Market Update - August 2016

There are significant changes occurring in financial markets which we think threaten the continuum in performance for low risk assets.

Governments around the world are growing impatient with the ineffectiveness of money printing and zero rates, and government spending is set to increase. Key commodity prices have been on the rise for six months along with the Australian dollar, and we recently saw a 20 basis point fall in Japanese Government Bonds when the Japanese government announced initial plans to increase spending.  In most equity markets financial stocks are starting to move upward.  The differences in valuation between safe haven assets and all others are at an extreme, we liken this to a coiled spring, waiting to be released.  The consequences for investors hiding in crowded low risk assets could well be severe.

Before delving further into how we see markets unfolding and why we think we are well positioned for this new environment, I would like to discuss investment performance. 

Over the five years to the end of July 2016, the Platinum International Fund returned investors 12.7% compound p.a., compared with the market return of 14.8%, an underperformance of a little over 2% p.a. for the period.  We would make the following observations about these performance numbers:

Firstly, these are strong positive returns in a period that excludes the initial recovery post the GFC.  $100 invested in the Platinum International Fund over this period would now be worth $181, though the same $100 invested in the market would worth $199; a difference of almost 10%.  The point being:

• This has been a period of relatively strong markets, and historically it has been the case that this doesn’t suit our conservative and risk averse investment approach.
• And as I will take you through, we have on face value been invested in what would appear to be all the ‘wrong’ places through this period, yet we are only 10% behind.  And it is not that we think this isn’t a significant differential, but we have certainly been at this point in the past, and yet more than caught up the differential in relative performance when market conditions changed.

Secondly, the bull market of recent years has been notable for the behaviour of investors who have been extremely risk averse.  This has been most notable in the bond markets.  We have seen huge positions built-up in negative yielding government bonds, with a flow through to fixed interest instruments of all kinds, and into the equity markets through the rerating of low risk companies such as the US consumer staples, which have performed extraordinarily well in spite of low to non-existent growth in their businesses.  There is a crowding of investors into these perceived low risk assets, and I want to stress here “perceived” low risk, because if you pay too high a price for a low risk asset you are changing the level of risk you take.   We do not think it makes sense to characterise a 10 year bond with a zero interest return as low risk, and likewise for low growth businesses on a high PE multiple.  So, as I was saying, the crowding of investors into perceived low risk assets of which the US equity market has a significant weighting, and the stronger economic performance of the US in general, has seen the US market significantly outperform all others. The other side of this risk averse behaviour has been that any asset that had any uncertainty associated with it have been heavily marked down.

At the core of our investment approach at Platinum is to avoid the crowded parts of the market and seek out those assets that are out of favour.  This is the same approach that has seen the Platinum International Fund, avoid much of the damage in the tech rout in 2001, the GFC in 2008, and provide a return of 12.5% over the last 21 years vs a market return of 6.2%.  And so while we started the period under examination with many consumer names, mainly in Europe, as these were rerated we have sold them and migrated to those areas of the market that had fallen out of favour.  Indeed, over this period we have made many good investments:

• We made a major move into Chinese equities during the collapse of this market as the country’s investment boom came to an end.  Though we have had to endure substantial volatility over the course of the last year or so, our Chinese stocks have made a strong contribution to performance.
• We were well positioned in Japan with exporting stocks (and our yen exposure hedged out) prior to Abe’s initial election and the subsequent devaluation of the yen.
• We built-up positions in India ahead of the election of the Modi government, whose reform program has resulted in a major change in sentiment and a major move up in that market.
• In the currency markets, we maintained a significant exposure to the US dollar through its strong bull market, and avoided holding the Australian dollar until recently when we added exposure of 15% in the low 70s.

We have made many good investment decisions over this period, but in relative performance terms have been fighting against the tide of an ever rising US market.  Indeed, if one is to look at the performance of our three geographic based Funds; the Asia Fund, the Japan Fund, and the European Fund, these have each outperformed handily over the five years to July, with the Asia fund outperforming the relevant index by 2.4%, Europe by 2.3%, and Japan by 7.8% p.a. 

Does our approach still work?  I think the performance of our regional Funds is evidence that it does.  But on a more fundamental basis, if one buys companies on attractive earnings yields, where the earnings are either distributed as dividends or stock buy backs, or sensibly invested in the business for growth, you will make good returns.  Many of the companies in our portfolios have starting valuations today of 8 to 15 times this year’s earnings, usually a substantial portion of which is distributed as dividends or share buybacks.  With these companies, our starting earnings yields are of the order of 7% to 12%, and in most cases we expect these earnings to grow.  We have some companies with lower starting yields (or higher P/Es if you like) but these companies we expect to grow their businesses at rates of 15% to 30% per annum for some time to come.  If one builds a portfolio from companies valued at these levels, and the underlying businesses perform through time as expected, then one will make money in the long term.

We have no doubt that this will be the case, but there is one significant catch, and that is that the companies need to perform as expected!  And indeed, in the current business environment globally, one of slow economic growth and rapid technological change, there is a much greater chance that a business you own will face a significant dislocation in its marketplace.  So when we examine outcomes for the portfolio, we are far more focused on whether our companies are performing as expected at the sales and profit level than the share price.  And when we look at our portfolio, by and large our companies are performing in line with the expectations we had for them, even if the share price in the short term is not particularly following the underlying profit performance as we would prefer.

I would note that there is no lack of conviction in what we are doing.  There have been no fundamental changes in the way we operate.  Our top 50 holdings account for around 70% of the portfolio, which is not very different from what has been the case for the last 20 odd years.  We have only 20% of our funds invested in the world’s largest market, and 10% net of short positions, relative to a more conventional position of 50%.  And we have almost 20% invested in the world’s second biggest economy, China, a market most others do not even bother to invest in.  Even within these positions, there are significant weightings in specific industries and companies, notably insurance and internet plays in China, banks in Europe, and technology in the US.  Rightly or wrongly, I think it is clear that we have a high conviction portfolio, and indeed we know of no other manager of substance with such conviction.  And the reason we are able to operate at this level of conviction is the quality and depth of experience in the team.  Today we have a team of 29 investment professionals, of which 14 have been with Platinum for 10 years or more.  Of these 29, there are 9 portfolio managers and a further 4 analysts who have direct decision making responsibilities.  We continue to hire and develop talent as we have over the last 22 years. 

When will our relative performance improve?  We do think that we are in the late stages of the bull market in risk aversion.  We would point to:

• Long term absolute valuation benchmarks for the US market such as cyclically adjusted P/E ratios are historically consistent with long periods of near zero returns for US stocks.
• Differentials in valuations between defensive stocks and cyclical stocks, emerging markets versus the US, or for that matter US stocks versus European stocks, are at extreme levels.
• Then there is the ongoing flow of funds out of actively managed equity strategies by investors the world over and the embracing of passive index type strategies. As a result of index weighting investors moving to passive strategies are increasing their invested position in perceived low risk high valuation sectors within markets.
• And there have been huge flows into fixed interest and other perceived low risk and risk averse strategies.

As I said at the outset, we see this crowding of investors into assets that are perceived to have low risk while avoiding all else, much like a coiled spring that is getting wound tighter and tighter.  The opportunity here is to be in those areas that are out-of-favour and we have rarely seen the value that we have in the long side of the portfolio today.  The question is, what will release the spring?

Investors continue to fret about a range of issues; we have moved on from Global indebtedness, China’s slowdown, and US rate rises… to Brexit and a Trump presidency.  Indeed there is no shortage of problems to worry about… but while these issues dominate the headlines it is interesting to note that:

• the US economy continues to travel quite well with labour markets continuing to tighten, and a rise in inflationary pressures.
• China’s property markets have stabilised and government spending initiatives are well underway with the fiscal deficit having increased to around 4% GDP.
• European economies by and large continue their slow recovery…

And while economies slowly continue to build momentum, governments are losing patience with zero rates and printing money.  China has been increasing government spending on infrastructure, Japan has announced that will also increase government spending.  Both US presidential candidates are proposing the need for greater infrastructure spending, and even Europe is starting to debate the need for changing its approach to fiscal policy.

We think it highly likely that over the next two years we will see a concerted push toward fiscal stimulus globally.  It is likely that we will see inflationary pressures, especially in better performing economies such as the US, and there will be upward pressure on bond yields.  The 20 basis point sell off in JGBs, in response to that government’s proposals to increasing spending, may well represent a major turning point for bond markets.  As I said earlier, we already seeing moves in commodity markets, financial stocks, and emerging markets; all potentially signs of a significantly different investment environment.  The combination of better global growth and slightly higher rates we think will be the trigger for releasing the coiled spring in valuation differentials between perceived low risk assets and the rest of the market.

Our summary of where we find ourselves today is simply this.  We have been here a number of times before.  If you look at our performance through time, it has been the case in the past that in strong bull markets we struggle to keep pace with the index.  The reason is straightforward, our approach takes us away from owning the more highly valued parts of the market where investors are crowding and creating momentum.  In past cycles, while this has cost us performance on the way up, ultimately the approach has paid off.  We are confident that in the current cycle, it will again prove to be the best course of action.

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.