By Andrew Mitchell & Steven Ng
Co-founders and Senior Portfolio Managers
In our December 2020 Letter to Investors we take a look at what 2021 might have in store for investors as the vaccine rollout confronts new, more virulent forms of the virus.
Dear Fellow Investors,
Welcome to the December 2020 Ophir Letter to Investors – thank you for investing alongside us for the long term.
Ophir Fund Performance
The Ophir Opportunities Fund returned +3.7% net of fees in December, outperforming its benchmark by 0.9% and has delivered investors +25.3% p.a. post fees since inception (August 2012).
The Ophir High Conviction Fund investment portfolio returned +2.5% net of fees in December, underperforming its benchmark by 0.9% and has delivered investors +19.6% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of -0.3% for the month.
The Ophir Global Opportunities Fund returned +11.5% net of fees in December, outperforming its benchmark by 10.2% and has delivered investors +39.9% p.a. post fees since inception (October 2018).
The V or the bear: what can investors expect in 2021?
Markets slow from a gallop to a canter
After most major global equity markets rose 10%+ in November, equities rose a still very respectable and above-average +3.5% (local currency terms) in December as positive vaccine news continued to roll in.
In this risk-on environment the Aussie dollar, commodity prices and the Australian share market all also rose, although the latter underperformed its global counterparts, up a more modest +1.2% (ASX200).
Post the extreme outperformance of the ‘value’ style of investing in November, it was back to ‘growth’ outperformance in December globally.
This was not the case in Australia, though. Aussie miners, particularly those with exposure to iron ore, including Fortescue (+28.5%), led the way during the month because the price of the steel input continued to rocket higher from increased Chinese demand and with supply from key foreign competitors disrupted.
This typical value sector, along with the relative underperformance of the healthcare sector (a favourite of growth investors), means value investing has now outperformed in each month domestically in the December quarter.
All of this happened on the back of a stunning year for shares in 2020 where many major markets saw the fastest bear market in history, down around 30-35% over February/March, to be followed up by the fastest bull market with 50%+ gains over the rest of the year.
So, after a remarkable 2020, what can investors now expect for 2021?
In this letter we look at the latest news on the vaccine front, but importantly whether a V-shaped recovery in earnings will deliver outsized returns for investors in 2021. Or, with valuations stretched and signs of investors exuberance emerging, will we witness a bear market this year?
Whatever the answers to these questions are, it is clear that stock picking skills – which we focus on at Ophir – will determine whether investors triumph in 2021.
Mixed news: virulency versus the vaccine
Despite much optimism around COVID in recent months, still the dominant theme for markets, there has been mixed reports recently.
In Ireland, a new, more virulent COVID strain has infiltrated the country – seeing case numbers soar (see chart below).
Ireland number of new daily cases
Source: Ben Hunt
The danger is that harsher lockdowns may be needed to combat these new strains before a sufficient percentage of the population receives an effective vaccine.
On a positive note, Israel is leading the world with just over 25% of the population having received a first vaccine dose. There are some early glimmers that infection rates are dropping off in Israel as they implement the highly effective Pfizer vaccine (see chart below).
Israel vaccinations vs number of new COVID-19 cases
Source: Johns Hopkins University, Our World in Data, MST Marquee
We should all hope that vaccine rollout occurs in sufficient time before more virulent strains become widespread. Those areas under harshest mobility restrictions due to more widespread virus cases are likely to see the biggest continuing hits to economic output. The Eurozone, UK, Japanese, Turkish and Brazilian economies all expected to contract in the March 2021 quarter.
A nice V-shaped earnings recovery
Looking to the second half of 2021, though, we have higher confidence the global economy will be in a more synchronised rebound as vaccine rollout helps economic activity normalise.
We believe corporate earnings will follow a V-shaped recovery, which we have already seen domestically in Australia because of our relatively low virus cases.
After a circa 15% earnings per share (EPS) contraction in 2020 in Australia and globally, we see a V-shaped rebound in 2021 with consensus forecasts of 19% growth in EPS in Australia and 26% globally.
As seen in the below chart, EPS looks to have troughed in Australia, though we will be waiting for the upcoming reporting season in February to confirm this.
As is typical, markets have been forward looking and anticipated the earnings recovery ever since it became apparent in March/April last year that social distancing measures were likely to stem the spread of the virus and allow some economic activity to resume.
Current market cycle following classic V-Shaped rebound path
Source: Company Data, RBA, Refinitiv, MST Marquee
But does the earnings V mean victory for returns?
Despite that V-shaped recovery in earnings, we think the large equity market gains though of the last few months are unlikely to be repeated throughout 2021, though.
We say this of course with the low level of conviction that should always be attributed to such short-term forecasting. Many may then say, “well why bother with forecasts at all?”. Here we find the quote that is often famously attributed to Dwight Eisenhower useful: “Plans are useless, but planning is indispensable”. Considering forecasts allows us to think through likely — and less probable — scenarios, which helps us position our portfolios for a range of outcomes.
So, what is likely to happen this year?
We largely agree directionally with independent research house MST Marquee’s central forecast for market share price returns and its constituent components over 2021 (see chart below).
Sharp rebound in Australian EPS, with valuation contraction tempering sharemarket returns
Composition of ASX 200 annual total returns
Source: Factset, Refinitiv, MST Marquee
That is, after EPS falls in 2020, we are likely to get a sharp rebound in 2021. But, unfortunately for investors, this may not translate into high share market returns.
That’s because the sharp earnings rebounds will be offset by the fact that valuations — as measured by price-to-earnings ratios (PEs) — are stretched compared to history.
The significant expansion of valuations in 2020 was the only reason major share markets globally (including in Australia) did not log heavy falls in total returns over the year.
But the probability of valuations expanding again in 2021 is relatively low. Indeed, they are more likely to fall because higher growth and inflation in 2021 will likely put upwards pressure on bond yields, and hence discount rates, that are used in valuing shares (see this month’s Investment Strategy note for further detail on this topic).
Beware the Bear?
With these valuations so stretched, a major dominate theme that could not escape many investors’ attention early in 2021 is the debate over whether share markets were in a ‘bubble’ or headed for a bear market.
The narrative goes something like this: after fast price increases over the last few months, evidence of stretched valuations, pick-ups in company IPOs and capital raisings, frenzied investor behaviour in things like Bitcoin, all the while COVID had not been squashed yet, we are due for a big market fall.
One of the main proponents of the bearish view is well known investor Jeremy Grantham, from venerable asset manager GMO, who built a reputation for foreseeing the 2000-2002 ‘tech wreck’ and the 2007-2009 GFC, though some of his bearish views throughout the last decade have been less accurate.
On the other side of the ledger, however, investors such as powerhouse global asset manager PIMCO are more positive. PIMCO’s latest asset allocation piece entitled ‘Early Cycle Investing’ notes the 2021 economic recovery should “provide a tailwind for risk assets”.
The ranks of market bulls also includes sought after market prognosticator Professor Shiller of Yale University. Late last year Shiller noted, “with (interest) rates so low, the excess CAPE yield (basically how much extra earnings a $1 investment buys compared to interest earned on bonds) across all regions is almost at all-time highs, indicating that relative to bonds, equities appear highly attractive”.
Some concerning signs
Citi has one of the more comprehensive Bear Market Checklists available to professional investors, as seen below, although it is by no means fool-proof.
Bear Market Checklist
Of the 20 indicators they follow, two are flashing amber and seven are flashing red. That is still short of the levels seen at prior market peaks before bear markets.
We would also note that the two red ‘valuation’ metrics primarily relate to valuations versus history. They do not appropriately consider the ultra-low levels of interest rates, so we are less concerned by them. We are also not concerned about the breadth of upward earnings revisions given they are coming off abnormally low COVID impacted bases.
We’re most concerned about measures that relate to buoyant investor sentiment and the increasing level of IPO issuance. But perhaps this is not so surprising when we have just had news of effective vaccines and pent-up IPO supply and demand after the ‘IPO window’ was effectively shut in early 2020.
Our stock-picking edge
Given this outlook, how should investors position for 2021?
Ultimately, given we find it very difficult for us, or most others to get an edge through analysing the market ‘tea leaves’ that millions of casual investors and thousands of professional investors increasingly have access to, we’d rather stick to the game we do think we have a chance of obtaining an edge in.
That is, very detailed individual research on small and mid-sized companies that less people are looking at or are misunderstood by others. This is an endeavour we believe we have a better than even chance of adding value for investors, and that view is unlikely to change in 2021.
Indeed, we think it is likely that outperformance through stock picking skill (or ‘alpha’ in industry jargon), where it can be found, is likely to play a more important role in total returns from equities in 2021 than it has over the last few months of 2020, where a rising tide in the market has generally lifted all boats.
But even as 2021 unfolds, we will remain focussed on selecting companies that we believe can grow and compound earnings over the long term.
In the short term we can easily be wrong about market forecasts and even forecasts for individual companies…and frequently are! In the short term (like a year), changes in valuations such as PE ratios have an outsized impact on total market and company returns. These changes, particularly at the market level, are very difficult to forecast as investor emotions, such as fear and greed, often have a large impact.
What does win out and drive the lion’s share of equity returns over the long term though is earnings growth, which we have a much better chance of forecasting through the hard work of company due diligence.
This dynamic is neatly summed up in a quote by Ben Graham, the father of modern investing who noted “In the short-run, the market is a voting machine (driven by popularity based on emotions), but in the long-run, the market is a weighting machine (where it weighs the ability to grow profits)”. Italicised comments added by us.
As always, thank you for entrusting your capital with us.
Andrew Mitchell & Steven Ng
Co-Founders & Senior Portfolio Managers
Ophir Asset Management
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