The structure and valuations of fixed income markets have changed dramatically over the past decade or so. Most obviously, interest rates have decreased dramatically and the compensation for taking traditional forms of fixed income risk have declined in tandem. Some of these changes may unwind as we enter a world of higher inflation and withdrawal of central bank stimulus measures over the coming years, but other changes are much more structural in nature.

In particular, regulations requiring banks to hold more capital are likely to persist, with an enduring impact being a withdrawal of banks from competing in certain types of lending and reducing their balance sheet commitments to liquidity provision in public credit markets during times of stress. This is creating both challenges and opportunities for asset managers and their investors as alternative sources of credit provision whilst navigating a disrupted liquidity environment and low returns for their traditional liquid bond portfolios.

As such, institutional and retail investors have been forced to adjust their approach to fixed income because of these changing dynamics, with the embrace of private debt markets alongside exposure to traditional public credit allocations in an effort to boost returns. Private debt is a complex asset class that can offer a differentiated opportunity set with unique return, risk, liquidity, and diversification benefits.

Part 1 of this paper will explore the issues above and, while Part 2 will examine how co-mingling public and private credit in a single portfolio can offer a solution to many of these issues and may offer one of the best opportunities to maximise the potential of each.

Distinguishing between public and private debt

Private credit is often also referred to as "direct lending" or "private lending" or even "alternative credit." Irrespective of the name, they are basically loans to borrowers originated directly by a non-bank asset manager rather than via an intermediary.

Unlike traditional bond issues or even syndicated loans (such as US term and leveraged loans), there is little intermediation between borrower and lender. The lender basically arranges the loan to hold it, rather than originating to sell it. As such, the borrower and the lender have a much closer and more transparent relationship, directly negotiating the terms of the finance.

In a recent Economist magazine special report on the asset management industry, one of their concluding forecasts was that private debt would become an increasingly important asset class. As the Economist notes, 

"The growth of private debt is, in large part, a response to the retreat of banks from lending to midsized businesses and their private-equity sponsors. Asset managers, starved of yield in the government-bond markets, are happy to fill the void." (1)

Private debt is now a significant subset of broader credit markets globally. Underlying exposures include private loans to mid-size or non-listed corporates (often backed by private equity sponsors), commercial, industrial and residential real estate loans that sit outside the risk appetite of the banking sector, as well as loans secured by securitised assets such as mortgages, other loan receivables (particularly from non-bank lenders) or 'alternative' cashflow streams such as royalty streams, insurance premiums or solar panel lease payments.

A key distinction-and advantage-across many types of private debt is the ability to customise lending terms thus exercise greater control over credit risk protection compared to public markets. Private credit investors can influence or dictate elements such as coupon and principal payment schedule (amortisation), loan covenants, information access and control rights, tailoring investments to their desired liquidity, return and credit risk profile.

In addition, this customisation does not come at the expense of returns. By not introducing an intermediary to arrange the transaction, the fees otherwise paid to the arranger can be shared between borrower and lender, enhancing the overall return profile of the investment relative to syndicated transactions.

Australia remains a relatively nascent market compared to offshore growth in private debt assets and corporate credit generally. But this comes with significant advantages due to the lack of competition from asset managers bidding down yields and credit protections to obtain deal flow means that underwriting standards and margins remain strong.

Sources: Private debt investor, Prequin, CIPAM Estimates

What is the Illiquidity premium and why does it exist?

Any risk premium in investing can be thought of as a transfer of economic rents from risk avoiders to risk takers. In equities, for example, there is a strong, academically established risk premium for investing in small cap companies. This is theorised to exist because these stocks often have less liquidity stemming from their lower overall market capitalisations and lower free float for external shareholders as well as less diversified revenue streams and/or robust balance sheets.

In many respects, similar arguments can be made for the existence of a higher rate of return expectation for private debt over public credit. 

The simplistic explanation is that private debt arrangements do not have the consistent structural features of public credit that facilitate consistent and efficient investor evaluation, such as official credit ratings, combined with security identifiers and legal structures that enable centralised clearing and settlement and thus easy trading.

This means that borrowers who obtain financing from such sources must pay a higher interest rate for a given level of implied credit risk to lenders, who need that higher rate of return to justify their reduced flexibility in managing their investment. Thus, by comparing the rate paid between private debt and public debt at the same assumed credit rating or risk level, one can establish a proxy for the quantum of the illiquidity premium.

Term Adjustment based on difference between 5 and 3 year discount margins for Credit Suisse Leveraged Loan index. Rating Adjustment based on difference between the Credit Suisse Leveraged Loan index. Currency Adjustment based on the short term rolling cross currency basis of 10 basis points less the cost of holding 10% in liquids at a cost of 4% for hedging purposes. All figures based on 31 December, 2020.

But this does not explain why borrowers choose to, or are forced to, access private debt financing in the first place.

The Structural Decline in Bank Risk Appetite

Obviously a structural decline in bank lending to non-investment grade corporates, commercial real estate debt, non-public asset backed securities financing (such as warehouse funding facilities (2) for non-bank lenders), long-term project finance and other sub-asset classes of the private debt universe due to tighter regulatory and capital rules has decreased the options available to such borrowers. This increased cost to hold risk has meaningfully altered bank business models. As a result, banks have grown more conservative as they now must consider the risk-adjusted returns of potential loans in the context of more stringent and complex capital requirements - pushing them towards prime home loan origination at the expense of lending to businesses, for example.

Changes in bank lending patterns have an important implication for investors. Bank securities-both fixed income and equity-should have different risk-return profiles going forward, as investors in bank-issued bonds and stocks are much less exposed to mid-size corporate lending and many types of real estate financing as well as fixed income trading revenue via the balance-sheet activity of their bank holdings.

Source: 1 APRA, 2 Standard eligible mortgage with no mortgage insurance

While these regulations have made the global banking system safer and have reduced risk to the financial system, certain risk exposures have become prohibitively expensive for traditional banks as a result of the new rules, creating a funding gap that increasingly is being filled by non-bank market participants. These regulations also have ushered in the rise of 'fintech' lending platforms and financial-disintermediation technologies that provide individuals and small businesses access to new sources of financing. Private credit is often an important source of funding for such new business models, particularly via so called 'warehouse funding' prior to them being able to securitise assets into public markets.

But other factors play a role as well.

The Growth in Private Equity Sponsorship

Firstly, the shift toward private markets has been a consistent macro trend over the past few decades: while private markets have grown substantially during this period, the number of publicly traded companies has declined over the past 20 years. As a result, there are more private companies that require debt financing to fund their growth. Therefore, making private loans to private-equity sponsor backed companies is a big source of private debt origination in Australia and offshore.

Generally, the private equity asset class has focused on companies with high cash-flow generation and stable business models, and the companies are often leaders in their specific segments.

Secondly, these borrowers are accessing private debt because they are looking for partners they can rely on to participate alongside them in a journey toward their objectives. They are also looking for some degree of flexibility or tailoring to line up the terms of their debt financing with their business objectives as well as speed and certainty of execution (particularly in a time-pressured acquisition financing scenario). Some or all of these factors are why many borrowers are willing to pay a premium over other lending alternatives.

Finally, many borrowers in private credit are too small to access liquid capital markets or don't have the revenue and resources to justify paying for and supporting the due diligence of public credit ratings agencies like Fitch, Moody's and S&P or covering the significant fees of an arranger (plus all the other service providers) who are tasked with structuring and distributing a debt package. Thus, private debt markets are an attractive source of funding for acquisitions, organic growth, and scaling through capital investment outside of raising additional equity.

In many ways, the making of a loan is analogous to the manufacturing of a product. In some cases it makes sense to have each stage of the manufacturing process (the due diligence, structuring, documentation and syndication) completed by a different party. But often it is more cost effective for a borrower to work with an individual lender who has internalised the manufacturing of a loan for themselves. What the borrower pays in terms of a higher interest rate is offset by the lower cost of the manufacturing process.

Source: Prequin Pro 2020, Australian Investment Council (AIC)

Lastly, an important distinction between public and private markets is that private lending markets are inefficient. In public markets, arrangers effectively run an auction process to establish the lowest yield at which they can sell all of the debt. In private markets, there is generally no auction process. Often a borrower will approach a very small number of lenders (in some cases only one lender, especially where there is a long-standing relationship) and consider the overall package- timeliness, flexibility of terms, execution risk (i.e. does the lender have to syndicate some risk in order to do the full deal), quality and reputation of the lender in addition to the cost of the borrowing. This inefficiency is an opportunity for private lenders, who arguably see more deals and have a better idea of risk and return than the borrower (or the borrower's owner), to identify the best opportunities. 

Continued in tomorrow's Newsfeed - look for Part 2

Co-authored by: Sam Morris, CFA - Senior Investment Specialist, Fidante Partners & 
Pete Robinson, Head of Investment Strategy and Portfolio Manager, CIP Asset Management.

IIn this episode of The Ardea Alternative podcast, Laura Ryan, Tamar Hamlyn and Alex Stanley discuss interest rate rises in response to inflation and what it might mean for fixed income assets.

Despite the best attempts of forecasters, the unpredictable nature of how the market will respond to a company's earnings leaves many working feverishly to calibrate their respective positions, especially when anomalies are rife. 

For example, it is not uncommon for a company's stock price to increase when the market expects a greater decline in revenue than what is reported. Conversely, if a company does not achieve expected revenue targets (even if these revenues are positive), then it can result in a decline in the company's ticker price as forecasters adjust their valuations.
It seems that recently, earnings season has become further complicated through the introduction of new and 'undefined' metrics that impact:

1.  the 'top-line', the company's ability to drive increases or preserve its revenue stream within the marketplace;
2.  the 'middle-line', the company's ability to effectively manage their costs, improve current processes to become more (cost) efficient, and manage its overall financial wellbeing (including debt obligations, etc) and;
3. the famous 'bottom-line', the residual between how much money a company can bring in, and what it costs them to get there.

The 'bottom-line' may not always paint a clean picture, given 'up-and-coming' businesses often reinvest heavily in market share acquisition strategies (such as marketing, or developing new products). This subsequently drives up 'middle-line' costs with the hope of gaining future 'top-line' benefits. Without itemizing each variable that sits within the top to bottom line segments, we trust the point has been made - earnings season is complex. More so now, it seems, with new environmental, social and governance (ESG) metric expectations.

Many businesses are now facing significant shareholder pressure to factor in ESG metrics. Whilst driving up middle line costs now, ESG so far appears to have significant customer and employee retention benefits, as well as being the public 'right thing to do'. The cynic may challenge whether these programs are truly driven by ESG good or future 'top-line' benefit. Whereas the optimist might assert that whilst either motive could be true, greater ESG benefit cannot be a bad thing, irrespective of the method(s) used to get there. 

This discussion calls into question the purpose of a company (generally speaking, to operate in self-interest) vs. the operation of a government (establishing the rules that do not allow this self-interest to operate unfettered). It is the classic economics example of 'who pays for the light bulbs in streetlamps?' The cynic argues that through the creation of jobs and payment of various taxes, it is the company who pays for streetlamp bulbs. The optimist, true to character, would just be happy they don't have to walk home in the dark.

If earnings season wasn't already complex enough, the wider adoption of these new metrics can feel like trying to drink water from a fire hose. Like anything that is new, there will inevitably be kinks that need to be ironed out and parameters that need redefining. Perhaps the nirvana for these new metrics and their wide-scale adoption comes through regular policy and regulation revisions that encourage and guide companies to do what is considered socially better. Or maybe the onus is on the companies to willingly take on these new expectations from the community and thereby lobby the policymakers to formalise these shifts. 

Is only doing the right thing because you were told to do it enough in our customer-aware world? Either way, we suspect this debate is far from over and we watch with great intrigue how this may continue to impact future earnings seasons.
In conclusion, earnings season and finding the next best company is fraught with hurdles that are likely not made much easier with the level of information available. 

We'd argue that this is only going to become increasingly complex in an environment where pundits and analysts are doing their best to quantify and price-in a rise in interest rates, ongoing supply chain constraints and inflationary pressures that are seemingly going unchecked. 

Relying on strictly linear forms of measurement or analysis is likely to negate an investing edge and conversely, too much information is likely to saturate one's bandwidth with little clarity on how to use it. We'd argue that the best way to navigate earnings season, or any other disruptive market cycle, is to not only remain convicted to one's tried and tested investment thesis, but also keep half an ear to the ground for emerging trends to consider how these might need to be examined

Why it's all about Earnings Growth

Companies that sustainably grow their earnings at high rates over the long term are called Compounders. Investing in a portfolio of Compounders is an ideal way to generate wealth for longer-term oriented investors that tend to also beat market averages with less risk. This chart shows the tight correlation between returns of the S&P 500 (orange line) and earnings growth (blue line) since 1926. NB: Grey bars are US recessions.

Source: Macrotrends.net

Insync's focus is on investing in the most profitable businesses with long runways of growth resulting in a portfolio full of Compounders. 

Inflation & interest rate impacts 

By focusing on identifying businesses benefitting from megatrends with sustainable earnings growth, means we do not need to concern ourselves with market timing, economic growth forecasts, inflation, or the future of interest rates.

Throughout the last 100 years we've experienced periods of high economic growth, recessions, different inflation and interest rate settings, wars, pandemics, crisis and on it goes, but the one thing that has remained consistent... Over the long term, share prices follow the growth in their earnings.  

Media and many market 'experts' continue to be concerned about the risk of a sustained period of higher inflation. They worry over a short-term 'rotation' from quality growth stocks of the type Insync seek to own to value stocks. The latter in many cases is simply taken as equating to lowly rated companies and reopening stocks, such as airlines, energy, and transport. There are 3 problems with this view that can trap investors:

1. Timing - no one has a crystal ball for consistently predicting changes to economic growth and inflation rates nor the pathway for the virus.
2. Share prices have already built in the upside. The value/re-opening stocks have already likely anticipated the potential for higher inflation and the opening up of the economy ahead.
3. All boats rise on an incoming tide. The major problem with low quality businesses that are prevalent in the latter category (so-called value/cyclical stocks) is that most remain low quality and continue with low returns on capital.

In sharp contrast good businesses remain strong at this stage of the cycle. They continue delivering the earnings growth that propel share prices over the long term. This is what makes their share price progress both sustainable and well founded. 

High margins and superior pricing power from Insync's portfolio of 29 highly profitable companies across 18 global Megatrends offers "the holy grail" of inflation busting companies. Pricing power, sound debt management and margin control allow great companies to handle inflation and interest rates well.

LVMH and Microsoft) are portfolio examples that recently increased prices of their products with no impact on their sales growth.

Profitability + Revenue Growth

Short term, investors typically fret over interest rate rises and all growth stocks suffer initially, as they adopt an indiscriminate machine-gun approach to selling. 

Over time however, the more profitable businesses with strong revenue growth start to reassert their upward trajectory in their share prices, as investors appreciate their long-term consistent earnings power.

Stocks with "quality growth" attributes, such as high returns on capital, strong balance sheets, and consistent earnings growth, have typically outperformed in past situations similar to what we face today (Mid-2014 through early 2016 and from 2017 through mid-2019. Source-Goldman Sachs). 

Ultimately, any short term hit to the share price of companies with these quality attributes will be temporary, as over the long-term, share prices always reflect the underlying growth in the earnings of these highly profitable businesses.

This is in sharp contrast to stocks with strong revenue growth projections that also have negative margins or low current profitability. They are highly sensitive to changes in interest rates (These stocks propelled the short-term returns of many of the Growth funds in 2021). Many of them lack profit and cash flow, which doesn't give you much downside protection if they don't deliver. Many rely on the constant supply of new capital to fund their operations.

These types of companies have very long durations because their present values are driven primarily by expectations of positive cash flows at a distant point in the future. We call this HOPE. As the saying goes; we don't rely on hope as a sound strategy. Stocks with valuations entirely dependent on future growth in the distant future are vulnerable to a dramatic drop in price if rates rise sharply or revenue growth expectations are reduced.

This chart (performance of the Goldman Sachs NonProfitable Tech Basket) shows the downside risk to this sector of unprofitable high revenue growth companies. The index has fallen by close to 40% from its peak in February 2021. The index consists of non-profitable US listed companies in innovative industries.

Source: Bloomberg

Unsurprisingly, popular "new era" stocks held by high growth managers have also suffered a similar fate with examples noted below.

Megatrends drive sustainable growth 

Megatrends enable us to locate the sustainable outsized market growth opportunity stock hunting-grounds (as well as help us avoid those that will dwindle). They are the 'fuel' to quality company's sustainable growth earnings. We are presently in the midst of one of the most disruptive innovation cycles in technological history. 

Thus, we resist the temptation of concerning ourselves with near term timing based 'market rotations' and changes in 'sentiment'. These distractions will otherwise prevent us from generating outsized returns in the years ahead. 

PWC consulting estimates that global GDP will be up to 14% higher in 2030 as a result of the accelerating development and take-up of AI. The equivalent of an additional $15.7 trillion USD.

Source: PWC 

Internet of people V Internet of Things

Our lives are already being impacted. In the past 5 years alone, almost all aspects of how we work and how we live - from retail to manufacturing to healthcare - have become increasingly digitised. The internet and mobile technologies drove the first wave of digital, known as the 'Internet of People'. 

Analysis carried out by PwC's AI specialists anticipate that the data generated from the Internet of Things (IoT) will outstrip the data generated by the Internet of People many times over.

This is already resulting in standardisation, which naturally leads to task automation and the automatic personalisation of products and services - setting off the next wave of digital progress. AI exploits digitised data from people and things to automate and assist in what we do today, how we make decisions and how we find new ways of doing things that we've not imagined before. 

"I skate to where the puck is going to be, not where it has been." Wayne Gretzky Canadian World Champion 

From one of the all-time ice hockey greats, this very apt thought describes the way Insync frames its investment thinking. Despite the market's sentiment shift on the rotation trade, Insync's focus is on where the world is moving to. Data continues to show an acceleration in spending on pets, the rollout of 5G, health & wellness, and digital transformation. 

Major corporates expect elevated growth in technology to both accelerate and persist for the foreseeable future (according to a Morgan Stanley survey), in areas such as cloud computing, digital transformation and artificial intelligence.

CIO intentions indicate that they expect to increase IT spend as a percentage of revenue over the next three years than they did pre-pandemic. The percentage of CIOs planning to increase spend versus those planning to decrease spend is known as the up-to-down ratio. It rose to 9.0, nearly 6x the pre-pandemic 2019 average.

The best way to invest in a megatrend isn't always the obvious way!

Semiconductors are driving the digital transformation of the world. Covid19 has had a profound impact on so many industries but one of the key areas everyone has started to care about, is silicon chips. This became abundantly clear when new car purchases were dramatically delayed because of chip supply chain shortages.

Semiconductor chip usefulness has gone further than any other technology in connecting the world. The companies that produce them enable us to do pretty much everything, from the smartphones in our pockets to the vast data centres powering the internet, from electric scooters and cars to hypersonic aircraft, and pacemakers to weather-predicting supercomputers.

Their manufacturing requires a high level of specialist technological know-how as it is a highly expensive, complex and a long process. It typically takes 3 months and 700 different steps to cover a silicon wafer with intricate etchings forming billions of transistors (microscopic switches that control electric currents and allow the chip to perform tasks). 

Semiconductor chips lay at the heart of the exponential transition that we're going to experience in computing over the next 5-15 years. More than we have ever witnessed before, and it will continue to grow exponentially. For example, AI applications process vast volumes of data-about 80 Exabytes pa today. This is projected to increase to 845 Exabytes by 2025. One Exabyte = One quintillion bytes = one thousand quadrillion bytes. Truly eye-watering numbers. 

Insync's investments in the most profitable semiconductor companies enable investors to participate in 3 of the 16 enduring megatrends: video gaming, workplace automation and enterprise digitisation. Their earnings growth will continue to compound at high rates with the resulting share price growth following. This is a consistent feature of the 29 companies in the portfolio. Patience will reward.

Hamish Douglass discusses why the less-threatening Omicron variant still comes with inflation implications, why he's recently invested in two companies exposed to structural growth in global travel and why today's stock market reminds him of 1999's. 

Sailing into the wind is a sailing expression that refers to a sail boat's ability to move, even if it is headed into the wind.  To reach specific points, alternating the wind's direction between the starboard and the port is sometimes necessary.  Equity markets similarly require the same agility to adjust for different market cycles and macro implications to deliver consistent returns for clients.  The last (almost) two years of Covid-related repercussions have certainly tested even the best skippers' navigation skills and having the flexibility in your process to adjust when necessary has been invaluable.  As we head into 2022 with concerns around economic growth and monetary stimulus likely peaking, the earnings cycle potentially maturing, and equity market valuations optically high, investment risks appear to be rising.  At Alphinity we continue to let earnings leadership, on a stock by stock basis, guide us through the next phase in the cycle, wherever earnings upgrades may lead us (rather than being tied to a specific style or macro outcome).

2021 - A normal, abnormal year

Nothing about the last 24 months since the Covid pandemic started has felt normal.  Global equity markets (with Australia no exception) have however followed a surprisingly normal recession and recovery pattern, albeit faster and more aggressive than usual.  Consistent with historical patterns, the first stage of the market recovery in 2020 was driven by valuation multiples expanding, with the market pricing in future earnings growth, which did not disappoint and drove the second stage of the recovery into 2021.  The two charts below illustrate the similar return drivers of the MSCI Australia and MSCI World Indices, with the former enjoying stronger earnings growth, but also a larger multiple contraction at the index level over the last year.  The key question from here is the expectation for each of these drivers (earnings and multiples) as we head into a new year.

MSCI Australia following a normal post-recession market pattern - up c60% since the trough with the PE expanding from 14.5x to 20x, currently back down to 18x

Source: BoAML Data

MSCI World has added c97% since the trough in March'20 with the PE expanding from 12x to 20x, currently back at 18x.

Source: BoAML Data

Different points in the earnings cycle heading into 2022

Global earnings revision breadth (or earnings sentiment as measured by the Alphinity Diffusion index, being the number of companies getting earnings upgrades vs downgrades) expanded to 30-year highs as analysts started pricing in the strong demand recovery and unprecedented corporate pricing power. Similarly in Australia, earnings sentiment soared to highs last seen in 2003, peaking in April 2021 driven by the early cycle commodity pullback, dropping into negative territory during lockdowns and finally stabilising in November 2021. Generally, these small upgrades still favour pro-cyclical earnings, but we are seeing some selective defensive positive earnings revisions coming through.

Australian earnings cycle - Less clouding, but not yet clear

Source:  Alphinity, Bloomberg, 31 December 2021

Globally earnings upgrades are still dominating, but the trend is narrowing to fewer stocks. In terms of relative sector earnings revisions, the picture is getting more mixed compared to the clear cyclical and growth leadership we have seen over the last 12 months with some defensive sectors slowly creeping into positive territory.

Global earnings cycle - Still positive but losing momentum

Source:  Alphinity, Bloomberg, 31 December 2021

High valuations offer less support and high dispersions increase vulnerabilities

Despite the recent multiple contractions seen during 2021, most global equity markets are still trading above their long-term averages driven in part by low interest rates and excess liquidity. Strong performance in the last 18 months has seen pockets of the market becoming particularly stretched and therefore vulnerable to material changes in earnings and interest rate expectations, real or perceived.  The valuation dispersion between the highest (80^th percentile) and lowest (20^th percentile) rated stocks is at a record high for the ASX200 and the MSCI World Index, with unprofitable tech a particular standout.  Factor and style dispersion were also extremely high during 2020, which makes sense for a year marked by very high uncertainty or a recession and extreme volatility. This dispersion has reduced a bit during 2021 but remains at unusually high levels across several styles, such as value vs growth, given the strong recovery in the economy.

Source:  Alphinity, Bloomberg, 31 December 2021

Global equity markets still trading above their long-term average valuations

Source:  Bloomberg, 31 December 2021

Adjusting the sails for the winds of change

Add to this peaking, but still robust, global economic growth, stubborn inflation data, likely less central bank support and ongoing uncertainty around new Covid variants such as Omicron, is probably going to make navigating macro influences on markets more challenging this year. The increasing points of uncertainty suggest a more diversified, balanced approach will be required, focused on individual company stories rather than large thematic biases, with flexibility to react to material changes in the investment environment. Introducing some defensive characteristics also seems prudent, as long as you can identify the relative earnings story.

Across our Australian funds we continue to follow the individual company earnings and where upgrades are coming from.  Along those lines we have added to some more defensive positions such as Sonic, Amcor, Medibank and Treasury Wineries in the last few months.   Global packaging company Amcor for example, offers a defensive earnings stream with strong cashflow generation and a solid balance sheet, which allow management the flexibility to do recurring buybacks and potential bolt-on acquisitions.  Amcor has beaten earnings and upgraded its outlook at the last 6 quarterly reports, primarily driven by better than expected synergies with Bemis, but also better than feared passthrough of higher resin prices.  Amcor's defensive qualities should see it deliver a steady return over the next 12 months and outperform the market on any potential correction.

Amcor - offering a defensive earnings stream and strong cashflow generation

Source:  Alphinity, Bloomberg

On the global side, we have continued to incrementally reduce our cyclical and higher PE growth exposure in favour of high-quality defensives such as Pepsico, Nextera and Nestle.  Pepsi is a high quality, defensive consumer stock with strong pricing power and under-appreciated long-term revenue growth driven by strategic reinvestment under a new CEO, a mix shift to the higher growth snacks segment, targeted M&A and market share gains in beverages.  Recent third quarter results displayed broad-based strength across the business, with management committed to offsetting rising inflationary pressures by leveraging strong brand investment and innovation to drive price increases and revenue management.

Pepsi - driving earnings growth through strong pricing power and innovation

Source:  Alphinity, Bloomberg

It seems likely that 2022 will be a more challenging year for markets, especially given the higher valuation starting point.  It is through choppy waters like the present that we rely on our agile, style agnostic process to get us to our destination.  As Thomas S. Monson once said, we cannot direct the wind, but we can adjust our sails.

Author: Elfreda Jonker - Client Portfolio Manager

In this episode on the Good Value podcast (recorded Monday 31 January, 2022), Jacob Mitchell and Alison Savas discuss three key themes to watch in global markets in 2022:

• Rising real yields in the US
• The potential for China to loosen
• Europe to outperform on a normalisation in services spending and a potential household re-leveraging cycle in the West. 

They also share Antipodes' stock to watch in 2022 - Seagate Technologies (NASDAQ: STX)

The last time Australia's official cash rate had a five in front of it, the world was going through the biggest financial crisis since the Great Depression. Within the next two years, rates could be back up at that level, bringing a world of pain to borrowers, equity markets and business balance sheets.

The prediction comes as share-markets around the world tumble amid expectations the US Federal Reserve will within weeks kick off the next interest rate-rise cycle. 

"We've already seen rationalisation start to come into the market. We can see that institutions and investors as a whole are no longer prepared to just pay up for these high-growth, expensive companies, many of which are not actually generating profits" 

If you look at the irrational behaviour happening over the last 12 months, it's resulted in 60 out of the ASX top 200 companies not being profitable. That's alarming.

While capital market conditions were favourable over the past two years, with excess liquidity pumped into the system, these hyper-growth businesses were the outperformers. However, these sorts of businesses are highly reliant on capital markets supporting them; they've got to keep going back to the well to survive. 

That well will run dry quickly if rates jump up to the level, we forecast. I see the Reserve Bank kicking off its own rate-rise cycle by the middle of the year, well before the 2024 start date the central bank was tipping just months ago.

The pressure on the RBA intensified last Tuesday, when headline inflation in the year to December 31 was revealed to have surged to 3.5 per cent, while underlying inflation was 2.6 per cent. Many now expecting the central bank to move this year.

I am predicting that the fallout for equities from the rate move would result in the share market contracting up to 15 per cent this year. The S&P/ASX 200 Acc. was down over 6% in January on the mere suggestion of a new rate-rise cycle. 

"We think there's a real risk now that rates are going to increase by amount to 3 - 5 per cent over the next two years"

The RBA might try and hold fire as long as they can, but then I think they're going to have to accelerate at a greater rate than what they would have preferred. You could easily see that 3 to 5 per cent occur over an 18-month period from July 1 this year.

If you also think about the amount of debt people and institutions have taken on over the last few years, you lift that cost of debt from 2 per cent to 6 per cent or 7 per cent over the next 24 months and it can have dire consequences not only on the property market, but also on equity markets and business balance sheets.

The key for investors looking to emerge unscathed is to ditch the recent investing mindset. 

"Investors who continue with the mindset of traditional investing over the next five years could risk giving away a significant amount of the wealth they've generated over the last five. Now more important than ever, investors need to apply a lot more active management to their portfolio, as opposed to the buy and hold index approach that worked very well over the past decade - invest for tomorrow, not yesterday"

The alternative investment manager isn't suggesting investors completely back away from equities, but to reconsider how to best manage that equity allocation. To this point, the Lucerne Alternative Investment Fund (LAIF) has in recent months increased its exposure the energy sector, which has outperformed as constraints to supply chains continue. Ironically, this was a sector ignored by much of the market in recent times with the push toward clean energy. "We feel there is more upside in this sector and some market commentators believe oil could reach USD200 per barrel".

Our message to investors out there is to get in front of this and start to think differently. Move away from that herd mentality, which only works well until it doesn't. 

LAIF, which actively manages a portfolio of alternative funds covering asset classes and themes including long-short equities, volatility, precious metals, resources, digital assets and convertibles, returned ~24 per cent last year, bettering the 22 per cent in 2020. For this year, the fund is tipping it can achieve an 8-12 per cent return, after delivering a return of ~1.5% In January. 

Author: Anthony Murphy, CEO

As an investor, you are often urged to act quickly on the latest investment opportunity or regret missing out. For those interested in profiting from long term structural change it seems odd that we would need to act so quickly. Surely a profound opportunity that will change the world over many decades allows you time to sort the wheat from the chaff? If the opportunity is so fleeting delaying action misses all gains, then perhaps it wasn't the structural change it was promoted to be.

At the end of 2021, it is now clear that the last 25 years was one of these generational opportunities to participate in the digitisation of, well pretty much everything. The question we ask: how early did you need to be? Well it turns out that when structural trends run for decades, investors are afforded plenty of opportunity to participate and capture these returns.

The examples we use are flawed by survivor bias, but we think as time went on the likelihood that Apple, Microsoft, Amazon, Google and Facebook were likely to be structural winners became a lower risk assumption. What returns were lost by waiting until these became the more obvious winners?

We start in 1995, when in August Windows95 launched and Netscape IPO'd (Yahoo followed in April 96, Amazon in Jun 97 and eBay in Sep 98). We have marked this as the beginning of the Internet era for public market investors.

Let's start with Microsoft. Had you purchased Microsoft in August 1995 and held to end Dec 2021 you would have made 19% per annum over 25 years. If you had of waited until the dot com peak (Mar 2000) that would reduce to 11% p.a. Maybe you wanted to wait until the dot com settled. A purchase in Aug 2004 (when Google IPOd) returned 19% p.a. Maybe you had doubts about Steve Balmer and waited until Satya Nadella became CEO (Feb 2014) - you would have made 33% per annum in the almost 8 years since.

In 1995, Apple was still in the wilderness. Steve Jobs had yet to return (1997) and the iPod was still six years away. Holding Apple from 1995 to Dec 2021 has returned 27% per annum (with a near death experience along the way). If you waited until the iPod launched, you got 38% per annum since Oct 2001. Maybe you waited until the iPhone launched (Jun 2007) to achieve 30.5% p.a. Warren Buffett ended up buying AAPL more than nine years after the launch of the iPhone (Nov 2016) yet has still realised a 46% p.a. return over the five years since.

We see a similar pattern with Amazon (37% p.a. from IPO, 20% p.a. from dot com peak, 33% p.a. from when Warren Buffett bought in Dec 2018), Google (26% p.a. from IPO, 28% p.a. from May 2017 when Charlie Munger said "we blew it" for not buying Google) and Facebook.

None of this was obvious or easy at the time. Looking backwards gives a false sense of inevitability to history that is anything but. The future for electric vehicles, artificial intelligence, robotics, blockchain and genomics may contain generational investment opportunities. Unfortunately, there are hundreds if not thousands of companies vying to be the few winners left standing and reward their shareholders as Apple, Microsoft, Amazon, Google and Facebook (and others) over the past 25 years have done. What is hidden from history are all the failures investors have endured along the way - either companies that failed to meet these lofty goals, or investor temperament that failed to hold onto the ultimate winners through an uncertain path.

Flywheels or Waterwheels

As small cap investors, Longwave invest in much younger industries and businesses than is typical of large caps. It is more likely that the industries and companies we invest in are younger than Australia's banking, mining, insurance, property and supermarket leaders. Just because we are not investing in 100+ year old industries doesn't however mean we spend our time funding businesses that are 10 months old. There is a lot of industry growth lifecycle between 10 months and 100 years - and the current wave of investment neophiles would have you believe any company more than a decade old is ex-growth.

Our investment approach is to wait until the likelihood of success is more certain. Not guaranteed - because nothing is - just more certain than largely unproven early-stage companies. One measure of more likely success is the demonstration of a genuine and observable growth flywheel. Flywheels are sometimes over-used however we like the metaphor for the image of internally generated and sustained momentum. We seek flywheels that are self-sustaining. A profitable business with high growth opportunities reinvesting positive cash flows internally (capex, R&D, sales and marketing) to drive higher growth and higher cash flows and higher investments and higher growth etc.

Many of the current crop of growth business look more like waterwheels than flywheels. Superficially the effect is similar (more investment -> more growth -> more investment) but the missing part is internal cash generation funding growth investments. Like a waterwheel, these pseudo growth businesses require external liquidity to keep turning. Maybe some of them really are self-sustaining and are using external liquidity to spin faster. Or maybe they are just not going to succeed should this external funding dry up.

Every investor has their own philosophy and process and there are many methods we acknowledge we don't pursue that may work for those investors. Our process seeks high quality small companies that have been seasoned by the reality of free market competition to emerge as genuine flywheels, not waterwheels in disguise.

Written By David Wanis, Founding Partner, CIO and Portfolio Manager