Market Update - 4 June 2020

We are certainly living through an extraordinary period. As restrictions are being eased in much of the developed world, we provide an update on our view on markets, how the portfolio is positioned and performance.

I can’t emphasise enough how important it is to understand the moves in individual stock prices that are driving the market indices. Despite the economic backdrop, or perhaps more accurately because of it, we are in the midst of a raging bull market in a relatively small number of stocks. Arguably, the rest of the market is in a prolonged and deepening bear market. This is giving rise to extraordinary opportunities to not only make money in stocks, but at the same time an extraordinary opportunity to do permanent damage to your wealth.

Our view is reflected in the way we have been positioning our flagship global equity portfolio, the Platinum International Fund (“Fund”). On 3 June 2020, the cash levels in the Fund had fallen to 6%. This is a result of the opportunities that this crisis has presented in both new and existing holdings. However, this change in positioning understates the movement in the portfolio, as we have also sold other holdings, predominantly those that have performed well, to fund these purchases, in addition to drawing down cash. Please do not interpret this as outright bullishness. These positions are predicated on a long and slow grind out of the deep recession we are likely facing. Indeed, many stocks we have been buying have risen sharply and are reaching short-term price targets and may be trimmed or sold. Markets are moving very quickly.
 
The short positions have been reduced significantly in recent weeks and as at 3 June’s close were at 10%, with a resultant net exposure of 84% for the Fund. Again, this is not a sign of bullishness or a view that we are over the worst. It reflects a reluctance to remain steadfastly short in the face of:

1. A high degree of cautiousness by investors. There are many, including ourselves, who would argue that when a market index, such as the S&P 500, is down less than 10% from what were enthusiastic levels reached in February, when we are facing what is likely to be one of the deepest recessions on record, that this makes little sense.  Most days, the front page of the Australian Financial Review carries articles outlining the cautious views of fund managers, many of them with extraordinary long-term track records. When such cautiousness is pervasive, even from capable and experienced investors, markets have a low probability of falling dramatically.

2. Secondly and more importantly, we, as would many others, attribute the level of markets and asset prices generally, to the creation of new money in the system resulting from the various fiscal and monetary initiatives of governments and central banks around the world. At some point, this support for asset prices will fade, perhaps as economies start to recover and this new money is absorbed by economic activity. We shall see. However, for the moment, it is likely that we will continue to see new initiatives from governments, as we are now seeing being discussed in Europe, the US, and here in Australia, which will potentially create more money and further support asset prices. As always, these type of variables are near impossible to predict.

So, for the moment we have cut back on our shorts, but again, please do not take this as a bullish stance. We have a long list of potential short ideas, companies whose businesses have been damaged by this crisis, and yet whose stock prices are back near, or even above, previous highs. We continue to look for potential catalysts for these stock prices to break lower, either individually, or in aggregate. We will continue to look to protect the very real downside that investors face as a result of current market conditions through the use of individual stock shorts and index shorts.
 
It is important to carefully examine the bifurcation that is occurring in the performance and valuation of stocks. It is not the first time this has been experienced in stock markets and as usual at this point, there are many reasons being put forward as to why “this time is different”. Among them, is the transformative impact of the internet, the cloud, and ongoing technological developments. Yet, this same phenomenon of stretched valuations can be seen across industries, not just in technology. In the past, I have mentioned the extraordinary valuation of consumer staples stocks, such as Colgate and Nestlé, yet these types of stocks have generally moved higher. Within the technology sector, it is not just about the extraordinary monopoly power that has accrued to the likes of the FAANG stocks or Microsoft. Indeed, the valuations of Facebook, Alphabet and Microsoft are far from the most challenging within technology. In past commentaries I have discussed the extraordinary valuation of the software-as-a-service (SaaS) stocks that defy basic mathematics and probability, though many of these have moved significantly higher in recent weeks. I will not go through these again, other than to say that these differences in valuation are not at all explained by “it's different this time” theories.
 
I appreciate that some of our investors will be questioning our position, after all, we have been talking about this at length for over two years now and the valuation differentials have continued to widen, and very dramatically so in the early months of 2020 and in the COVID-19 period. For anyone who is interested in an alternative approach to examining this issue, I suggest the following article “Is (Systematic) Value Investing Dead?” by AQR, one of the world’s pre-eminent hedge funds.^[1] I do recommend reading this article, while they approach markets from a purely quantitative approach, they conclude similarly to our qualitative approach to finding value. (I should add, our very capable but much smaller quant team has delivered the same findings internally.) The high-level conclusion of their paper, is that the differences in valuation between the highly rated (or growth stocks) and the lowly rated (or value stocks), are more extreme now than they were in 2000. We all know what came next.

If it is not the beauty of technological change that is driving this phenomenon in the stock market, then what is it? It is simply risk aversion of investors forced into the stock market by low interest rates. And here is the problem for owners of the fancied growth and defensive stocks today. They have made good money, partly because of the strong performance of the underlying business in some cases, not in all, but largely they have made money because of falling interest rates. Is this a bet one would want to continue with as rates approach zero in the United States? Most investors can’t bring themselves to buy the US 10-year Treasury at 0.74%.^[2]  But if you can’t do that, why expose yourself to the same risk by owning stocks whose high valuation is predicated on rates at that level.

To return to the portfolio, at the individual stock level, the crisis has provided an interesting set of new opportunities. One of the obvious areas, which you would expect us to be looking at, is travel. This industry will face a long recovery period, with significant unknowns around the opening of borders. There will be some change around behaviours with respect to business travel. However, as the fear of the virus passes, which will be accelerated if a vaccine becomes available, travel will return. It is a hard-wired part of human behaviour and it will recover and then continue to grow. Our timeframes in assessing the potential of these travel businesses are based on recoveries that take at least three years. We are not talking about entering the dark den of buying airlines or cruise companies that face the potential of bankruptcy if the recovery is slow. We are buying high-quality businesses with pristine balance sheets, many of which were previously valued as high-flying growth stocks. Examples of current holdings in this sector include Booking Holdings, the owner of the world’s largest online travel agent Booking.com. Another area of interest, is aerospace and specifically the aircraft engine manufacturers, who operate classic razor and blades style business models, where engines are sold at near cost, but profits are made on spares and maintenance. Generally, these are highly predictable businesses that generate strong cashflows, but the growth in the spares and maintenance business is a function of how many engines have been sold and the number of hours flown. Clearly, they have taken a hit on both fronts. General Electric is one of the Fund’s holdings in this sector that we have added significantly to in recent weeks. Other new stocks include biotech and healthcare names, and a software-as-a-service business, all of which were sold down significantly in March and April. We also took advantage of attractive prices to add to existing positions in semiconductors, such as DRAM producers, Micron and Samsung, which we have discussed at length previously in our quarterly reports, and electric vehicle plays such as battery maker LG Chemical. In Europe and China, one area of likely government spending is decarbonising the economy, and as such the electric vehicle story is likely to receive a significant boost.  
 
On currencies, we have been moving away from the US dollar. We did hedge 10% of the Fund back into the Australian dollar (AUD) when it was trading below 60 cents. Unfortunately, this window was brief and we have been surprised by the ongoing sustained strength of the AUD since March. We also added to our euro exposure (now at 21%) and closed our Chinese Yuan shorts.

Over the last two years, performance in most of our funds has lagged relevant market indices, with a couple of notable exceptions. I have little doubt that this is a cause of concern and frustration for investors, as much as it is for us. While one can look at contributions of longs, shorts and portfolio positioning through time, the most significant factor in our lagging performance is this widening gulf between the narrow group of stocks driving indices higher and the rest. We are being asked more frequently if our approach is broken and whether we should change tack.
 
My response is this. At the core of our approach is the idea that our cognitive biases will cause humans to over discount the bad news and over extrapolate the good. While we are in extraordinary times in financial markets, I doubt very much that basic human psychology has changed at all. The times may be extraordinary, but they are not unique, not at least as far as the stock market goes. We have been here before, or at least somewhere quite similar to this on a couple of occasions in the last 26 years and at those times our approach ultimately produced very good outcomes for investors.

Now turning to an update on health care and Asia. Our inhouse virologist and portfolio manager for the Platinum International Health Care Fund, Dr Bianca Ogden, noted that a number of things are happening in relation to SARS-CoV-2 (the virus that caused COVID-19). For example, global testing capacity continues to increase, with some countries establishing ‘testing tents’ to regularly test employees and schoolchildren. Tracing is paramount to containing outbreaks and for monitoring when to increase containment measures. Her team is seeing some vaccines in the next phase of human testing, while others are at the start of the human testing process. Many companies are expanding manufacturing capacity, sometimes with government financial support and various collaborations with contract manufacturers. Meanwhile, on the treatment side, several new therapies will be tested and data is expected by the late Northern Hemisphere summer. Hospitals are vigilant and doctors are better prepared, with much greater knowledge about the disease. The pandemic has highlighted the arsenal of tools being developed by the biotech industry. It is a watershed moment for demonstrating swift development and both scientific and commercial capabilities.

With respect to China’s economic recovery from COVID-19, Dr Joseph Lai, portfolio manager for the Platinum Asia Fund, noted that there has been a general pick-up in activity and this is coming through in his team’s dialogue with corporates. Strong companies appear to be doing well and in some situations, it appears that markets are consolidating more rapidly around a number of dominant players. The recovery is also revealing pent-up demand in a number of areas, including smartphones, and importantly, this is being achieved without the need for major government financial stimulation, which is a good thing, down the track. While geopolitical tensions appear to be on the rise, this is often reflected in the share price. It is sensible portfolio management to try and avoid those companies directly in the “line of fire”. The portfolio has been focusing on ‘domestic champions’ in China and looking outside in the rest of the region. There are a number of companies that may indeed be direct beneficiaries of increased tensions, if not simply immune.

^[1] https://www.aqr.com/Insights/Perspectives/Is-Systematic-Value-Investing-Dead
^[2] As at 4 June 2020. Source: FactSet

DISCLAIMER: This article has been prepared by Platinum Investment Management Limited ABN 25 063 565 006, AFSL 221935, trading as Platinum Asset Management (“Platinum”). This information is general in nature and does not take into account your specific needs or circumstances. You should consider your own financial position, objectives and requirements and seek professional financial advice before making any financial decisions. You should also read the relevant product disclosure statement before making any decision to acquire units in any of our funds, copies are available at www.platinum.com.au. The commentary reflects Platinum’s views and beliefs at the time of preparation, which are subject to change without notice. No representations or warranties are made by Platinum as to their accuracy or reliability. To the extent permitted by law, no liability is accepted by Platinum for any loss or damage as a result of any reliance on this information.