By Andrew Mitchell & Steven Ng
Co-founders and Senior Portfolio Managers
In our October 2020 Letter to Investors we review how we have been positioning our portfolios in light of the US election result and better than expected vaccine news.
Dear Fellow Investors,
Welcome to the October 2020 Ophir Letter to Investors – thank you for investing alongside us for the long term.
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Dear Fellow Investors,
Welcome to the October 2020 Ophir Letter to Investors – thank you for investing alongside us for the long term.
Ophir Fund Performance
The Ophir Opportunities Fund returned -1.8% net of fees in October, underperforming its benchmark by 2.3% and has delivered investors +24.9% p.a. post fees since inception (August 2012).
The Ophir High Conviction Fund investment portfolio returned +2.1% net of fees in October, underperforming its benchmark by 1.1% and has delivered investors +18.4% p.a. post fees since inception (August 2015). ASX:OPH provided a total return of +10.2% for the month.
The Ophir Global Opportunities Fund returned +3.4% net of fees in October, outperforming its benchmark by 1.9% and has delivered investors +29.8% p.a. post fees since inception (October 2018).
Month in review: Covid vaccine – the starter’s gun has been fired
October’s sharemarket results are well and truly now in the rear-view mirror after two major pieces of news that investors were looking for arrived in early November – a US election result and a potential COVID-19 vaccine.
This last piece of news has seen the “starter’s gun” fired on investors positioning their portfolios ahead of an opening of economies in 2021.
We are now seeing a strong rotation towards ‘out-and-about’ companies that will benefit from a return to normal and to value stocks. But the question for investors is whether that rotation is sustainable?
In this letter we’ll also look at a historical trend that could start to deliver a pleasant surprise for investors this Christmas.
Seems like ancient history
Sharemarkets in October were mixed with US (S&P500 -2.7%) and European (Euro Stoxx -5.9%) markets falling as virus cases rapidly escalated through second and third waves, and as prospects of US fiscal stimulus pre-election waned.
Australia rose +1.9% (ASX200) on the back of Victoria gaining control of the virus, a big spending Federal Budget and likely further monetary support by the RBA, whilst Emerging Markets (MSCI World EM +1.5%) also improved.
This is all ancient history, though, after the biggest news of the second half of the year arrived in early November that Pfizer’s vaccine was 90% effective in early trials. The probability of a widely available vaccine in the US during the first quarter of next year has now jumped from 50% to around 90% (see chart).
‘Super forecasters’ say vaccine could be near
Source: Goodjudgement.com, MST Marquee
Why markets liked the US election outcome
The vaccine news has overshadowed the US election result as the most important near-term news for markets, and rightly so.
Still, the result did have implications for the economy and markets. A President-elect Biden, and a likely (though still to be confirmed in January) split Congress, means a fiscal stimulus in the US early next year to support COVID impacted businesses and households is now expected to be smaller.
Based on modelling by MacroPolicy Perspectives in the US, all else equal, this is likely to see a slower return to pre-COVID trend growth in the world’s largest economy (see chart).
More positively though, markets saw a Biden win, but without Democrat Senate control, as a more favourable outcome because it increases the chance of more central bank support, increases the chances of corporate tax hikes being dead in the water, and it greatly reduces Biden’s ability to ratchet up regulatory oversight.
It should also provide a less aggressive trade stance between the US and its major trading partners, including China. This may ultimately be beneficial for Australia (given our alignment with the US), in light of our recent trade issues with the Middle Kingdom.
US Real GDP levels with and without different fiscal proposals (100 = pre COVID peak)
Source: MacroPolicy Perspectives, Refintiv, MST Marquee
Record vaccine inflow volumes
A likely market-friendly US election result, and the very positive Pfizer vaccine news, triggered an all-time record in inflows into global equity funds in the second week of November (see chart).
Largest week ever of global equity inflows
Source: BofA Global Investment Strategy, EPFR
These inflows have gone hand in hand with strong equity market returns in early November as investors price in a stronger recovery in global economic growth and corporate earnings in 2021.
Key to this ongoing support for equity markets will be further positive news on the vaccine front. Here markets won’t have to wait long to find out more with very positive early phase 3 results from Moderna just in, and AstraZeneca trial results to be provided in the next few weeks.
But the vaccine-led gains of early November have seen the emergence of winners and losers.
The big news has been the market rotation from so called ‘stay-at-home’ companies to ‘out-and-about’ companies leading the way as investors envisage the potential for a return to normality sometime in 2021 on the widespread availability of a vaccine.
This has also seen a rotation from ‘growth’ stocks (typified by the tech sector), towards ‘value’ (such as financials) and ‘cyclical’ (such as energy) parts of the market.
This potential was something we flagged in our last Letter to Investors and for those interested you can read that Letter here.
These swift and strong rotations can be seen when looking at the returns of industry sub-groups of the US share market for the first two trading sessions after the vaccine news this month (see chart).
S&P 500 Top and bottom performing sub-industry groups 8/11/20 to 10/11/20
Source: FastSet and Citi Research – US Equity Strategy
But how long will this rotation last?
The problem is that over the last decade, the rotation towards value-style companies (those typically trading on low prices compared to fundamentals such as revenues, earnings and book values) has been short lived. The rotations have lasted on average for only around 2-3 months, with outperformance of around 10-15% compared to more highly priced stocks (see chart).
Value rallies typically last only a few months during rising equity markets
Source: Goldman Sachs Global Investment Research
Given the degree of pent-up demand an effective vaccine could release, and as the rate of economic growth broadens and speeds up, there is some reason to believe the current rotation could be more elongated.
Importantly, history suggests that value rallies in rising equity markets (which we expect on the back of a vaccine) tend to be more about value ‘catching up’ to higher-priced companies, rather than outright large sell offs in the latter.
Still, there may be limits though to any value rotation, beyond the vaccine impact, for primarily two reasons we see. Firstly, the rotation may occur in fits and starts. With COVID cases rising rapidly in the much of the world, we aren’t going back to normal just yet, and more monetary policy support and downwards pressure on interest rates is likely.
Secondly, if we do indeed return in 2021 or 2022 to a world that resembles the pre-COVID world of 2019, we still will likely have to contend with low interest rates, sparse growth/inflation and more slack in labour markets to be worked off. This has not been an environment particularly conducive to value outperformance.
As highlighted in our last Letter to Investors, our investment process sees us looking for companies that have underlying structural or cyclical growth tailwinds where we believe they can compound and grow earnings faster than the market. We have a strict focus on valuations though to ensure we are not overpaying for those earnings. In fact, a large percentage, around 30-50% of our Funds, are comprised of companies trading at below market price-to-earnings valuations.
As long-time investors will know, we don’t seek to meaningfully time our allocations to styles, sectors or companies off the back of top down macroeconomic or political factors. This is not because we believe these factors don’t have an influence. They most certainly do. Rather it is due to our belief that we do not have a meaningful edge in timing allocations based on these factors that are poured over by thousands of analysts and millions of investors on a daily basis. Moreover, there is a lack of consistently reliable and predictable models to assist with this process.
Given this, the majority of our targeted outperformance can be expected to come from bottom up stock picking. That is to say, we are best placed to outperform if we stick to what we believe we are good at, that is fundamental proprietary research on companies to find those we believe are mis-understood or mis-priced by the market, with clean balance sheets and that are not overleveraged.
The winds of Growth versus Value may change but this part of our process will not
Ultimately, at the margin, we have been for a few weeks now increasing our exposure to reopening theme type companies as it became clearer a vaccine was likely. This process has been accelerated more recently on the Pfizer and Moderna vaccine news as we have increased our allocations to good quality companies that are growing faster than the market and likely to benefit from relaxation in social distancing measures.
We should stress this has not involved investing in Value and Cyclical type companies for the sake of it; the core of the Ophir Funds remain in businesses we believe can grow and compound earnings largely regardless of the macroeconomic environment.
Good things come in small packages this Christmas?
To finish we’d like to leave you with some insight into a historical trend that has started to re-assert itself in the world’s largest sharemarket.
In the US, small caps have outperformed large caps coming out of nine of the last ten recessions (see chart for the last four).
The outperformance has tended to begin during the second half of the recession and on average last for about 12 months after the recession ends.
Some of it is due to investor risk aversion and some of it is due to fundamentals. At the start of an economic downturn investors tend to favour less risky, more liquid large caps. On a fundamental level, small cap revenue, profits and cash flow are more levered to, and have a higher correlation, with US GDP growth, so tend to fall more during the recession.
All of this tends to reverse coming out of a recession, but as markets are forward looking, the outperformance of small caps more often than not starts before the recession is over.
Small cap versus large cap performance
Source: Bloomberg, Morgan Stanley
Subject to no further extreme lockdowns occurring in the US, and with most economists forecasting the recession to be over and growth resuming in the latter part of 2020 and into 2021, we may now have entered one of those periods conducive to small-cap outperformance.
If history reasserts itself, now may be one of the more favourable times to be invested in the small cap part of the market where, of course, Ophir is focussed.
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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