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Portfolio and Market Update

Summary

The opening line from Rudyard Kipling’s poem, If, which if written by a wise investor, might have gone on to say you can pick up some attractively priced companies.

Reflection

“If you can keep your head when all about you are losing theirs…”

The opening line from Rudyard Kipling’s poem, If, which if written by a wise investor, might have gone on to say you can pick up some attractively priced companies.

Conflict

The Russia/Ukraine/NATO situation is fragile and the risk of a likely invasion by Russia is being priced into markets.  Like any dictatorship, when a disgruntled population faces rising prices for essentials, the distraction of a foreign campaign and sabre-rattling against old foes is appealing.

Valuation

Stock markets have discovered that unprofitable companies, especially those that IPO’d in the last couple of years either directly or via SPACs, were too highly valued in equity markets that have had a good run since March 2020.  We don’t own those companies, but financial markets have extrapolated growth fears and the ensuing contagion has impacted growth equities across the board with few exceptions.  The companies that the T. Bailey Funds are predominantly exposed to are profitable, well-run businesses in themes that will endure over the next few years.

The speed and severity of the sell-off has brought loose holders out as sellers, so some of the selling has become indiscriminate.  Much of the sentiment indicators we look at are oversold.  The Fed talk on rate increases this year has been reasoned but the interpretation of phrasing is in danger of becoming hysterical.  Four rate increases are projected in 2022, more than that looks improbable and difficult to achieve in a mid-term election year.  Supply shortages, economic growth and inflation should abate in the second quarter of this year.

Inflation

Energy inflation is a tax on economies.  Raising rates to deal with resultant inflation from higher energy prices is an economic error learned fifty years ago.  Labour costs are more likely to persist, so our focus is always towards businesses and themes that do not involve labour-intensive processes and/or businesses that possess pricing power.  Although base rates, Fed Funds rates and bond yields are rising, negative real yields will persist for some time. Our focus on businesses and themes that avoid leverage will mitigate increases in debt service cost.

What Have We Done?

Last September, we raised cash on both funds and let it build as inflows came in.  Additionally, on a look through basis, cash was even higher.  It has not helped much through the rotation into ‘value’ equities.  Also in September, we trimmed growth beta, recognising its vulnerability and continued to do so.  With hindsight, we could have done more.

We expect earnings for the underlying businesses to remain strong and as happened a couple of times last year, support those profitable thematic holdings.

Last week cash was 11% on Growth which also had 6% in Commodities.  Dynamic’s cash position was 12% with 13% in commodities, 14% in absolute return strategies and 10% in real assets, most of which have an inflation linkage.  In our hunt for cheap assets, we have reverted back to a holding last held a couple of years ago which is not dependent on market direction.  Both funds have invested 4% of their cash into the Polar Capital Global Insurance Fund.  The beauty of the insurance market is that it has pricing power, especially when it invests in those companies able to write bespoke insurance policies and charge the appropriate premia.  I should add that these are non-life, non-catastrophe insurers.  This fund should return circa 10% per annum in most market conditions when relatively cheap to its history, which it is now.  The fund isn’t actively marketed but we know the team well.

Valuation II

For clarity, here are two bullet points on valuation which we concur with, written by one of our providers.

  1. A valuation metric, a price to earnings (PE) ratio or free cash flow yield is in isolation a meaningless number. An investment outcome, good or bad, is determined by the valuation of a company relative to the outcome the business achieves. A high PE stock can be a very rewarding investment if the company that sits behind it outperforms operationally the expectations embedded in that rating. Equally, low PE stocks can be poor investment if the business fundamentals behind it are deteriorating.
  2. The valuation of a company is a function of the future profits, and therefore cash, it generates and the discount rate (the cost of debt and equity prorated to match the funding structure of the company) attached to it. Although both have an influence on valuation, typically the discount rate is less important for the most successful companies as they produce profits higher and longer than expected.

We would add to the above by stating that by buying into companies and businesses that are not labour intensive, have decent profit margins (price-makers) and are either disruptors or have leadership positions without being leveraged or overly indebted, you will probably have a portfolio that has quality growth characteristics.  If those businesses are in long-term demand themes, then that portfolio should be durable and deliver good investment returns over time.  They will also suffer from bouts of financial market turbulence along the way.

We are currently in one of those periods of turbulence that occur from time to time.  The initial beneficiaries of the growth sell-off have been low-growth, thin margin businesses (price-takers) with no leadership position.  Even these ‘value’ stocks have their moment in the sun, not least when they are perceived to be ‘cheap’ enough by one of the isolated valuation metrics mentioned in paragraph 1 above.  They can be found populating the FTSE 100. The last time I looked, the best performer in recent weeks, was an airline group. They are not appealing long-term investments, nor do they sit in long-term demand themes.

What Does History Tell Us About a Rate Hike Cycle?

The chart below sourced from Bloomberg shows that in only one of the past twelve rate tightening cycles, did the US S&P 500 equity index cost investors money.  Back then nominal and real interest rates were higher.

Inflation II

It is likely that globalisation ended during the pandemic, onshoring production to be nearer to market and be more demand responsive is the new order with pressure on wages a result. Energy price rises are a tax on consumers and businesses and should not be a cause for interest rate increases.  Supply shortages and energy prices should abate in Q2 2022 with inflation pressures subsiding as a consequence.

You may have recently received a letter informing you that the investment objectives of the T. Bailey Growth and Dynamic Funds have been updated to change the performance horizon from 3 years to 5 years. This change had been planned since mid-2021 in response to current industry practice and the ongoing implementation of the FCA’s thematic review into UK authorised funds. We would like to assure you that the change is not a result of recent market turbulence and there is no change to the way we manage the funds, nor their risk profile.

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