June 8, 2021
Letter to Investors – May

By Andrew Mitchell & Steven Ng
Co-founders and Senior Portfolio Managers

stock market graph

In our May 2021 Letter to Investors we take a look at the better than expected economic recovery from COVID and ask whether a V-shaped rebound is making way for one more resembling a “Z” or “F”.

Dear Fellow Investors,

Welcome to the May Ophir Letter to Investors – thank you for investing alongside us for the long term.

Better vaccine/economic news creating greater chance of a Z than a V shaped recovery?

As you would have seen, share markets followed April’s big gains with further rises in May. Australia (MSCI Australia +3.3%) lead the way. Other markets also posted gains, but their rises were more muted, including in the US (S&P500 +0.7%) and Japan (Nikkei +0.2%).

It was vaccine rollout news that kept markets healthy, with infections dropping in India, and the US potentially moving towards herd immunity, all of which kept investors in good spirits (see chart below).

Progress to herd immunity

Percentage of population, end of month

Source: Centers for Disease Control and Prevention, John Hopkins CSSE, Our World in Data, J.P. Morgan Asset Management.

*Share of the total population that has received at least one vaccine dose. **Est. Infected represents the number of people who may have been infected by COVID-19 by using the CDC’s estimate that 1 in 4.6 COVID-19 infections were reported. *** Est. Infected & vaccinated assumes those infected equally likely to be vaccinated as those not infected. On March 6th, 2021 we moved up our threshold for herd immunity from 60-80% to 70-90% based on the comments by Dr. Anthony Fauci that the prevalence of more contagious variants have pushed up the target herd immunity threshold for the U.S.

Guide to the Markets – U.S. Data are as of May 31, 2021.

But if we lift the curtain on the market’s vigour, we actually see some sectors and stocks are sicker than others, and some more robust than others.

In this Letter to Investors — amid an alphabet-soup of possible recoveries (V, Z, F) — we take a look at whether the recovery is overdone. We particularly look at one class of stocks whose rehabilitation is too-good-to-be true, and who face a day of reckoning when investors realise their post-Covid 19 trajectory isn’t permanent.

We also take a further look at the Value versus Growth rotation. Most investors assume Value is universally healthier than Growth. But the diagnosis is more complex; and, indeed, we are seeing some interesting opportunities in growth-oriented companies now trading at reasonable valuations.

And we remind investors that our main game is bottom-up stock picking, and not timing the markets. As famed investor Peter Lynch once said, “Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves”.

May 2021 Ophir Fund Performance

Before we jump into the letter, we have included below a summary of the performance of the Ophir Funds during May. 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 +0.1% net of fees in May, underperforming its benchmark which returned +0.3% and has delivered investors +25.2% p.a. post fees since inception (August 2012).

Download Ophir Opportunities Fund Factsheet

The Ophir High Conviction Fund investment portfolio returned -0.1% net of fees in May, underperforming its benchmark which returned +0.6% and has delivered investors +19.2% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of +0.3% for the month.

Download Ophir High Conviction Fund Factsheet

The Ophir Global Opportunities Fund returned +1.9% net of fees in May, outperforming its benchmark which returned +1.0% and has delivered investors +43.8% p.a. post fees since inception (October 2018).

Download Ophir Global Opportunities Fund Factsheet

It was vaccine rollout news that kept markets healthy, with infections dropping in India, and the US potentially moving towards herd immunity, all of which kept investors in good spirits (see chart below).

Have governments gone too far this time?

Macro forecasters and business owners alike have been struck by how quick the global economic recovery from COVID-19 has been, with only a few exceptions.  We are used to slower recoveries from global economic downturns triggered by slumps in demand. The latest downturn, however, was a stop-start on the supply side of the economy because of Government’s restricted mobility to control the virus.

The scale of the fiscal response from governments this time is also different – and that includes Australia with its ‘spendathon’ Federal budget in May. For the last few decades policy makers primarily relied on monetary policy to stimulate economies during a downturn. But this time, with interest rates rapidly hitting or nearing their ‘zero lower bound’, governments have played the primary role by making fiscal transfers to those most impacted.

The scale of the fiscal response has been truly historic. It has only been matched by that seen during World War 2. Historically, ‘Keynesian’ counter-cyclical spending by governments during downturns was to soften the blow and fill the gap created by the exiting of private demand.

This stupendous stimulus has led to something remarkable: as seen below, household income and spending some instances is now in a BETTER position than the pre-COVID-19 trajectory. That’s because much of the fiscal support has occurred AFTER the likes of retail sales in the US were tracking back above trend.

$575bn of $850bn direct transfers and 2.5T of expected QE are being provided AFTER retail sales were ABOVE pre-covid trend and AFTER vaccine confirmation

Source: Stan Druckenmiller

Have governments gone too far?

We won’t know the answers to this question for some time, and the answer will in large part depend on whether the fiscal medicine delivers any excess inflationary side effects. The money, after all, must come from somewhere: ultimately it adds to the stock of debt that future generations will have to pay for.

Z, F or V recovery. What will it be?

The global economic recovery is also playing out at the individual stock level.

For investors, the key question in all this is whether the rapid economic recovery due to vaccines, and fiscal and monetary support, will create the V-shaped earnings recovery most had expected, or as some are starting to price in, a Z-shaped or even F-shaped recovery for certain stocks.

Source: MST Marquee

As stylised above, a Z-shaped recovery is one where above-trend earnings growth occurs after the recession to ‘catch-up’ for the previous shortfall.

There are a number of Australian stocks now that fit in this boat such as media companies like Nine Entertainment (ASX:NEC), minerals testing companies like ALS Limited (ASX:ALQ) and housing transaction volume related businesses like REA Group (ASX:REA) and Domain Holdings (ASX:DHG).

The danger is if markets start pricing some companies as if they will undeservedly have F-shaped earnings trajectories – that is they believe these companies’ above-trend earnings trajectory will be permanent.

For some companies such as those where demand was structurally increasing but COVID-19 merely accelerated it, including those in food delivery, e-commerce and cloud enablement technologies, this may be a reasonable assumption.

But it would be dangerous to extrapolate above-trend growth for many, in fact most, businesses. These are the ones we are watching out for at present where COVID has pulled demand forward from the future but it’s only a temporary boost (such as an “A” profile below), though investors are pricing the business as if it will be permanent (such as an “F” profile).

Investors in these businesses may face a ‘reality shock’ when pent up demand peters out and central banks, and especially governments, ease up on the stimulus.

Not all rotations are created equal – Fed issuance to keep it spinning

We have also been answering many investor questions about the market rotation from Growth-style companies (such as the Tech sector) to Value-style companies (such as Financials/Banks).

We have been pointing out that, firstly, the rotation in both timing and size is different in different markets. In the 3 panels below, you can see the timing and size of the rotations in US Large Caps, US Small Caps and Australian Shares respectively.

Panel 1 – S&P500 (US Large Caps)

Panel 2 – Russell 2000 (US Small Caps)

Panel 3 – Australian shares

Source: Panel – Bloomberg

It’s clear that, since just before COVID-19 began last year, the outperformance of Growth peaked at around 33-34% in both US Large and Small Caps, but only circa 13% in Australian Shares. That’s largely because of the higher growth- orientated Technology sector weighting in the US, compared to the higher value orientated Financials/Bank sector weightings of Australia.

You will also see that the rotation has basically wiped out the Growth style outperformance in the Russell 2000 – with almost all of the outperformance reversal occurring over a three-week period in late Feb/early March and a two week period in early May. Yet large Growth-style outperformance still persists in US Large Caps (about 20%).

In Australian shares, the large outperformance of the Value style has been much more pronounced. The rotation towards Value started around the same time as the news of the first effective vaccines in early November last year.

The differences in the size of the rotations between US Large Caps and Australian shares since February last year (with Growth outperforming in the former and Value outperforming in the latter) can in large part be put down to the big sector weighting differences referred to above, and also that the fact that the large Tech behemoths in the U.S. (think the FAAMGs) are incredibly profitable and have been more resistant to the rotation.

Lightly buying growth-oriented companies

From this starting point, if the past is a prelude (and that’s debateable), we can get some insight into which markets may be impacted most if the rotation from Tech to Value continues.

Just stepping back, one of the main reasons for the rotation in the first place is the reflationary economic environment we find ourselves in, with higher expected growth and inflation pushing up interest rates. On a relative basis that benefits companies with more near-term earnings – i.e. Value companies – because of the way interest rates interact with the discounting of future cash flows to arrive at company valuations.

But one of the other, less spoken about, reasons for higher interest rates – which is supporting the rotation – is the supply/demand mismatch for US Government Treasuries, the major interest rate market in the world.

The US Government has been issuing fewer bonds to finance its fiscal spending over the last couple of months. The Government has been drawing down on its bank account with the Fed instead. This can only go on, though, for a few month months before the Fed will start having to issue more debt, putting upwards pressure on bond yields again.

Combined with the likelihood that the US Fed will taper its Treasury buying program in the second half of this year, we could see further upwards pressure on interest rates and a further continuation of the rotation in equity markets ahead.

As such we are not calling the rotation over and pinning our ears back buying the highest priced and highest growth stocks out in the market. We have, however, been lightly buying those more growth-orientated companies that are trading at more reasonable valuations, but we continue to remain cautious.

It’s clear that, since just before COVID-19 began last year, the outperformance of Growth peaked at around 33-34% in both US Large and Small Caps, but only circa 13% in Australian Shares. That’s largely because of the higher growth- orientated Technology sector weighting in the US, compared to the higher value orientated Financials/Bank sector weightings of Australia.

You will also see that the rotation has basically wiped out the Growth style outperformance in the Russell 2000 – with almost all of the outperformance reversal occurring over a three-week period in late Feb/early March and a two week period in early May. Yet large Growth-style outperformance still persists in US Large Caps (about 20%).

In Australian shares, the large outperformance of the Value style has been much more pronounced. The rotation towards Value started around the same time as the news of the first effective vaccines in early November last year.

The differences in the size of the rotations between US Large Caps and Australian shares since February last year (with Growth outperforming in the former and Value outperforming in the latter) can in large part be put down to the big sector weighting differences referred to above, and also the fact that the large Tech behemoths in the U.S. (think the FAAMGs) are incredibly profitable and have been more resistant to the rotation.

Lightly buying growth-oriented companies

From this starting point, if the past is a prelude (and that’s debateable), we can get some insight into which markets may be impacted most if the rotation from Tech to Value continues.

Just stepping back, one of the main reasons for the rotation in the first place is the reflationary economic environment we find ourselves in, with higher expected growth and inflation pushing up interest rates. On a relative basis that benefits companies with more near-term earnings – i.e. Value companies – because of the way interest rates interact with the discounting of future cash flows to arrive at company valuations.

But one of the other, less spoken about, reasons for higher interest rates – which is supporting the rotation – is the supply/demand mismatch for US Government Treasuries, the major interest rate market in the world.

The US Government has been issuing fewer bonds to finance its fiscal spending over the last couple of months. Instead, it has been drawing down on its bank account with the Fed. This can only go on, though, for a few month before the Fed will start having to issue more debt, putting upwards pressure on bond yields again.

Combined with the likelihood that the US Fed will taper its Treasury buying program in the second half of this year, we could see further upwards pressure on interest rates and a further continuation of the rotation in equity markets ahead.

As such we are not calling the rotation over and pinning our ears back buying the highest priced and highest growth stocks out in the market. We have, however, been lightly buying those more growth-orientated companies that are trading at more reasonable valuations, but we continue to remain cautious.

Why we place most of our bets on the bottom up – not the top down

In our Investment Strategy note this month (hyperlink), we detail why forecasting the market in the short term, and making large, short-term market-timing bets based on overall market valuations is a fool’s errand. At Ophir we want most of our alpha or outperformance to be earned through so-called ‘bottom up’ stock bets. This is distinct from ‘top down’ macroeconomic and market calls impacting things such as:

  1. How much cash versus equities we hold; or
  2. How much we overweight or underweight a sector, geography or currency versus the benchmark.

Our investment process is about 80-90% bottom up in nature, comprised of the work we do completing due diligence on the investment thesis of individual companies. Conversely only about 10-20% of our process is looking at top-down factors and making active bets versus our benchmark at a cash, sector, geographic or currency level.

The reason we have structured our process this way is simple. We strongly believe that is easier to gain an edge on a company by undertaking ‘bottom-up’ work than gaining an edge on the market by undertaking ‘top down’ work. This is because there are fewer informed investors to compete against, and more importantly, it is where our skills and experience lie.

There are literally hundreds of thousands of investment professionals worldwide looking at the macroeconomic, business cycle and aggregate markets data, making it a much more competitive endeavour to try and obtain an edge in. And this is leaving aside the lack of sufficiently accurate predictive tools to consistently identify market turning points.

It is hard to add alpha by market timing and changing the cash/equity split in our portfolios. Many investors have access to the same macro and markets data and it is rapidly priced into markets. Indeed, when it comes to the average investor, as shown below, their returns are significantly below the constituent asset class returns because they incorrectly time markets. We don’t want to be one of them.

Market timing costs

20-year annualized returns by asset class (2001 – 2020)

Source: Barclays, Bloomberg, FactSet, Standard & Poor’s, J.P. Morgan Asset Management; (Bottom) Dalbarlnc, MSCI, NAREIT, Russel.

Indices used are as follows: REITs: NAREIT Equity REIT Index, Small Cap: Russell 2000, EM Equity: MSCI EM, DM Equity: MSCI EAFE, Commodity: Bloomberg Commodity Index, High Yield: Bloomberg Barclays Global HY Index, Bonds: Bloomberg Barclays U.S. Aggregate Index, Homes: median sale price of existing single-family homes, Cash: Bloomberg Barclays 1-3m Treasury, Inflation: CPI. 60/40: A balanced portfolio with 60% invested in S&P 500 Index and 40% invested in high-quality U.S. fixed income, represented by the Bloomberg Barclays U.S. Aggregate Index. The portfolio is rebalanced annually. Average asset allocation investor return is based on an analysis by Dalbar Inc., which utilizes the net of aggregate mutual fund

Guide to the markets – U.S. Data are as of May 31, 2021. 

Investing in shares is a game that is skewed in your favour – markets almost universally go up over time. As we highlighted in the introduction, the famed investor Peter Lynch once said, “Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves”.

Market falls are part and parcel of investing in share markets. Over the last 40-odd years the average intra-year drop in the S&P500 has been 14.3%, yet positive returns have been earned in over 75% of years with a 12.4% pa. return received (see chart below).

S&P 500 intra-year declines vs. calendar year returns

Despite average intra-year drops of 14.3%, annual returns positive in 31 of 41 years

Source: FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980-2020, over which time period the average annual return was 9.0%.

Guide to Markets – U.S Data as of May 31, 2021. 

We’d love to be able to time those lows in share markets each year, but since that’s impossible, we remain happy to be largely fully invested and instead use any market volatility or drawdowns to ‘high grade’ our portfolios – shifting into those companies we believe have been oversold.

This is what has worked for us in past market sell offs, setting us up for better future returns. It also remains why we will continue to spend most of our time talking to company management than trying to read the macroeconomic tea leaves.

As always, thank you for entrusting your capital with us.

Kindest regards,

Andrew Mitchell & Steven Ng

Co-Founders & Senior Portfolio Managers

Ophir Asset Management

This document is issued by Ophir Asset Management Pty Ltd (ABN 88 156 146 717, AFSL 420 082) (Ophir) in relation to the Ophir Opportunities Fund, the Ophir High Conviction Fund and the Ophir Global Opportunities Fund (the Funds). Ophir is the trustee and investment manager for the Ophir Opportunities Fund. The Trust Company (RE Services) Limited ABN 45 003 278 831 AFSL 235150 (Perpetual) is the responsible entity of, and Ophir is the investment manager for, the Ophir Global Opportunities Fund and the Ophir High Conviction Fund. Ophir is authorised to provide financial services to wholesale clients only (as defined under s761G or s761GA of the Corporations Act 2001 (Cth)). This information is intended only for wholesale clients and must not be forwarded or otherwise made available to anyone who is not a wholesale client. Only investors who are wholesale clients may invest in the Ophir Opportunities Fund. The information provided in this document is general information only and does not constitute investment or other advice. The information is not intended to provide financial product advice to any person. No aspect of this information takes into account the objectives, financial situation or needs of any person. Before making an investment decision, you should read the offer document and (if appropriate) seek professional advice to determine whether the investment is suitable for you. The content of this document does not constitute an offer or solicitation to subscribe for units in the Funds. Ophir makes no representations or warranties, express or implied, as to the accuracy or completeness of the information it provides, or that it should be relied upon and to the maximum extent permitted by law, neither Ophir nor its directors, employees or agents accept any liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. This information is current as at the date specified and is subject to change. An investment may achieve a lower than expected return and investors risk losing some or all of their principal investment.  Ophir does not guarantee repayment of capital or any particular rate of return from the Funds. Past performance is no indication of future performance. Any investment decision in connection with the Funds should only be made based on the information contained in the relevant Information Memorandum or Product Disclosure Statement.

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