Against a backdrop of economic and geopolitical uncertainty, rising inflation and rate hikes, Australian investors are searching for investments that can benefit from these evolving market conditions.

With credit spreads at attractive levels, now might be the opportune time to have exposure to hybrids and credit.

With minimal returns on cash continuing to underpin strong demand for hybrid securities, we anticipate demand for yield to remain robust throughout 2022, resulting in strong returns over the year for this asset class.

The upside of rising interest rates

Rising inflation, above average GDP growth and the unwinding of quantitative easing (QE) in 2022 has seen financial markets reprice interest rate expectations.

The rising rate environment will push the outright return on hybrid securities higher, without having a material impact on spreads given the strong economic backdrop. Given most hybrids are floating rate, investors will benefit via higher income from these rising short-term rates.

Strong balance sheets you can bank on

Australian banks are the largest issuers of hybrids domestically and their balance sheets are in fantastic shape, with capital ratios at historical high levels. COVID-19 provided Australian banks with access to cheap funding via the Term Funding Facility (TFF), which provided them with a degree of funding certainty and lower funding costs.

Following the withdrawal of the TFF in 2021, new bank issuance is coming to market at attractive credit margins, providing the ideal environment for active credit managers to identify the most positive risk adjusted opportunities.

For instance, bank senior credit margins are significantly off their TFF lows, which is leading to an attractive re-pricing across all bank capital issuance (refer to Chart 1). Overvalued growth sectors are likely to lead an equity market sell off similar to 2000 - 02, but are unlikely to impact credit market returns.

Chart 1: Bank senior credit margins - Well-Off their TFF 2021 lows

The higher the carry (running yield of an investment), the greater the protection it offers investors from adverse movements in credit margins. The carry for the Yarra Enhanced Income Fund is currently sitting at ~3.0% above cash.

Based on an average portfolio maturity of ~3 years, we'd need to see an extreme 1.0% move wider in credit margins to wipe-out the carry. However, given the robust economic backdrop in 2022, we expect credit margins to remain relatively stable throughout, adding to floating rate credit's income generating credentials.

This benign outlook is in contrast to the capital losses currently being observed in traditional fixed income due to the reset in interest rates and real yields. Usually, a rise in real yields will impact the value of everything long interest rate duration, from traditional fixed income to most equities. That's not the case with floating rate credit, since its short duration offers protection to portfolio valuations from rising interest rates. This is observable in EIF's outperformance compared to traditional fixed income (Bloomberg Composite Index) since February 2020 (see Chart 2).

Chart 2: Floating rate credit with carry continues to outperform fixed rate with little carry

Making the grade

In a world that seems to be getting riskier by the minute, investment grade hybrids look to be a safe haven for investors. Here's why:

• Investment grade hybrids appear to be fairly priced in an environment appearing increasingly more expensive, especially if real yields rise or normalise in a post QE world.
• Investment grade issuers remain well capitalised, making them more likely to be able to service their interest payments and repay debt.

• Most Australian investment grade hybrids are floating rate securities, which tend to pay higher yields if prevailing rates go up because they are based on a variable interest rate, rather than fixed. Not only does this mean more income when rates rise, but there is also no loss of capital.

Getting exposure to hybrids and credit

Being able to access fixed rate securities for floating rate portfolios remains a key competitive advantage for Yarra's clients. The Yarra Enhanced Income Fund invests in high yielding, floating rate credit and hybrid securities to deliver better returns than traditional cash management and fixed income investments.

Lifting of pandemic restrictions has generated an overly enthusiastic view that economically sensitive companies will rebound quickly across many business sectors. Insync deliberately has no exposure to stocks of this ilk. We favour companies that are not only are some of the most profitable companies in the world but are also expected to consistently grow their earnings at high rates regardless of how the global economy performs. 

As the earnings growth across our portfolio continues to compound at high-rates, the gap grows ever wider between their stock price and their valuations (currently circa 50%+ below valuations). In these shorter periods of relative underperformance, a tension permeates in markets. This creates ideal conditions for entry as a sudden 'snap-back' in stock prices can occur very quickly. Snap backs are triggered by a change in market conditions, an event or simply the market recognizing the big disparities between the companies promising to deliver to the ones actually delivering.

We liken it to an elastic band. The more you stretch it (the widening of the gap between valuation and share price), the greater the likelihood of a rapid 'snap-back'. Whilst it's impossible to time exactly when the snap back will occur, when it does do so, it delivers strong outperformance to those stocks with the real underlying earnings and profits to support a sustainable uptick in their price. At the same time, the reverse occurs for those presently leading this latest bout of exuberant price growth.

We like value but we are not value Investors.

We recently had an extensive meeting with a fund researcher where we took him through our valuation approach. One of his key conclusions was that Insync is a 'value investor'.

Whilst we would not describe ourselves as value investors based on conventional metrics (just buying companies based on low Price/Earnings ratios), an important part of Insync's process includes building a high degree of confidence in understanding the worth of a company's future cashflows beyond its present state.

To make money involves finding companies where the value we see is significantly greater than the price we have to pay. The current investor exuberance around

chasing returns in hyped up sectors has the Insync portfolio of quality growth companies trading at circa 50% below our assessed valuations.

A question to ponder is this.....

Would you buy into highly profitable businesses if you could buy them at such a large discount? And after doing all your investigations and crunching the numbers, its forward earnings were compounding strongly. Or would you buy a very richly valued popular business whose forward looking numbers don't support its price but everyone was enthusiastic about it today? This is the choice that investors face and this sets up perfect conditions for the Insync portfolio to deliver strong returns.

P.S. Insync is of course categorised as a 'Quality Growth' Investor.

Traditional valuation metrics are losing their predictive power.

PE (Price/Earnings) and PB (Price/Book) ratios have been declining in their ability to predict value. The main reason is in the "E" part of the P/E ratio.

Our modern global economy is increasingly driven by intangible assets. Items such as intellectual property, R&D, brands, and networks. In the last decade or so this has accelerated to dominate in many key industries. In the past capital equipment and other tangible assets used to figure large on balance sheets.

'Intangibles' now represent 84% of the market value of the S&P 500 as depicted above. The old focus supported the old P/E and P/B ratios suitability. The problem occurs when it is applied to this new world - to the industries and companies that invest heavily in intangibles. It creates a misleading and distorted picture.

By example, when Pfizer invests R&D in a new drug for Covid-19 (forecasted to generate sales of US$45.7 Bn this year), or Amazon spending on building their cloud capability (sales of US$60 Bn expected from this division), these investments are classified as intangibles.

They have to be expensed through their income statements. This means it significantly depresses their earnings today despite these 'investments of expenditure' creating significant sales and profits for many years to follow. Their resulting P/E and P/B ratios are thus negatively impacted. This is important to remember when investing for the future. Beware of using the rear-view mirror. Life has changed. Fastest decline in history.

By way of contrast, old-industry companies, say a steel company, has to invest heavily in property and machinery (tangibles). The accounting rules treat these investments as capital expenditures. It immediately goes onto the balance sheet and does not detract from that year's earnings unlike intangibles. Effectively this inflates its present earnings and the book value. P/E and P/B ratios look good.

This inconsistent treatment of the drivers of future growth between intangibles and tangibles leads to wrong conclusions on what actually represents good value and what does not. P/Es are thus not a useful indictor for industries with high intangibles, and even more misleading if taking an average across a broad index.

Conventional portfolio blending methods.
Passed their Used By date?

Many research houses lump funds managers into simplified groupings primarily based on P/E ratios.

Growth managers tend to be holding businesses with higher than market average P/E or P/B ratios. Value managers holding a portfolio of low P/E ratios, and GARP or Core managers somewhere in-between.

Not only is this old measure being over-used to compare managers in the same group, it is further adapted as the primary means of blending managers across entire client portfolios and investment models. People tend towards simplicity even if its misleading. Given the change in intangible expenditures this is an increasingly unwise approach for professional advice givers. It is also worth noting that P/B and P/E ratios represent two of the three variables used to determine stock inclusion in the widely followed style index, MSCI World Value.

The key driver of future earnings - intangibles, is not being appropriately reflected in the income statements and balance sheets in a rapidly changing economy. Accounting rules have not yet adapted. This, we strongly contend, is a key reason for the long-term underperformance of Value indices post the Global Financial Crisis.

Intangibles- a key to investing in today's world

Even though it is impossible to measure the value of intangibles precisely, it is essential for investment professionals to come up with a logical approach to incorporate intangibles into their decision making; otherwise, they risk being relics in this new age of information.

At Insync we have developed a systematic way of incorporating the cashflows that intangibles are delivering into our valuation methodology. This results in a more accurate assessment of the value of a business and a key reason of our successful stock selections.

Over the years I have often sat alongside guests on a TV or radio panel and heard them conclude the easy gains have been made. For the first time in many years I agree.

In recent years investors have made substantial gains from equities but a close look at the driving force behind those gains is likely to reveal investors won because the tide was rising. Sure, many companies grew their earnings too but there were a huge number of companies whose share prices went parabolic despite the absence of earnings. A rising tide does indeed lift all boats, but don't mistake a rising tide for genius, or so the axiom goes.

Since 1979, without exception, every period of inflation and or rising interest rates, was accompanied by a contraction in price to earnings (PE) ratios. And using data back to the 1980s, we find the decline in the earnings multiple is greatest when interest rates move up from lower starting levels, just as we are witnessing now. For the last four decades, whenever inflation or interest rates have risen, the multiple of earnings investors have been willing to pay for a share in a company has declined. In every one of the seven phases when US 2-Year Treasury yields rose between 1980 and today, the US S&P500 12-month forward PE Ratio declined.

In other words, if Jerome Powell and his team at the US Federal Reserve continue on the path articulated in our blog post The End of Zero, investors can kiss goodbye the easy wins resulting from shares simply becoming more popular, and that rising popularity being reflected in ever expanding PE multiples.

I will go so far as to suggest we are, right now, in a period of adjustments to a regime of lower PEs. Plenty of investors haven't yet worked that out and this can be seen in the steep gains for almost all equities amid the hope and talk of peace in Ukraine.

Fundamentally however, rates are rising. And while I think rates will rise by less than the most bearish forecasts, the impact on PEs is already underway.

Going forward

Investors should now be looking at the quality of their portfolios and seek at least some exposure to high quality growth. 

If a company, with earnings of $10 per share, sees its PE of 35 times fall to 25 times, the share price will decline 28 per cent, from $350 down to $250. Plenty of high-quality growth companies have experienced this, and worse. And that represents a new opportunity.

In an environment of high short-term inflation expectations history tells us not to expect expanding PEs. If the best we can hope for is PEs remain static, the way to generate capital growth will be from earnings growth.

If the PE ratio for our hypothetical company stays at 25 times earnings, the share price will return to $350 provided earnings grow 40 per cent to $14 per share (E$14 x PE25 = Px$350).

The work investors need to undertake now is to uncover those companies able to grow.  One place to look is among those companies enjoying structural or megatrend tailwinds.  And if among those companies you also find a capital light and highly profitable business with net cash on the balance sheet, more power to you.

Avoid capital intensive, low growth, mature, cyclical, geared businesses, or those with lumpy contract-type revenues, and those exposed to discretionary spending (unless they are on a store roll-out tear) and those companies playing in the revolving door of capital - paying out cash, they need later, as dividends today and subsequently raising dilutive capital to replace it.

In the next period investors will be wise owning businesses selling products and services with inelastic demand and the recipients of non-discretionary spending. Think of Microsoft - nobody is going to cut their subscription to Microsoft Office just because Jerome Powell said interest rates are going up, or because Putin decides to invade Ukraine. 

Inelastic services like Microsoft Office are entrenched in the daily systems of hundreds of millions of businesses and individuals. That durability provides Microsoft low cyclicality, higher profitability, stable, recurring and growing cash flows and little or no need for debt. 

Another company that comes to mind is held in the Polen Capital Global Growth Fund; Adobe. Adobe's Digital Media products enjoy a near monopoly and are "industry standard".  Adobe creates and markets software for creative professionals and hobbyists. Its digital media segment supplies 70 per cent of revenue and 90 per cent of it is recurring. Meanwhile its SaaS based digital marketing solutions for enterprises produces 24 per cent of revenue, while Print & Publishing is two percent.

In 2011 Adobe commenced a transition to annual subscription-based sales, forever altering the company from a "boom, bust" product cycle business to a predictable, subscription-based model.

Unsurprisingly the company generates a return on invested capital of 33 per cent, a return on equity of 43 per cent, has US$1.1 billion of net cash on its balance sheet, produced earnings growth in 2021 of 23.6 per cent, free cash flow growth of 29 per cent and an operating margin of 45 per cent. They are numbers most businesses owners would be envious of. 

But when Adobe recently announced it was ceasing new sales to Russia and not collecting on subscriptions there, the share plunged nearly 10 per cent. Great!

Since its share price highs last year, the shares have declined 37 per cent. Sure, the rate of growth that saw revenue of US1.6 billion in 2004 rise to US$15.8 billion in 2021 may slow but this is a structural growth story, a very high-quality company and remember, shares prices generally track earnings if the PE remains constant. 

And finally, let us say interest rate rises have the desired effect of reducing inflation. Well, what follows is disinflation and in a disinflationary environment, when the economy is still growing, PEs expand again. That would be icing on the cake for investors who heed the suggestion to invest in quality growth after share prices have been slammed by contracting PEs.

Author:  Roger Montgomery, Chairman and Chief Investment Officer