A challenging macroeconomic backdrop of rising inflation and interest rates has tested investor patience over 2022 and more recent recession fears have done little to help. We asked portfolio managers Anthony Aboud and Sean Roger how a bottom-up stock picker goes about adding value when the broader market is so dominated by macro themes.
Twelve months ago, the broader Perpetual Australian Equities team had a clear view that we were heading into an inflationary environment and the market was underestimating this trend. Fast forward to August 2022 and it’s a lot more difficult to call where we go from here. And while we aren’t macro investors in the Perpetual Pure Equity Alpha Fund or Perpetual SHARE-PLUS Long-Short Fund, we run different scenarios and consider the different macro drivers for each stock. Ultimately, we really focus on bottom-up stock-picking and we try not to make any big macro calls.
While reporting season will shed more light on the balance sheets of Australia’s top companies, we feel that equities are in a tough spot in the short term. Usually when the market falls 20% quickly, as it did in July, we are licking our lips as we try to snap up a few bargains. However, we are not massively excited at the moment. We believe that there is heightened risk of material downgrades to earnings over the next 12-18 months. Our reasoning is that we are entering a period with margins at record highs, runaway cost inflation across the board (labour, oil derivatives, insurance, interest, energy to name a few) at a time when the consumer is likely to pull in their discretionary spending. This cycle is being driven by rising interest rates, food and electricity prices, which will eat into buying power at a time when confidence may be dashed by a declining share market and property prices.
It’s not all bad news though. Australia is in a strong position relative to most countries, largely because we have plenty of what the world needs, starting with food and energy. On top of this, once immigration inevitably ramps up, we will be one of the few developed countries with population growth. Australian corporates generally have very strong balance sheets which suggests that, outside of a few pockets, there is unlikely to be a corporate credit crisis. The risk will be with the consumer and the level of mortgage debt. Given these headwinds and the lack of valuation support in aggregate, how are we looking to invest this year? This is a tricky period, and we will continue to play to our strengths, which is bottom-up fundamental analysis. While the macro environment plays a part in our analysis, it is not the sole reason for owning a stock. A few things to think about in this environment are:
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When running a portfolio which gets marked to market on a daily basis, extreme volatility can be quite stressful and impact how you think. We feel that the next few years will be quite volatile but ultimately sideways moving as the market grapples with structurally higher interest rates and inflation expectations without a requisite increase in real growth. This sort of market will likely gravitate from unbridled optimism to despondent pessimism and back again in short time periods.
From a stock-specific perspective, market participants’ lack of conviction and lack of tolerance for short-term negative company news will likely see individual share prices plummet despite very little change to the long-term investment thesis. As stock pickers, we want to capitalise on those opportunities and invest in companies at the right price, even if the immediate outlook is negative and we are made to look silly in the short term. On the other side of the coin, we want to make sure we maintain our discipline of selling our long positions when the share price has run past our fundamental valuation.
We don’t think that this sort of market will suit momentum investors or passive strategies. Given how well these strategies have performed over the last decade, there is a lot of money in momentum-style strategies. The problem is they only like buying what is already going up and selling what is already going down. This will be problematic in more choppy markets.
Over the last twelve years of decreasing interest rates and what has generally been a bull market, we feel that investors have been rewarded for lack of liquidity. In a bull market, the stocks with the highest beta go up the most. Stocks with low liquidity are generally higher beta. This has been taken to another level among asset allocators.
Increasing allocation to private equity and unlisted property is seen as smart in the early stages of a bear market as the mark to model on these private assets outperform the listed market. In some cases, this is a fool’s paradise. We believe that given the high level of uncertainty and likely volatility, we want to keep the portfolio fairly liquid. Things can change quickly, and it is very difficult to know what the future holds. Remaining liquid allows you to change your mind when the facts change.
Quality of portfolio
Beauty is in the eye of the beholder and so, it seems, is quality. It is a subjective business and our view is that high quality companies are those with pricing power, barriers of entry, structural growth, balance sheet optionality and having the best management in the sector. What we have seen to date is that some of the perceived higher quality companies have de-rated more aggressively than the market given their higher valuation metrics. This makes sense when there is a bond sell-off. We believe the next phase of volatility will likely come from earnings downgrades.
There are small pockets of opportunity at the moment to shift from a lower quality but slightly cheaper company to a substantially higher quality but slightly more expensive company as the P/E differential has compressed in some areas of the market. We are capitalising on this.
On the short side, we have maintained our short positions in stocks which have unsustainable business models. Over the last few years, the market has been more focussed on narratives and the macro rather than sustainable earnings. However, going forward, we believe this will change. We feel that there will be a renewed focus on earnings and earnings quality. We are seeing some opportunities shorting companies with an inflating cost base and no pricing power. This will result in margin squeezes which, in some cases, is not being anticipated by the market.
We look forward to the next twelve months. We like our long and short positions currently, but also know that the year ahead will probably throw out some great opportunities on both the long and the short sides. Being active, staying true to our style, continuously questioning our existing positions and uncovering new ideas will be key for us over the next twelve months and beyond.
Originally published by Anthony Aboud, Portfolio Manager, Perpetual