Swiss Franc and other safe-haven currencies continue to rise too, further confirming the current ‘risk-off’ environment. Thankfully because The Spark invests across several markets, I get exposure to the rising dollar without having to purchase a short-term bond or money market fund (such as TIP5).
US (Yellow), UK(Blue) and German (Orange - left scale) 10-year bond yields showing slowing growth expectations, Source: Bloomberg
Further to the above case, market breadth has fallen substantially, a worrying sign. Breadth can be measured by the number of companies in an index above their 200-day moving average (MA). If a stock is above its 200-day MA, then the stock is said to be in an up-trend (generally speaking), and if it is below, it is in a downtrend. Breadth is now low, but the indexes continue to make new all-time highs. This shows that the market is being held together by a small number of very large companies. This is not good as it suggests a weakening market under the proverbial hood. See here for further evidence.
The NASDAQ Market breadth, Source: LinkedIn - Eddie Donmez
Growth stocks will underperform
Having said all of this, I believe we are likely to witness another good quarter of earnings due to a lot of companies being able to pass on rising costs to customers for now, and because of the ‘Santa Claus Rally’, as the population spends a lot of savings on presents. However, with these higher expectations placed on many companies (through their higher valuations) there is likely to be greater execution risk and therefore even more casualties in earnings season 2022 Q1 compared to Q4 2021. This means many of the high-valued growth stocks may have huge surprises to the downside if they do not live up to their expectations for earnings, hence why I am avoiding such companies at current valuations.
This is why I currently focus on strong businesses with good free cash flow. Bristol Myers Squibb (BMY) announced this week that it will initiate a $15bn share buyback program and increase its dividend. This shows two examples of what a company can do if they have strong free cash flow. Other uses include mergers and acquisitions, or research and development. These activities are all value accretive for shareholders. There are times to be more aggressive (such as 2020) and buy companies further along your risk parameters, but this is not one of those times. In my opinion, valuation and free cash flow are the most important aspects of investing at present, and the market is paying great heed to these measures of performance today.
There are two ways the valuations of these high-valued companies could come down. We may see a mid-cycle transition where price-to-earnings ratios normalise for the highest-valued companies (price gradually falls) – as we have seen already this year with the likes of Cathie Wood’s ARKK ETFs - as the rest of the market remains strong. On the other hand, we may see a correction/crash across the market as investors become increasingly worried about the economic outlook, and this means the highest valued growth stocks have the furthest to fall. For the reasons outlined above (breadth and bond market movements), I tend to lean towards the former over the latter. Having said this, the story behind many of these stocks is compelling and there is longevity and secular growth in many of these high-growth companies. Should there be a correction, I will add to such industries like Buy Now Pay Later (BNPL), Renewables, and cannabis stocks.
Plug Power (Blue), Block Inc (Purple) and Global X Cannabis ETF (Green) stock charts rebased to 100 - growth is underperforming this year, Source: Bloomberg
I aim to hold around 10-15% of capital in cash to take advantage of such companies as their prices fall and valuations become more attractive (as you will see below with one of this week’s additions). You may be wondering why I am continuing to add stocks to the portfolio if I believe there may be a correction. I have two reasons for doing so. One, stock markets are only down about 12% of the time. Being bearish is a loser’s game. I prefer to be conservative but still invested in the market, as there is always a chance that I could be wrong (hence why I limit the amount of capital I put in any individual stock). The second reason is that there are still great opportunities in the market at current prices, with The Spark’s most recent portfolio addition Discovery Inc being one example. The sentiment toward the market being overvalued is skewed because a large part of the ‘PE ratio’ is attributed to a small number of companies (the FAANGs) – and therefore it is a generalisation to assume that the entire market is overvalued and should be avoided. There is still plenty of value to be had if you avoid the sectors mentioned above.
Where we are today
Today, I believe we are moving to a slowing economy, as suggested by the bond market. This means sticking with defensive companies, with assured revenues, a moat, and strong free cash flow. Alongside falling yields, inflation expectations over 5 and 10 years are also falling in the US. This suggests the market sees the hawkish tilt by the Fed as effective in taming inflation. However, inflation expectations are hitting new highs here in the UK (see below). It is hard to judge how the market will price inflation concerns over the coming month since both the fed and the fed fund futures curve indicate three interest rate hikes in 2022. Regardless, the portfolio is well-positioned to take advantage in any inflation scenario. ISM manufacturing reports are still strong (above 50 is expansionary), and this is a leading indicator of GDP growth. Retail sales are also strong, and there is huge saving on the side-lines which may start to be unleashed in the coming months, hence why I have added two stocks that will benefit from this (more below). If ISM figures start to roll over in the coming months, I will start to get worried and sell down some of my more volatile holdings.
US 5-Year Inflation Expectation - elevated but falling, Source: Bloomberg
On a side note, although the Omicron variant is spreading rapidly, it does not appear to be as deadly as previous variants and will help the population reach heard immunity. I am however unsure of the government’s decisions over the coming months regarding lockdowns. Potential further lockdowns have made me skeptical of a continued recovery for Dave & Busters (PLAY). This is an excellent company with great management, but consumer discretionary stocks will suffer in a lower growth environment.
The Portfolio
The Spark’s Portfolio breakdown
In my mind, the portfolio is split into four sections. I hold GARP (Growth at a reasonable price) through MU, VRTX, DISCA, and AAF, Cyclicals are represented through Energy and PLAY, Quality includes BMY, REGN, PNN, and SJPA, and finally, Alternatives are held in the form of precious metals.
In terms of sector exposure, I will start with what I do not own. I have zero exposure to financials. Financials would have been an excellent holding during the reflation trade from December 2020 through to March 2021, as you can see from many of the major bank’s price charts. The market was pricing in a global recovery and higher loans written as expansion occurred coming out of lockdowns. However, as I have mentioned on several occasions recently, the 10 minus 2-year yield is now falling. This suggests banks’ net interest margin (and therefore willingness to lend) is falling, and therefore banks’ profits are falling. I may add exposure to financial services but will likely avoid the major banks unless the economic outlook improves.
Another sector I have no exposure to is real estate. At present, it is difficult to find a real estate investment trust (REIT) that does not trade at a premium to net asset value (NAV). When a REIT trades at a premium to NAV this means that the value of the REIT’s assets (properties) is less than the value of its stock. This again creates a higher valuation risk, and I am unsure of how real estate will perform during the next rate hiking cycle. However, if I can find an attractive opportunity trading at a discount to NAV, I would be happy to add this to the portfolio. Data centres and warehouses are the most attractive REITs with great long-term prospects, however, they trade at a premium to NAV. REITs such as these would be a great addition to the portfolio if valuations were to come down.
I also don’t hold any materials (miners etc), even though these companies are extremely attractive. The outlook due to the faltering property market in China has caused many materials companies share prices to slide, and they now look very attractive on valuation and profitability measures due to higher commodity prices. I have been monitoring several companies, one being Ferrexpo (FXPO), and if the global growth outlook improves, I will not hesitate to add it to the portfolio.
Although I don’t hold any consumer staples (CS), they perform much like that of utility companies. Again, for CS is it difficult to find a suitable opportunity at present. Diageo PLC (DGE) is probably the best opportunity in the space but trades at a high valuation.
I have high exposure to healthcare, being defensive in nature. However, the companies I hold are extremely attractive with exciting growth aspects (as I outline below). I also hold 15.6% of capital in Alternatives in the form of precious metals. These should protect the portfolio if inflation is priced to the upside over the coming months, and it also has a low correlation with the overall equity market. The Bank of Ireland’s recent decision to increase their holdings in gold by a third is also interesting. All central banks have to hold gold reserves, but this is a huge increase and is a strange decision unless they forecast higher sustained inflation.
On a company-specific level, AAF is the best performer, up 27%. They have recently signed a deal with UNICEF, which was the catalyst for their recent move to the upside. It is still attractively priced, and I will continue to hold it. The recent correction in uranium (and therefore CCO) was expected, as I believe it was overshooting in the short term. However, over the next few years, the story for uranium is compelling. The recent correction in oil prices has hurt my energy holdings, but due to falling exploration and production (from $950bn per year to $350bn), the medium-term outlook is exciting. For my healthcare holdings, the market is starting to realise the under-appreciation of REGN, BMY, and VRTX. All three stocks have made moves upward recently. VRTX has had success in recent drug trials, and REGN and BMY both have huge drug pipelines which are in the price for free. MU is starting to be appreciated also. PNN should do well in a slowing growth environment as utilities are defensive in nature (everyone needs water supplies). With real yields (Yield minus inflation) deeply negative, and the Gold: Silver ratio being high compared to historical levels, precious metals should perform well. One concern I have is regarding POLY, which I outline below.
Threats abroad
Tensions are rising with China, as the US just blacklisted a further eight companies from US investment due to China’s treatment of Uyghur Muslims. China’s invasion of Taiwan’s airspace is also a concern. Furthermore, Lithuania is pulling diplomats out of China over concerns for their safety. Alongside this, Russia’s de facto leader Putin has moved soldiers and missiles to the boarders of Georgia and Ukraine. He seems to be preparing for an invasion. Whether this happens or not is not what worries me. Putin is probably doing so to leverage his plans for the Nord Stream 2 pipeline, and to prevent Ukraine from entering NATO. The worrying part of this is that Russia owns Europe’s gas supply, and therefore Germany and Europe’s other major countries are at the mercy of Russian control. The fact that Germany stopped a recent movement of weapons to Ukraine further confirms this point (Putin may have had a quiet word with the German Ministers). On a side note, one longer-term positive of this however is that it will further push EU countries to adopt alternative energy sources, benefitting Uranium stocks such as Cameco.
The geopolitical risks here are increasing, so I am closely monitoring my position in Polymetal International (LSE: POLY). The company is excellently managed, has strong ratios, an attractive valuation, and a great balance sheet, however it operates in Russia. The risk of US sanctions on Russia, and negativity the market will attribute to operators in Russia as a result, cannot be ignored. This may lead to price weakness for the miner regardless of fundamentals. I am not panicking yet but may have to rotate capital to an alternative gold miner before the new year. Keep an eye out for this change in the portfolio, as I will not produce another article until January 2022.
Adding to quality and Santa stocks
Lockheed Martin (NYSE: LMT) is one of the largest security and aerospace companies in the world, operating through four segments: Aeronautics, Missiles and Fire Control, Rotary and Mission Systems, and Space. The company is defensive in nature, with a free cash flow yield of 8%, trading on an EV/EBITDA multiple of 10. The strong free cash flow comes through its assured revenues of government contracts, and also means the company provides an attractive 3.5% dividend yield. Lockheed is also buying back stock.
This company will give the portfolio exposure to industrials, a sector not currently represented, and is therefore good for diversification purposes. However, there are several catalysts for share price appreciation also. The growing tensions between the US and China/Russia should help support ongoing US government contracts with Lockheed. Another catalyst is their growing ‘Space’ segment. We have seen Bezos traveling to space recently, and with his stepping down to focus on Blue Origin (Amazon’s Space travel business), he obviously sees a huge opportunity. Space as a business is predicted to reach a market value of $1.4trn industry by 2030. The potential growth is exciting.
Asos PLC historical EV/EBITDA ratio, Source: Tikr Terminal
Two other companies I am adding to the portfolio are Royal Mail (RMG) and ASOS (ASC). Both should benefit from the Santa rally and the continued consumer spending boom, especially if further lockdowns ensue. Royal Mail has initiated a share buyback program and has very good free cash flow levels. It was previously bogged down by pension liabilities which have now been cleared and has now seen a substantial turnaround. Despite its 220% rally, it trades on a Price/Sales ratio of 0.4x. Asos also looks extremely attractive, has fallen over 60% from its recent highs, and now trades on its lowest valuation since 2009. The company is expanding across Europe and the US, and on a personal level is the only place I shop for clothes. Its huge clothing site and online presence should help it continue to expand. The valuation does not fairly reflect the growth, and I see the recent drop as a great opportunity to add the company. Boohoo (BOO) is another attractive clothing retailer I am following, which recently released news that profits will be affected by dress returns, higher shipping costs, and delays, sending the shares down 20%. These are short-term problems, and the downward spiral of its shares seems overdone. The company now trades on its lowest valuation ever, even with a predicted 20% growth rate in revenues. I do not feel comfortable adding it yet, but it is definitely on my radar.
Action:
Selling 50% of total position in Dave & Busters (NYSE: PLAY) at $33.82
Buying 2.5% in Lockheed Martin (NYSE: LMT) at $344.14
Buying 1.5% in ASOS PLC (LN: ASC) at £22.09
Buying 2.4% in Royal Mail (LN: RMG) at £4.96
Portfolio return since inception: 4.5%
Send me any questions, let me know your thoughts, or even recommend a stock to analyse by emailing thesparknewsletter@gmail.com
Until next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.