By Andrew Mitchell & Steven Ng
Co-founders and Senior Portfolio Managers
In our November 2021 letter to investors we take a look at the Fed’s pivot to likely removing the monetary punchbowl earlier, the emergence of the new Omicron strain and the recent meltdown in smaller non-profitable tech companies.
Dear Fellow Investors,
Welcome to the November Ophir Letter to Investors – thank you for investing alongside us for the long term.
Equity markets were generally chugging along quite nicely for most of November when news broke that a new Covid-19 variant, Omicron, had started spreading outside of South Africa, grabbing global headlines and sparking fears of a new round of economy and company-damaging restrictions.
Then on the last day of the month, US Federal Reserve Chair Powell threatened to become the ‘grinch who stole Christmas’. He abruptly changed his tune on inflation. Powell announced he would retire the word ‘transitory’ – the word he’d been using to quash concerns about a possible sustained surge in inflation. Powell’s about-face was a hawkish signal that the monetary punchbowl that has turbocharged markets might be drained faster than expected.
As a result, most equity indices fell between 0% to -4% over November. Europe (MSCI Europe, -2.5%) and Japan (Nikkei, -3.7%) fell heavily. US small-caps (Russell 2000, -4.2%) and particularly US small-cap growth (Russell 2000 growth, -4.9%) copped the brunt of the late-month sell-off.
The Aussie share market did us proud and was one of the relative outperformers (ASX300, -0.4%), along with US large caps (S&P500, -0.7%) and tech stocks (Nasdaq, -0.3%).
But one section of the market, ‘non-profitable’ tech companies, has been particularly severely affected. These companies entered a veritable bloodbath, slumping -13.4% for the month and taking falls from their November highs to a bear-market sized -25%.
Non-Profitable Tech Index bear market
Bloomberg, Goldman Sachs Non-Profitable Tech Index
In this letter, we will explore the impact of Omicron. (At the start of December, investors were becoming more sanguine about the variant’s impact and some of the late November losses were being recouped, particularly in US and Australian large caps and the US Big Tech stocks (such as the FANGs).)
But we will also take a closer look at this ‘non-profitable’ tech sell-off and particularly its implications for our Global Opportunities Fund. The good news is that we are finding opportunities amidst the carnage and despite the challenges it has created this market could actually deliver some nice Christmas presents for the portfolio.
November 2021 Ophir Fund Performance
Before we jump into the letter, we have included below a summary of the performance of the Ophir Funds during November. 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 +0.2% net of fees in November, outperforming its benchmark which returned -0.3%, and has delivered investors +25.9% p.a. post fees since inception (August 2012).
The Ophir High Conviction Fund investment portfolio returned -4.1% net of fees in November, underperforming its benchmark which returned +0.5%, and has delivered investors +19.3% p.a. post fees since inception.(August 2015). ASX:OPH provided a total return of -4.8% for the month.
The Ophir Global Opportunities Fund returned +1.0% net of fees in November, underperforming its benchmark which returned +1.6%, and has delivered investors +36.4% p.a. post fees since inception.(October 2018).
Omicron – different, different, but same?
Late November and December usually have little stock-specific news. The last quarterly or six-monthly results are out of the way and investors are waiting for the next earnings results in late January and February the following year. Late in the calendar year markets are often driven by macro factors like inflation, unemployment, GDP growth and geopolitics.
Omicron is the ‘X-factor’ driving markets late this year. Seemingly originating in South Africa, the variant has gained a foothold in over 70 countries and accelerating, with experts are worried this new strain could send the COVID fight back to square one.
The excellent chart below from Nextstrain.org shows just how different Omicron is to previous variants, including the previous variant Delta. It details the number of mutations to the spike protein (S1) that different variants have undergone. Omicron is in red and the most recent Delta variant in green. Different indeed!
Genomic epidemiology of novel coronavirus – Africa-focused subsampling
But the growing consensus is that while Omicron may potentially be more transmissible than Delta, it may not be as severe. Early evidence also suggests that whilst existing vaccines may provide less protection against Omicron, they still guard against severe disease and booster shots may help re-establish previous protection levels.
Studies suggest the Spanish flu in the early 1900’s eventually mutated to a less serious form. There is hope that Omicron is following a similar pattern. As you can see in the chart below, the recent rise in cases in South Africa has not been accompanied by a rise in deaths as was seen in previous waves.
Omicron: more cases but fewer deaths?
Source: Deutsche Bank, Bloomberg Finance LP, JHU
If Omicron follows the path of the Spanish Flu, it would be one of the best Christmas presents in years.
It is too early to be definitive, though. Omicron cases in South Africa have been disproportionately in the young and in a population with higher vaccines levels than in the past, which makes historical comparisons tricky.
Markets hate uncertainty and news on this new variant will dominate markets moves until there is greater clarity across three key areas:
- Its transmissibility
- Its virulence
- The effectiveness of current and future vaccines
Fortunately, answers to these questions are likely only weeks away.
For equity investors, the impact of the virus on company valuations is often most directly felt through the effect of mobility restrictions on demand for companies’ goods and services. Governments will be loath to reintroduce more restrictions given what countries have already been through. However, if Omicron threatens to overwhelm health care systems investors need to be prepared for fresh measures. Some countries have already slapped restrictions on travel between certain countries and the UK is encouraging its citizens to work from home, again.
Given the uncertainty, and the likelihood of further variants, we continue to manage the Ophir funds so that companies in our portfolio are the ones impacted as little as possible by virus outcomes. Examples of these businesses for our Australian equity funds includes:
- Elders – the rural services business involved in the sale of wool, grain, seed, fertilizer and animal health products.
- EBOS – the medical consumables and equipment company that supplies goods to hospital and pharmacies.
- NextDC – Australia’s leading independant data centre operator that benefits as businesses move to the cloud.
Given our lack of PhD’s in virology, we are unlikely to get an ‘edge’ on the market by pricing Omicron outcomes. So we remain content to maintain our edge from the bottom-up work we do in meeting with company management and others (customers, suppliers, competitors, etc) in the eco-system in which they operate.
Inflation (and rate rises) – A Scrooge-like shadow
Outside of COVID, the other main risk garnering attention for equity markets in 2021 is inflation, which is casting a Scrooge-like shadow over Christmas.
COVID and inflation are linked at the hip – with the former in large part causing the latter. Today’s current multi-decade-high consumer price inflation levels in some major developed economies has been caused by two main influences:
- Huge fiscal stimulus by governments in response to COVID. When combined with mobility restrictions, this pent-up demand has been disproportionately spent on goods, while supply chains simply haven’t had the capacity to keep up with that demand.
- Labour supply has taken a knock because COVID has forced some workers permanently out of the workforce and others are unwilling to come back to work yet due to virus-related health concerns.
Inflation has persisted longer than most economists predicted, including central bankers whose job it is to tame it, so many now expect the removal of rock-bottom emergency-level interest rates to be brought forward.
Nowhere was this more apparent than Fed chair Powell recently asking us to resign to the dust bin of history the adjective ‘transitory’ to describe today’s current inflation.
Earlier this year, most expected US interest rates to only begin increasing at the start of 2024. Now the consensus is steadily moving towards rates lifting off next year.
One way to see this sooner-than-expected rate rise expectations in the US is to look at how the market is pricing US government debt of different maturities and how it has evolved over the second half of this year.
Below we show the US government debt ‘yield curve’ – or the rate of interest you receive for lending money to the US Government for different time periods from 1 month up to 10 years. You can see these rates have been consistently moving higher recently, particularly for short periods like the next 2-3 years.
US Government yield curve
Bear market bloodbath: Under the hood of the ‘expensive small growth’ implosion
This has created headwinds for domestically orientated small-cap growth businesses in the US. At the pointiest end of small-cap growth are what industry pundits call ‘non-profitable tech’ companies. These up-and-coming technology-based businesses are not making profits yet or are deliberately suppressing profits to reinvest for future growth and to grow market share.
Some examples of more well-known names in the market to be hit hard here include, with their share price falls from their 52 weeks highs in brackets: Draft Kings (-61.2%), Pinterest (-59.9%), Lyft (-43.7%), Robinhood (-76.8%) and Docusign (-55.6%).
In the chart below of US small-cap growth (as proxied by the Russell 2000 Growth index – purple line), and non-profitable tech businesses (darkest blue line), you can see steep falls over the last month or so as bond yields (red line) have continued to move higher.
Small cap growth underperforms recently as markets price in higher interest rates
Why are these parts of the market being hit harder whilst US large-caps (S&P500) and US large-cap tech (Nasdaq) have escaped relatively unscathed recently?
Higher interest rates disproportionately negatively impact the valuation of businesses with the most profit growth out further into the future – and this tends to be the smaller and less profitable businesses today.
The median valuation of non-profitable tech stocks has almost halved (!) from a peak this cycle of 10x Enterprise Value/Sales in March this year, to 5.6x today.
Some of our most growth-orientated and high valuation companies in our Global Opportunities Fund have had their valuations de-rate substantially – hurting performance – whilst underlying company fundamentals such as revenue growth, in general, continues to be strong and beat consensus.
This explains a significant portion of the softer performance in the Global Opportunities Fund in recent months. There have also been a small number of holdings that have disappointed on fundamentals; though whilst disappointing and something we always try to minimise, this has not been outside of the normal range we’d expect over time.
Fortunately, we limit the GOF’s allocation to more expensive high-growth businesses which has mitigated the impact on performance. The Fund still has about 35-40% of the portfolio in ‘value’ companies that trade on below-market price-earnings multiples.
The key question for us is whether there is much further to go in the valuation pull-back for the ‘growthiest’ parts of the global market, particularly the US small-cap market? The good news is that the underperformance of non-profitable tech versus Big Tech (Nasdaq) has been historically extreme recently, with the biggest gap seen in years (chart below).
We have therefore been adding to positions in companies we are highly confident are growing significantly and likely to beat expectations that are now cheaper than ever. In the last couple of months, we have met with almost all portfolio companies in the Global Opportunities Fund and we remain razor focussed on getting every company position right and sticking to our process that has served us so well over the long term.
Valuations in our pond still looking ok
Before we finish our last letter for 2021 – we thought it worthwhile revisiting why we scratch our heads when people ask us if we are worried about present valuations in the market.
The reality is there is no one ‘market’, just a collection of individual companies in which we can invest. That said, the two most ‘expensive’ parts of the markets are the two pools we don’t invest in – US large caps and US Big Tech.
In the chart below, you can see that the long-term average (cyclically adjusted) price-earnings ratios of the S&P500 and the Nasdaq are well above their pre-COVID levels. Global small-mid caps (MSCI World SMID Cap), US small caps (Russell 2000) and the Australian share market (ASX200) valuations don’t look anywhere near as worrisome. This hopefully provides some insight about why we continue to be excited about the companies we are finding in our fishing pond and the prices we are getting them for.
Valuations – US Tech and large caps standout
A happy and safe Christmas and holidays
We continue to remain personally fully invested in the Ophir funds and reinvest any profits from the business back into further personal investments.
The uncertainty of Omicron and more recent heightened volatility can no doubt create some unease for investors. For those perpetually worried about market falls and trying to time them, the wise words of famed investor Peter Lynch often come to our minds:
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
With that sentiment we’d like to thank you for reading our Letter to Investors over 2021 as much as we’ve enjoyed putting them together. For our fellow investors, we sincerely thank you for your valued support throughout the year. We are in a very privilege position to do what we do, and we could not do it without you.
We wish you and your families a safe Christmas holiday period. We hope you all get to spend some cherished time with your loved ones. It’s certainly something we are looking forward to and for which the challenges of the last couple of years has given us a newfound appreciation for.
And finally, our Christmas wish is that we get to see many of you face to face at an Ophir event in 2022 – it is something we have sorely missed!
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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