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Beware Of Undercurrents (PiggyBack August 2022 Market Comment)
The stock market's surface lays still after a summer recovery rally. So things are rosy? Not really. Long-term investors face fundamental undercurrent risks, especially in U.S. stocks. (PBL #6 2022)
This week’s free PiggyBack Letter (PBL) is a short comment on the recent 2022 (bear market?) summer rally. Takeaway: entry valuations still matter for long-term investors. Medium-term we have an inflation problem to consider.
In our new link section PiggyBack’s Value Elsewhere, we highlight an interesting holding company discount read.
Johan Eklund, CFA
Beware Of Undercurrents
August 2022. A treacherous calm has set in on the global stock market’s surface after a summer recovery rally. Sentiment- and macro-wise, this may look/walk/talk/smell like a bear market rally. So market strategists and traders suggest tactically reducing risk exposure as the sensible thing in the short run.
If they are wrong? A “pain trade” for short-term market timers would be "recovery" to new levels of low-interest rate market craziness. Fear Of Missing Out (FOMO) all over.
We are not in the business of making or trading these shorter-term market calls. PiggyBack is in the business of making long-term fundamental risk-reward calls.
Strategically, there are a few important stock market undercurrents to beware of today. Fundamental forces that will affect the long-term investor's expected returns. Beyond the next month/quarter/year leg price move in the markets.
Medium Term Risk: The Inflation Problem
Let’s say inflation does not come down fast with increased interest hikes into a global recession. Then we have a stagflation problem. (As we discussed here.) Here it is better to be safe than sorry in equity portfolio risk management.
But playing safe does not need to mean market timing, in terms of selling everything in hope of being able to buy back cheaper. As long-term investors, we can also express the inflation risk in our security selection.
Until the inflation shock is under control there is a clear risk of lower equity valuations:
If central banks fight inflation credibly with (much, much) higher interest rates, those interest rates mean higher discount rates and lower valuation multiples on stocks. Here the highest valuation multiple, “glamour” stocks are most susceptible to return headwinds. They get crushed via falling share prices, the classic valuation multiple compression. Especially if their businesses are cash-flow negative and rely on issuing new equity to keep their doors open. Like many recent year unprofitable growth tech darlings and SPAC IPOs. Falling share prices here means worsening dilution of existing shareholders, with each new round of capital needs.
Lower earnings/asset quality business stocks may face severe headwinds if higher interest rates deepen a recession. Even risks of being impaired in a restructuring/bankruptcy if cyclical customer demand drops to where it no longer supports fixed costs or debt loads.
And if central banks capitulate and let inflation run to “save” the economy, the same lower earnings/asset quality stocks may still destroy capital, only more slowly but steadily. Here the problem is lacking pricing power, to compensate for long-term cost inflation on inputs and reinvestment.
Note that low quality businesses include low quality value stocks. If shareholders do not demand strategic asset sales, mergers or liquidation in time, their initial asset discounts are like melting ice cubes.
So where to hide in stocks?
One can try to position in at least some stocks with built-in inflation protection, or even inflation upside. Think commodities, energy, infrastructure, utilities, staples, and well-positioned suppliers to such industries.
Another option are strong pricing power asset-light “quality” businesses with non-cyclical demand. Easier said than done to buy these at discount valuations, but bear markets present some such opportunities.
Related to inflation-fighting via higher interest rates are risks of tighter financing conditions. Given the levels of debt that have been propped up by near-zero interest rates and central bank purchases, expect some things to break if inflation interest rates continue higher.
While the timing, chain of events, and collateral damage in terms of regions and sectors are uncertain, major stress events to the global financial system are a recurring phenomenon after long periods of credit expansion. It is prudent to plan for short-term credit to tighten or dry up:
Refinance for longer maturities and fewer covenants on any well-motivated financial, business, and personal debt leverage.
The same goes for stock-picking. Avoid firms that depend on highly levered, short term debt profiles to produce meaningful shareholder returns.
A positive leverage case can be found in firms that lock in attractive long-term debt against some convincing long-term investment plans. While not without risk, properly used leverage can create long-term printing presses. Debt creates the opportunity to build real equity as inflation reduces the debt’s real payback value. Debt also provides a cash tax shield, so that more current income can be reinvested or distributed.
Long Term Risk: The U.S. Valuation Problem
Geographically, the U.S. stock market is still historically expensive. See for example Research Affiliates’ excellent cyclically adjusted P/E (CAPE) summary.
The basic fundamentals: U.S. stocks price in low interest rates and near-record profit margins. In the long run. Nothing new here, but still time to reconsider. If we are to make a macro bet, do U.S. equity valuations provide worthwhile “bang for the buck” (risk reward)? Your Analyst doubts it, more broadly speaking. A market that is not a good value will still have its pockets of value though.
Long-Term Opportunity: Global Value
Let's end on a positive note. Research Affiliates' data also highlights an aspect overlooked by today’s U.S.-focused equities bears:
Many regions around are already getting more reasonably priced, or even cheap. Both from historical and fundamental valuation perspectives.
Global diversification we have already discussed. An active, long-term investor making use of that opportunity should currently have no lack of value stocks to pick apart. And PiggyBack.
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PiggyBack’s Value Elsewhere
Free value investing content and other recently enjoyed curiosities with “shelf-life”.
The Wolf in Cashmere’s Conglomerate (~53 min)
Ever wondered about the origins and playbook of global luxury conglomerate LVMH? (Moët Hennessy Louis Vuitton, Euronext Paris ticker: MC)
Mr. Christian Billinger, CFA, a Swedish investor operating the private family holding company Billinger Förvaltnings AB, breaks it all down. Get great insight into the economics and practical realities of investing in true luxury. Hint: Quite different from performance-focused premium brands. Host: Zack Fuss for Business Breakdowns
BEEPING Holding Company Discounts (~10 min read, ~2 min comment)
“For various reasons, holding company discounts are evident across the world. Most management teams shrug their shoulders when the right thing to do for shareholders is to just spin off their holdings. However, a corporate manager’s natural compulsion is to preside over the largest possible empire rather than a smaller one.”
— David Eborall, CFA portfolio manager SaltLight SNN Worldwide Flexible Fund
SaltLight SNN Worldwide Flexible Fund, managed by South Africa’s Saltlight Capital, published an interesting investor update this summer. Portfolio manager David Eborall’s topic was holding company discounts. Specifically, the value that insiders and major shareholders can unlock from big discounts.
SaltLight’s example was extreme: the Amsterdam/Johannesburg-listed holding company Prosus (ticker PRX for both, and U.S. ADR PROSY). Prosus's main asset is a long-term stake in the Chinese Internet giant Tencent (Hong Kong-ticker HKG: 0700, U.S. ADR TCEHY). Earlier this year, the market value of Prosus’s Tencent stake was around twice Prosus’s total market value.
This means the market was so pessimistic that one could buy Prosus shares to:
Get indirect Tencent exposure for only half price.
And get the rest of Prosus “for free”. (This remaining portfolio at the time had got a low accounting book value, compared to the Tencent stake.)
Professional speculators: One could also buy Prosus while short-selling Tencent. This creates a purer bet on a narrowing Prosus discount. More or less isolated from Tencent’s short-term share price movements.
Your Analyst has nothing intelligent to add about Tencent’s valuation at this moment. Most of our readers should however sense the bargain opportunity. PiggyBack will hopefully get to offer readers a fair share of digging deeper into holding discounts.
Chart of the Week - Global Equity (Population) Growth (~2 min)
An easy-to-forget demographic challenge for the world economy: population growth is stalling to a near halt in Developed Markets, and to very low levels in Emerging.
Combine with populations that generally (1) are getting older and (2) already have seen women joining the workforce. This means that the Developed and Emerging world will have to do without the historical tailwind of a steadily growing labor supply.
Optimists look to Frontier Markets for more predictable demographic tailwinds. S&P Global Ratings have highlighted Sub-Saharan Africa in particular.
Chart by Callum Thomas’ paid publication Topdown Charts. Mr. Thomas also publishes the free The Weekly S&P500 #ChartStorm, a PiggyBack Recommendation:
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Johan Eklund, CFA
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