Market Update - April 2015

As investors crowd towards the perceived low-risk and high-certainty assets, we at Platinum continue to apply the same contrarian approach as we always have, and we are finding undervalued opportunities in the less fashionable parts of the market.

We are now in the 34^th year of one of the great bull markets of all time, that is, the bull market in global interest rates.  At the highs in interest rates in 1981, US government 10 year treasuries were yielding over 15% pa.  Today, you receive a mere 2%, up from 1.6% a couple of months ago.  Though this appears quite generous when one considers the 20 basis points you would receive from investing in German 10 year bunds or 40 points for Japanese Government Bonds.

Today, investors hold over 1.5 trillion Euros of European government paper that is providing them with negative yield and almost certain loss.  This is a pretty interesting statement about just how risk-averse markets have become or as we would prefer to put it, how much they crave certainty.  Of course, this collapse in interest rates has flowed through to other markets as investors seek out returns better than the paltry rates available on government paper.  The risk premiums available on corporate paper have fallen as well, and combined with low government rates, has resulted in the corporate sector, across the spectrum from AAA to junk, funding itself at all-time low rates/costs.

The need to replace these lost income streams has spilled over into equity markets, creating a thirst for yield, and as a result “dividend paying”, “low beta” equities have become a surrogate for holding risk free positions.  Take for example the valuation of consumer staples such as Nestle, Unilever, P&G, Danone and Colgate, which have very steady reliable earnings streams.  These stocks at the bottom of the market in 2009 traded on a trailing P/E of 14x.  Today you are paying 22x.  This, for stocks that have on average grown revenues at a mere 1.5% pa over the last five years.  Another example is the Australian banks, where we so often hear from very capable and disciplined investors that the fully franked yield is hard to pass up and relatively little discussion about whether the earnings, underpinning those dividends, are sustainable.

Today, it is very clear to us that the fashionable investment of the moment is low risk or high certainty!  For those of you who have followed us for some time, you understand that at the core of Platinum’s investment approach is to avoid the loved and favoured investments of the day, as invariably these will provide the poorest returns.  Instead we seek out neglected and out-of-favour stocks.  So it should come as no surprise that we are not at all interested in owning bonds of any type, the consumer staple names that I mentioned earlier or for that matter, Australian banks.

So where is the opportunity today?  If low risk and certainty are loved today, then very clearly what is out-of-favour is risk.  One market that is clearly perceived as facing numerous risks is China.  There is no question that the Chinese economy has slowed significantly as the credit fuelled investment boom has come to an end.  It is highly likely we will see a significant rise in bad debts for Chinese banks.  Yet it is exactly this risk that global investors are trying to avoid that is giving us an opportunity to buy companies at very attractive valuations.

Take for example one of our favourite investments, Kweichow Moutai.  Its product of the same name is the white spirit of choice, with alcohol content a mere 54% and the only truly national spirit brand.  The company’s growth rate has been slowed by the corruption crackdown in recent times but previously grew sales at 20-40% rates annually and today you can buy the stock on 14x last year’s earnings; compare this with Nestle and co!  Or Shanghai Automotive, whose two key business units are joint ventures with Volkswagen and General Motors.  The auto market has been relatively immune to the slowdown, we think because the buyer is predominantly the consumer who has had to pay cash.  You can buy this automaker on 8.5x 2014 earnings and receive a 5% dividend yield.  What both these companies share, along with our Chinese insurers and internet properties, besides pretty interesting valuations, is a relatively low level of sensitivity to Chinese economic growth.  All up, our Chinese holdings account for over 20% of the International Fund and 37% of the Asia Fund.

Another area of neglect is the legacy technology names.  Here we are referring to the likes of Cisco, Oracle, Intel and Microsoft, stocks which the International Fund has 5.5% invested.  These companies 15 years ago were amongst the hottest investments in the world, all because of the potential of the internet.  As an aside, a good example where the market has attributed a certainty that subsequently wasn’t there, even though the internet has delivered much more than was ever imagined back in 2001.  Each of these companies faces particular risks as a result of technological change and continue to grow at high single digit rates and produce significant free cash flow, yet these stocks trade at multiples of 12x to 15x earnings.  Take Oracle for example. 

The company is seen as threatened by the transition of software to the cloud.  Yet their key profit earner, their database product, remains a crucial element in the deployment of most enterprise software systems, including nearly all of the leading cloud based offerings.

Europe has clearly been the cause for much concern, with capital requirements of the banking system a key issue.  You may recall that a couple of years ago we were buying into high quality banks such as Intesa Sanpaolo and Mediobanca in Italy at big discounts to book value.  Now the story on these two banks has started to play out with credit costs having peaked and recently the first signs of credit growth.  Indeed we have made good money on both these names, having close to doubled from our initial entry point.  But lingering concerns around the state of Europe mean that these banks are still only trading at book in the case of Mediobanca and a 20% premium to book for Intesa.  Again an interesting comparison with the much loved Australian banks!

Elsewhere, we continue to find opportunities in Japan despite that market’s run-up over the last couple of years, where the weaker yen has meant a step-change in competitiveness for corporate Japan.  In India, we continue to see opportunities for making money in financials, infrastructure and utilities, areas which will benefit significantly from government reforms.  In terms of new areas of focus, clearly the collapse in crude oil prices has created a new set of potential out-of-favour opportunities.

To summarise, we are doing as we always have at Platinum; avoiding the hot part of the market, which today are perceived low risk, high certainty assets and seeking out the opportunities in those parts of the markets others prefer to avoid.  Now as we have seen in the past, this does mean that our performance is lagging the market and I will talk more about that in a moment.  But typically, what we are asked at this point in the cycle is how long until the relative merits of our position comes to the fore.  Trying to predict the timing of such major changes in market trends is always fraught with danger and we have a long history of thinking the changes will come sooner than they do.  But at the moment there are some interesting developments which suggest a turning point in our favour sooner rather than later.

Firstly, as pointed out at the start, US interest rates despite being low, are quite attractive relative to other major markets and the result has been a strong US dollar.  US economic growth continues to be good, leading to the on-again, off-again debate about when the Fed will increase rates, further underpinning the strength in the US dollar.  Even if rates are not raised, the currency appreciation we have seen will act as a tightening of monetary policy and a brake on growth.  It is interesting to us the earnings estimates for the S&P500 Index for the year ahead are for no growth in earnings and of course the usual pattern for estimates is that they are reduced as the year goes on.  You might like to note the last three times earnings in the US were flat to down were 1998, 2001 and 2008!  While we don’t have a strong view about when interest rates might be lifted, the performance of the US market in absolute and relative terms in recent weeks, gives one an idea about how US assets might perform when this eventually occurs.

Meanwhile, Europe and Japan, sit on the other side of this US dollar appreciation, having experienced significant depreciations of their currencies over the last year.  Ultimately one would expect this to flow through to better growth prospects in the year ahead.  In China, the PBOC has cut the bank’s reserve requirements and progressively removed restrictions on property financing.   Similarly, we have seen the first interest rate cuts from the Reserve Bank of India.  Of course our enthusiasm for investing in these markets, as discussed earlier, is about the prospects and the valuations of the businesses we are buying and in the case of India and China, the longer term reforms taking place in both countries, rather than these short-term macro variables.  However, we do see these developments as supportive of European and Asian markets during 2015.

As a final note on China, while we are very bullish on Chinese stocks and think that economic growth rates in China will improve throughout the course of the year, we do not think that this economy will return to the extraordinary growth rates of recent times, nor do we expect that this will flow through the price of commodities such as iron ore and coal.  As a result we are not expecting much strength, other than perhaps a trading rally, in the Australian dollar.  Indeed when viewed against the Yen or the Euro, the Australian dollar depreciation to date has been of little significance.

Finally, a few brief words on performance.  To the end of February, the Platinum International Fund has over five years returned 11.1% compound pa versus the MSCI World Index return of 13.7%.  While not ideal, we would point out that this return has been earned while typically being invested to the tune of around 80% and with a significant underweight position in the one market to be in, the US.  While not pleased with this result, we do see it as inevitable that if we are to avoid playing the risky game of investing with the crowd, there will be times that we will underperform.  We remain confident that this remains the right course of action and that we will recoup this difference in time.   For anyone who may be wondering whether the process is broken or we have too much money to manage, questions we often get during periods of underperformance, we would point you to the performance of our Asia Fund.  Within Asia, we have not had to deal with a bull market in certainty and low risk, as there is little of that on offer in this region.  This $6 billion Fund has returned 12.7% pa over the last five years, comfortably in front of the MSCI Asia ex Japan Index of 10.6% pa.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.