By Andrew Mitchell & Steven Ng
Co-founders and Senior Portfolio Managers
In our February 2021 Letter to Investors we take a look into recent bond market volatility and what it might mean for equity market leadership.
Dear Fellow Investors,
Welcome to the February 2021 Ophir Letter to Investors – thank you for investing alongside us for the long term.
Pistols at Dawn – Central Banks vs Bond Markets
A tale of two halves
Share markets started February on a bullish tone as investors focussed on the global rollout of vaccines, still-low interest rates across the world, and a big bazooka USD$1.9 trillion fiscal stimulus in train from US President Biden. This saw many major equity indices up over 5% mid-month.
During the month equity markets continued the themes playing out since vaccine news first hit the airwaves in November last year. That is, outperformance of value over growth, cyclicals over defensives, small cap over large cap, and ‘out and about’ over ‘stay at home’ stocks.
It should come as no surprise that at the top of the winner’s list in February was the Russell index (US small caps), global value stocks and cyclical commodities (oil, copper and iron ore), whilst defensive gold positions trailed the pack (see chart).
Asset returns – February 2021
Source: JP Morgan, Bloomberg
Meanwhile, we saw the best Aussie equities reporting season in decades as profit ‘beats’ resoundingly trounced ‘misses’, and FY21 earnings forecasts were ratcheted up by record amounts.
But then markets were hit by some major, and quite jarring, moves in bond markets. That saw equity markets give back some gains to finish the month up in the low single digits. And despite the strong earnings results from Aussie equities the market reaction was muted, suggesting it was poised for good news and further upside may be hard won.
February 2021 Ophir Fund Performance
Before we jump into the letter, we have included below a summary of the performance of the Ophir Funds during February. Please click on the factsheets if you would like a more detailed summary of the performance of the relevant fund.
The Ophir Opportunities Fund returned +3.3% net of fees in February, outperforming its benchmark which returned +1.5% and has delivered investors +25.4% p.a. post fees since inception (August 2012).
The Ophir High Conviction Fund investment portfolio returned +0.2% net of fees in February, outperforming its benchmark which returned +0.1% and has delivered investors +18.7% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of +1.4% for the month.
The Ophir Global Opportunities Fund returned +5.2% net of fees in February, outperforming its benchmark which returned +3.4% and has delivered investors +42.5% p.a. post fees since inception (October 2018).
Three key issues
In this month’s letter we take a look at three key issues. Firstly, whether markets are getting too optimistic around a COVID-19-vaccine recovery. We also look at whether investors should be worried about the sudden spike in bond yields and what that means specifically for high-flying growth stocks. Thirdly, we look at whether the record Aussie reporting season is sustainable, or whether results will normalise.
By understanding these issues investors will appreciate the need to be cautious of expensive parts of the market where investors are overly optimistic, and that the best way to outperform in this environment is to remain focussed on bottom-up investing in companies they deeply understand, which is obviously our own ongoing focus at Ophir.
1. Vaccine vicissitudes – Are we out of the COVID woods?
Corporate earnings and sharemarkets in 2021 will still likely be primarily dictated by the course of COVID-19, the efficacy and speed of vaccine rollouts, and whether any mutant variations of the virus successfully evade any ‘tweaked’ vaccine potions.
In the U.S., the home of the world’s largest sharemarket, virus news during February was about as good as you could have hoped for, with case numbers and hospitalisations dropping precipitously. As an example, hospitalisations for those aged 85 and over dropped by 81%, as you can see in the data below from 10 states.
Covid Hospital Admissions
Rate of weekly admissions per 100,000 residents by age group
Absent rogue virus variants, cases and hospitalisations should continue to improve in much of the world as vaccine rollouts ramp up.
In Australia, recent GDP data indicates that the rebound in economic growth in the second half of 2020, due largely to our relatively better management of the virus, was well ahead of expectations. In fact, it is quite likely the economy has now recovered, or is very close to having recovered, to its pre-COVID level of output.
Household spending has been particularly strong of late, spurred on by JobKeeper payments and the winding down of savings rates. Looking at spending changes over the last year you can get a sense of which industries were the biggest beneficiaries, but also where spending is likely to pick up the most in 2021.
There remains scope for further reopening-related spending tailwinds
Source: Morgan Stanley
As can be seen above, households spent more on vehicles and alcohol (though hopefully not used at the same time!) as well as household goods. The key services of transport and hospitality saw the biggest pull backs, due to social distancing measures. But they can also be expected to be some of the biggest beneficiaries of re-opening related spending.
This of course is not just an Australia specific phenomenon. If Airbnb CEO Brian Chesky on a recent analyst call is to be believed, travel will be top of the pops as economies reopen:
“We did a survey recently of American travellers and we found a couple of things. The first thing we found is that people missed traveling, that’s not surprising, but we also found that people missed traveling more than any other out-of-home activity. People missed traveling more in America than going to a restaurant, going to sports, live music or other activities.”
It is hard not to find an investment strategist now that isn’t favouring re-opening, cyclical and value type trades for 2021, or at least the nearer term. We think it pays to be cautious, though, when the consensus is so one-sided. It often means that this view is largely factored into prices.
Markets appear to be pricing in a very optimistic scenario for virus containment at present and a return to something resembling normality this year. But we would just caution that we are not out of the woods yet, and virus mutations continue to pose a risk. We are not overloading on those investments that are highly reliant on unabated re-opening. Rather, we are taking a more balanced approach so that performance in our funds is not overly reliant on the exact course the virus will take because we believe the recovery path still has the potential to be bumpy and uneven.
2. Markets get ‘real’ – Why did the bond spike spook investors?
As mentioned, during the last weeks of February virus and vaccine news was overshadowed by the bond market, of all places. In fact, the selloff in bonds, particularly those of longer maturity – which caused equity market falls late in the month – meant that most balanced portfolios would have seen some of their largest two-week declines since the GFC.
The Australian and U.S. 10-year government bond rates increased by 0.79% and 0.34% each to 1.92% and 1.41% respectively over the month. Those are huge moves in such a short time.
So what is happening?
US 10Y Nominal Yields, Real Yields & Break-evens (%)
Source: Citi Research, Datastream
As seen above, the US 10-year bond yields (gold line), often known as the most important ‘risk-free’ rate of return in the world, has been increasing for several months without upsetting the share market apple cart. The rising yields were driven by normalising inflation expectations as the outlook for the US economy improved (as reflected in the purple line above, which represents the 10-year break-evens, a measure of expected inflation).
But then ‘real’, or after-inflation, yields (as seen in the grey line above) have suddenly shot up. That has been more challenging for equity markets and triggered a sell-off in late February.
MSCI AC World 12m Fwd PE & US Real Yields (%)
Source: Citi Research, Datastream
So why did the real-yield spike spook equity investors?
As you can see above, there is a relationship between real yields and global share market valuations (All Country World Index Price-to-Earnings Ratio). Global equities rose over 2019 and 2020 as real yields fell.
That was reversed late February: when real yields rose, equities fell. Higher real and nominal yields in bond markets are reflecting a healing economy. But equity investors fear short, sharp increases in yields because yields can overshoot. That can result in a tightening in financial conditions that can actually blunt the economic recovery. Indeed, former U.S. Treasury Secretary Lawrence Summers recently warned that the US Federal Reserve will likely be pressured into raising interest rates sooner than expected due to the bond market moves.
We now have a somewhat ‘pistols at dawn’ standoff between bond markets and central banks.
In the hope of putting downward pressure on long-term bond yields, key central banks universally reinforced their resolve to keep interest rates low for an extended period. US Fed Chair Powell recently noted that they are “not even thinking” about removing policy accommodation. The RBA also responded by doubling the rate of its buying of longer-dated Australian governments bonds to put downward pressure on these yields and counteract the upwards pressure of market forces.
All else equal, higher real yields tend to have a more pronounced negative impact on ‘growth’ orientated shares because more of their cash flows are earned further out in the future (think the tech sector). This is more an issue for the US share market where these types of growth sectors tend to dominate the market (see chart).
Growth Sector Weightings
Source: Citi Research, MSCI
We think bond yields are most likely to continue to head higher but only modestly and constrained by central banks. High public and private debt levels, elevated unemployment and still-low core inflation is also likely to limit the size of any increases. That said we are mindful upside risks to inflation and bond yields have increased, so we don’t want to be overexposed in the most growth orientated and expensive parts of the market at present.
It is good to see that the classic James Carville (Bill Clinton’s political adviser) quote still rings true: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
3. Australian Reporting Season – Is the record reporting season sustainable?
The final stop for this month’s letter is a brief review of the Australian February 2021 reporting season that has taken up a significant chunk of the Ophir investment team’s time over the last few weeks.
For the Aussie market it was the strongest reporting season in over 20 years in terms of earnings upgrades for financial year 2021. Much of this, though, was in large cap areas where we typically don’t invest, such as the ‘Big Four’ banks (which have benefitted from the write back of COVID-19 provisions), and the big miners (such as BHP, Rio and Fortescue) that are benefitting from an iron ore price bonanza.
The strongest reporting season in over 20 years
ASX 200 reporting season aggregate EPS upgrades/downgrades for the 12 months to June
Source: Company Data, Factset, MST Marquee
One of the most impressive features of the reporting season was the ability of Australian companies to contain costs, despite pressure in raw materials, freight and some wages. This saw plenty of companies report higher-than-forecast margins, with many citing an improving cost of debt as the reason for the margin ‘beats’.
Retailer City Chic was one business highlighting rising freight costs. But more of its business is shifting online and this positive change in mix helped to improve profit margins. Appliance maker Breville was another company with a notable margin beat due to less discounting on the back of strong demand which more than offset its freight cost issues.
But despite a strong beat-to-miss ratio on profits for companies reporting and multi-decade high upgrades to financial year earnings, share market reactions were generally pretty soft.
Stocks that reported ‘in-line’ results fell 1.1% on average on the day and have continued to trade lower.
Share price re-actions to stocks announcing earnings; conditional on Beat/Miss vs GS Expectations (+/- 2.5%)
Source: FactSet, Bloomberg, Goldman Sachs Global Investment Research
As you can see above, the share prices of companies that reported profit ‘beats’ (versus Goldman Sachs expectations) rose on the reporting day. But then their share price fell over the rest of the month. Meanwhile, the share prices of companies that were ‘In-line’ with forecasts, and those that missed forecasts, were sold off on the day and for the rest of the month.
This typically happens when markets have high expectations and sentiment is quite bullish. It suggests investors were already positioning ahead of reporting season for a high number of so called ‘beat and raise’ results, where reported profits beat forecasts and guidance for future profits are raised.
Analysts are now mostly looking to financial year 2022 numbers and a more normalised operating environment, including higher costs. Given the uncertainty of COVID, companies have been holding back on capex, with toll road operators and energy companies seeing the biggest dollar cuts. Anecdotal comments from companies suggest capex will be returning though which is a positive for the economic outlook as private expenditure replaces government stimulus.
We think we are likely in an environment where COVID beneficiaries, particularly those at the growthier end of the spectrum, will have to beat estimates by significant margins and still have room to the top of their valuation trading ranges to find material support in the market. This argues we believe for caution investing in the ‘growth at any price’ end of the market and we certainly have been making sure we are not overpaying for growth at present as a whole across the Ophir Funds.
In general, we have been relatively happy with reporting season for both our Australian and global equity strategies. Each has outperformed for the month of February, despite a challenging backdrop to navigate given the strong macro forces at play (virus and bond yield impacts). Given the difficulties in forecasting them, we don’t try to meaningfully time the impacts of the forces we looked at above, but we acknowledge they can heavily impact markets, particularly in the short term.
Whilst we don’t read too much at all into any one month’s performance, our strategies’ performance in February highlights that we outperform through bottom-up stock picking, and not over reliance on any one investing style. We outperformed during the month despite the two styles we are most often associated with, ‘growth’ and ‘quality’ both underperforming — particularly growth — both domestically and internationally.
To reflect the need to focus on specific stocks, we’d like to share a quote from 97-year-old investing legend Charlie Munger from last month’s Daily Journal Annual Meeting (which he chairs) that really resonated with us:
“I find it much easier to find four or five investments where I have a pretty reasonable chance of being right that they’re way above average. I think it’s much easier to find five than it is to find a hundred. I call it deworsification—which I copied from somebody. I’m way more comfortable owning two or three stocks which I think I know something about and where I think I have an advantage.”
The sentiment of concentrating bets within your circle of competence really resonates with us at Ophir. Whilst there are always lots of factors impacting markets and companies at any one point in time, we are always reminding each other that you don’t need to know everything or even anything on all the factors. What’s important is that you focus your concentration on a small number of companies and get to know, more than anyone else, the important levers that move the dial for each of those companies.
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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