This is an abridged transcript for the Platinum Market Update delivered by Clay Smolinski and Cameron Robertson on 14 September 2021 to financial advisers.
Clay Smolinski: Global
Since late May, our stocks with cyclical exposure as a group have tracked sideways as the COVID Delta variant spread rapidly and investors began questioning whether the global economy might weaken from here. At the same time, the market reacted to the latest regulatory wave in China – and with a meaningful investment there, these stocks dragged while much of the world market moved higher.
With this lull, we are being asked how will we perform from here, and what is the outlook for inflation and interest rates - both of which impact equities? The answer comes down to whether we remain in a strong growth environment, or if we return to secular stagnation.
The current trend is one of strong growth. In the US, employment is leading to rapid wage increases in both small and large corporates. In our conversations with companies, discussion of labour shortages and wage hikes are a constant.
More people in work, earning more money and spending it, is leading to economic activity and higher prices – we see this in rent increases and companies’ increased confidence to raise prices.
Europe is similar, but about four months behind. The only counter example is China, where the regulation wave is creating uncertainty, and there has been a heavy lockdown to control Delta.
However, the Chinese government reacted by greenlighting infrastructure projects and increased SME lending. It is also highly unlikely we will approach President Xi Jinping’s re-election in October next year with the economy in recession.
Overall, strong activity is creating inflation everywhere you look, and the central banks are starting to move. However, the question is, will it persist?
Despite the heat in the US economy, Congress is introducing a huge infrastructure package. Why are they doing that? We believe we are in a redistribution of wealth phase and such periods can foster a dramatic shift in economic activity.
A book worth reading in this context is The Lessons of History by Will & Ariel Durant, who devoted their lives to studying human civilisation. In their gem of a book, they spotted recurring patterns in economies that apply today.
Firstly, they concluded that the free market was the most productive system in creating prosperity, but its downside was that it always led to inequality of wealth and power, as a small group adapts better to any given economic situation. Today, with globalisation and scaling of technology businesses, the available prize for this group in the knowledge and digital age has never been greater.
Secondly, they described the repeating element as the “Pendulum” – as the concentration of wealth, and hence inequality increased to extremes, it would break and swing back into wealth redistribution, which happens through legislation/regulation or revolution.
Today, we are seeing the two largest economies in the world starting to pursue legislative policy focusing on redistribution. In the US, this unrest was building through the election of Trump, but the storming of Capitol Hill by an armed mob in January, is a wake-up call to every politician that change must happen.
Since then, we have seen Biden announce further stimulus measures, family tax rebates, moves on minimum wages, and now infrastructure spending. In China, its focus is on “common prosperity”, which is about wealth redistribution and pulling lower-income workers up the income ladder.
In redistribution phases, generally, this creates years of higher economic activity, as income and opportunity are transferred to those who have a very high propensity to spend it. This biases us towards higher activity and growth providing a directional framework for inflation and interest rates.
Over the first half of the year, our global portfolio had a strong recovery element to it and now outside of travel, global recovery is strong and so we are moving to the next areas of growth and change.
We need to think about where the marginal dollar might be spent. This includes decarbonisation, a desire to automate as labour costs rise and trends like working from home changing preferences, and the march forward of technologies such as artificial intelligence (AI) and in healthcare.
Many of the solutions are industrial/technology hardware in nature, including copper, uranium, semiconductors, machine tools and equipment. It is still early days for many of these changes and many attractively priced stocks will likely benefit.
One such example is Showa Denko, a Japanese specialty chemicals and materials science company which is benefiting from decarbonisation. It is a major producer of specialty materials used in the manufacture of semiconductors. Increased electrification equals more power semiconductors, and so the growth outlook for this division is promising.
They are also the world’s largest supplier of graphite electrodes. A graphite electrode is a consumable used in making steel in an electric arc furnace. So, what does steel have to do with decarbonisation? Well, there are two ways to make steel – virgin steel uses iron ore and coking coal in a blast furnace or you can melt scrap steel in an electric arc furnace (known as EAF). EAF’s energy consumption generates 70% less CO2 vs. a blast furnace.
Over the past 20 years, China built too much blast furnace steel making capacity, and used this excess capacity to export and thus, crushed global steel prices. Now, to meet China’s CO2 goals, they are taking action, and despite record-high steel prices have moved to close blast furnace capacity, removed steel export credits and are importing scrap steel to switch to EAF. This is great for graphite electrode demand, and prices are rising. Showa Denko is trading on 9x earnings today or 4x earnings if electrode pricing continues to be strong.
Cameron Robertson: Asia
In recent months, while China has dominated news flow and Western media coverage has been dramatic, we continue to believe China remains a great source of prospective money-making opportunities for investors. When we see fear and uncertainty, and hear people referring to a market as ‘uninvestable’, this is a siren call for investors with a contrarian bent.
In China, the pressure is on politicians to adopt a more populist agenda given the social discontent through inequality. Reforms to try and spread wealth better are not necessarily the materialisation of some socialist-communist fever-dream. Rather it’s quite likely the political leaders are just trying to move to something a bit closer to what we have in Australia, Japan or Germany.
”Common prosperity” is an idea that has gained currency in China – this is how they describe these same issues of inequality. Despite being a single-party state, the Chinese government is acutely aware that their legitimacy rests upon continued improvement in the living conditions of the broader population. It’s not to say the execution is always perfect, but we are all familiar with the idea that good government intent can have a clumsy implementation.
And given its stage of maturity, there are a range of risks and issues. Their systems are more in flux, while regulatory frameworks and governing bodies are still in varying stages of establishment or maturity. Even anti-monopoly regulations are relatively new in China, with laws established less than 15 years ago. The State Administration for Market Regulation was only established in 2018.
So, investors have been spooked by a long-running series of regulatory interventions catching many off-guard. In the last couple of years there’s been: restrictions on approval of computer games; scrutiny around the storage and use of consumer data; anti-monopoly investigations; and changes to the property industry to try and get housing prices under control. There was the high-profile pulling of Ant Financial’s initial public offering (IPO) last year. Many of these issues are ongoing.
In July, there was a regulatory decision which essentially banned for-profit operators from offering tutoring to school children. We did have a small position there, which had been a carefully calculated risk, that did not pay-off. That was followed up by the news that China’s ride-hailing champion, Didi was in trouble for ignoring a regulator’s request. Markets fell, and we started hearing the question “is China uninvestable?”.
Tencent is an example of how we navigated this period. In the global strategies we were reducing our exposure through most of last year and in the Asian strategies from the fourth quarter of 2020. We were openly of the view that, while still a good company, the market was increasingly ascribing it a full valuation and risk-reward was becoming less attractive. As the stock sold off with escalating fear, we’ve been adding back to Tencent.
China is changing and growing, as you would expect of a developing country. Alongside that, the regulatory environment is evolving. Having recently established an agency responsible for policing monopoly practices, it’s no surprise there’s a catch-up effort there. It has been a bit of a cowboy business culture in China in some ways. Establishing clearer legal and regulatory frameworks, and enforcing them, is part of the process of becoming a more mature country.
This single-eyed focus on risks arising from regulation and government intervention misses the broader context. A strong, well-functioning regulatory presence is not altogether bad, though the transition from not having regulatory oversight, to having it, is bumpy. The end destination is not one to fear.
Large companies like Alibaba have come under scrutiny for policies preventing brands from selling through competing online sales channels. This was an explicit exploitation of their monopoly position in e-commerce. Here we would be shocked if companies were brazen enough to do these things, but some investors are decrying “crazy regulatory overreach”. With nerves fraying, we hear the old tropes about a “scary, foreign country”. People recall risks of fraud, auditability of accounts, Variable Interest Entity (VIE) structures, and more.
In Australia, it’s hard not to be influenced by geopolitics with leaders on both sides sabre-rattling and creating a more negative perception of the country. But, it needs perspective. China still only has GDP per capita of US$10,000. There are capable, well-educated, hard-working, driven entrepreneurs. Industries are still being formed. Consumer preferences are being shaped. Chinese companies are at the leading edge of innovation, globally.
And now, there is fear in the market. Compared to earnings, or to book value, the Chinese market is trading at a significant discount to the rest of the world, near its all-time lows. We go through these cycles and bouts of fear. But, we also, later have bouts of optimism, focusing on this wonderful growth opportunity. Historically, it’s proven to be a really attractive point to be getting into the market when it’s scared and hence adding back to old favourites like Tencent.
We’ve also been buying many emerging Chinese firms. Examples include:
A great medical devices business (small position) – another regulatory crackdown, because “bribery “was a big part of distribution – similar to pharma and medical device companies giving our doctors free holidays to ‘education seminars’. The regulator expressed displeasure and public hospital procurement practices have changed. Investors panicked, but we were able to invest in a globally competitive company, founder owned and run, operating as a domestic champion in a high-tech market dominated by Western multinationals. The government actually wants to give regulatory support to technology leaders like this. So, while the market’s focus is on procurement process changes and how they hinder marketing-led firms, this is an opportunity. Obviously, we haven’t just been diving in headfirst into companies facing regulatory pressures. Frankly, those are the small minority of our portfolio.
It’s not all regulatory driven – we own Leader Drive, the number two global manufacturer of harmonic drives – a key component in robotics. Their customers include high-profile Western players like Universal Robots, the clear market leader in cobots, or collaborative robots.
We own companies at the cutting-edge of applying artificial intelligence to healthcare problems.
We own companies helping to improve grid infrastructure, so that power systems handle the changing needs from things like renewables and electric vehicles.
We continue to believe China remains a great source of money-making opportunities and we’re continuing to scour the country for entrepreneurs and interesting businesses that are mispriced. We largely see the fear and confusion of some investors in the market as our opportunity.
But, despite all the focus and questions, there is a lot more to Asia than just China.
For example, we have a position in the dominant low-cost airline in India, InterGlobe Aviation. We purchased our stake during a COVID-related sell-off. This is a really well-run company with great long-term prospects, riding the wave of a growing middle class, hungry to travel. Their dominance over the local industry means they are competitively advantaged in serving customers, able to utilise scarce airport slots at major hubs to connect the country.
In the Asia strategy we also have holdings in some smaller companies in the region including:
IndiaMART, which is helping to modernise and digitise procurement for SMEs in India. We’re investing alongside the founder, who still runs the firm. And this is a marketplace business, with all the beautiful economic characteristics that it entails – serving a nascent market as millions of SMEs are still digitising.
Vietnam’s Mobile World Investment Corp. This is the largest retailer in a country that doesn’t yet have a well-established modern retail industry. Mobile World dominates consumer electronics retail, and has a rapidly growing grocery offering. This is all supported by a leading e-commerce presence and a toe-hold in the nascent Cambodian market. We think these guys are really well positioned. Revenues have grown four-fold over the past five years. The founder is still involved. And we were buying this on a teens-PE ratio, which is attractive.
So, it’s not just about China. But, given China has been capturing the headlines, it dominates the discussion, and is currently a fruitful hunting ground.
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