Value on Offer
Welcome
Hello and welcome to the first edition of ‘The Spark’! This newsletter is designed to educate and provide investment ideas, which you should do your own due diligence upon. It is also a way for me to challenge my own knowledge by putting my thoughts on paper. Hindsight is wonderful, especially in investing, as things can change very quickly (as we all saw last March). For further information please visit the ‘About’ Section of the website. I should reiterate this column is for longer-term investing not trading. Compounding your wealth over time should be the aim of every young person (Warren Buffet made 99.7% of his $81 billion fortune after the age of 52). If you want to turn £100 into £1,000,000 in 23 days, this is unfortunately not the page for you. So, without further ado, thank you for reading, and let’s get stuck into it!
Using Delta to Generate Alpha
There has been huge debate over the past year on whether value stocks would outperform growth stocks. We have seen value win the battle since news broke of a vaccine, with retailers recovering and commodities soaring to multi-year highs. However, now we seem to be at a crossroads, with several factors creating market fear at present. First, the rapid spread of the delta variant has created fear in the market of further lockdowns in developed markets, as we have seen in some Asian countries of late. Partly as a result of these shutdowns, alongside other factors, the market is also worried about slowing GDP growth coming out of the pandemic, with many major banks now downgrading US GDP forecasts for Q4 2021. These fears have led to a sell-off in many cyclical stocks which benefitted from the reopening.
Source: Bloomberg, Russell 1000 Growth index/Russell 1000 Value index
The current Delta variant of COVID-19 has been sweeping around the world and as a result, we have seen many Asian countries locking down for a second and third time. Even Australia, which successfully avoided the first wave of the pandemic by closing their border, hasn’t been able to avoid it. A fact we all must face is that Covid will be here for many years. Looking at the recent surge in the UK, cases have risen exponentially, and are not far from the figures seen during the second wave in January 2021. However, cases are beginning to roll over and at the same time, deaths and hospitalisations are nowhere near January’s levels. Young people are continuing to get vaccinated and further booster shots are reportedly starting next month. Vaccinations are working, and therefore I don’t believe the government can justify further lockdown, especially with furlough ending soon.
As Warren Buffet says, “Be greedy when others are fearful, and fearful when others are greedy”. Using the legendary investor’s mantra, I believe this is a great time to reinvest in the ‘Reflation’ trade – buying value stocks that would benefit from the reopening. We have seen growth start to outperform recently (see graph above), and many airliners, retailers, and miners have sold off, mainly due to the Delta variant fears highlighted. I believe these fears are overdone, and the market has provided us a great opportunity to purchase excellent companies, many of which have fallen by 20% or more from their recent highs. The ‘Pingdemic’ here in the UK may have slowed growth recently, but this should not continue as we return to normality.
Valuation matters
A second and arguably more important worry is that the Federal Reserve (Fed) will begin tapering (reducing their purchase of Mortgage-backed Securities and Government Bonds). There is concern that reduced liquidity will create a similar outcome to the 2013 ‘Taper-Tantrum’. This has led to a stronger US Dollar and a subsequent cooling in both commodities and Emerging Markets (exacerbated by China’s recent crackdown).
The Fed has been extremely clear with their communication thus far on how and when they will begin tapering and raising interest rates. In the past few days, five Fed members have confirmed that tapering will arrive this year. This is now priced into market expectation. With this in mind, I believe you should now avoid richly valued growth companies. These companies (e.g., Cannabis, Renewables, Electric cars) performed exceptionally during 2020 as investors reached for the most speculative assets with rates at the floor and liquidity through the roof. However, as liquidity is drawn from the market, I believe these companies will continue to underperform, as they have of late.
Millennials today seem to believe that investing is simple. Meme stocks and the ‘Everything Bubble’ of 2020 meant if you bought virtually anything it would make money. This is an anomaly that will probably never be repeated. When it comes to choosing investments, there are two things you must consider. The macro-economic backdrop and the price you pay.
I don’t want to begin a history lesson, but at the end of 1999, record low interest rates led to astronomical amounts of capital pouring into the tech companies of tomorrow (sound familiar?). Once the Fed started hiking interest rates things went downhill... to say the least.
Source: Bloomberg, Price Chart of Amazon. Even the greatest companies feel the pain in tapering.
I am sure there is a very sorry individual that sold Amazon after it fell 95% in the wake of the 2000 ‘Tech Bubble’. Would you be able to stomach a 95% loss on your investment and still hold it? If you had bought the top, it would have taken almost ten years to see a paper profit. This provides 2 important lessons. One, valuation matters, and two, it shows the importance of fully understanding every investment in your portfolio.
Value wins during Tapering
Recent tapering news has led to a turnaround in the bond market. We have begun to see yields turn up and start to rise. I believe this is set to continue. Below I have attached a chart of the 10yr minus 2yr yield on the UK Gilt. This curve is a great indication of banks’ profitability, or their net interest margin, as banks would borrow on the short-end of the curve and lend on the long-end. Rising yields, alongside sustained higher inflation, suggest value stocks may start to outperform again as these conditions benefit such companies more.
Source: Bloomberg, UK 10yr Gilt minus 2yr Gilt
Although tapering is likely to reduce inflationary pressures, wage-spirals, and supply chain issues, along with ultra-loose monetary and fiscal policy, will lead to higher-than-average inflation. The Central Banks have already stated they will tolerate this.
When looking for value plays, there are several factors to consider. Debt is huge in differentiating between an undervalued company and a value trap. If a company is using the majority of its’ earnings to meet interest payments, it will find it extremely difficult to grow. The EBIT/Interest Expense ratio would be a good way to assess this.
Other things to look out for are; Share dilution; poor or falling margins – suggesting no pricing power; low cash conversion; and poor free cash flow generation. Many of the above are reasons why companies such as Rolls Royce are currently trading extremely cheaply. It is preferable to back solid companies, with good free cash flow generation (more than 6%) and good valuations relative to peers. Good examples for further research are; Bae Systems and Serco in the UK, and in the US Dave & Buster could benefit as we continue to reopen.
I hope you enjoyed the first edition of The Spark. I would really appreciate any feedback or questions which can be posted to my email through the form on the website. Don’t be afraid to disagree/challenge me!
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.