by Ray David and Joseph Koh – Portfolio Managers
When Freddie Mercury penned the eventual smash hit “Don’t Stop Me Now”, little did he foresee how the lyrics and growing song popularity would be analogous to market conditions today. Originally released in 1978 on the group’s album Jazz, the song only reached 86 on the USA’s top 100. Forty years later, “Don’t Stop Me Now” has grown to be one of Queen’s most popular songs – the band’s second most streamed after Bohemian Rhapsody. In fact, time has been kind, with “Don’t Stop Me Now” experiencing exponential streaming growth, as has occurred with the money supply due to central bank asset purchase programs. In 2013, the song was streamed 7 million times. In 2020 the song was streamed over 120 million times, taking total streams to over 1.1 billion on Spotify. Over time, “Don’t Stop Me Now” has been adopted by television shows, movies and commercials, urging consumers to splurge on brands from Google Photos, Toyota, and Visa to Cadbury Chocolate.
The urge has also been felt by central banks, with policy settings having been in clear “…don’t stop me, don’t stop me” mode for some time. Central bankers have leaned heavily on growing the money supply, after exhausting the official cash rate tool, with short term rates now floored to zero. Conservative term deposit holders are collateral damage; market speculators the beneficiaries. Governments have also chimed in with deficit monetisation, providing much-needed relief to offset COVID-19 lockdowns. The cost of this is a significant debt pile, making it more difficult for central bank policy to ever reverse course. Since March 2020, The Federal Reserve’s measure of M1 money supply has grown by $US 15 trillion. A stratospheric increase, with a significant portion of funds having ended up in financial assets. Inflation is now a mounting risk, the hangover of excessive policy.
Housing, crypto continue to soar
The ABC’s Four Corners exposé of the Australian housing market “Going, Going, Gone” paints the market picture aptly. One agent said, “People are buying property sight unseen from another state…they’re not doing building inspections…there’s a lot of people taking a lot of risk”. Feverish market conditions are not just confined to housing but exemplified by the growth of TikTok influencers preaching cryptocurrencies to penny stock pump and dump schemes. In an unprecedented move, ASIC stepped in to a private WhatsApp channel in October to alert pundits that pump and dump schemes are illegal. Unfortunately, “fintwit” influencers were overlooked in the Royal Commission into misconduct in banking and financial services and continue to influence inexperienced investors.
Short selling in these market conditions is fraught with hazard but could equally be rewarding. In a market that is overwhelmed by momentum and flow of funds, there are significant instances where market prices are deviating from fundamentals. One must simply observe the price action in Tesla, now valued at one trillion dollars, led by serial Dogecoin tweeter and Saturday Night Live host Elon Musk. Tesla is still yet to generate meaningful cashflow, and competitors such as Ford and Volkswagen are catching up. Then there was the Gamestop saga, the Reddit fan favourite which crushed short sellers following a concerted social media campaign, fuelled by viral memes.
Opportunities abound for short sellers
ASX technology darlings like Afterpay (APT) and WiseTech (WTC) have been short seller widow makers. WiseTech’s valuation is now breaching 30x revenue and is valued at $17bn for a company that originally quoted a total addressable market of USD $5bn at the time of listing. Looking at ASX300 constituents, you will discover a collection of billion dollar plus valued startups. These include battery technology manufacturing concepts, biotech development companies and undeveloped lithium mines. Combined, there is approximately $20bn of startup ASX300 market valuation for a total $135m of revenue and a cast of dreams.
Timing and sizing of short positions is critical to survival. Blow off risk is managed through an evidence-based process and strict risk management protocols. Portfolio diversification and tracking the short thesis is critical, as market exuberance can extend much longer than you can stay solvent. The advantage of fundamental investing over quantitative- or momentum-based investing is that fundamentals eventually prevail. Only sound judgement in sensibly weighing value relative to market pricing delivers investment returns over the long run.
Ask ASX listed data annotator Appen (APX), which uses humans to correct artificial intelligence models for Facebook and Google. Even these tech platforms know that artificial intelligence can go awry if not corrected. Financial markets are no different, as security prices tend to over and undershoot, especially under the weight of quantitative investing strategies. Today, Appen’s share price of $11.40/share or market capitalisation of A $1.4bn is down 72% from its August 2020 peak. While still highly profitable, the weight of money chasing Appen’s earnings upgrades ‘like a rocket ship on it’s way to Mars’, simply evaporated.
Positive contributors to the fund over 12 months have been investments in lithium producers Orocobre (ORE) and Independence Group (IGO). The outlook for lithium is no doubt positive as the world transitions away from internal combustion engines to electric vehicles. Lithium-ion battery demand is forecast to grow 25% pa to over 2,500 GWh/year, which equates to over a 5.3x increase in lithium demand from today. While we exited ORE during the year, we have retained our holding in IGO. IGO trades at a discount to ASX listed lithium players based on a price to book ratio, despite its investment in Greenbushes being one of the lowest cost and long life hard rock spodumene mines.
South32 (S32) was another positive contributor, having benefited from the increase in alumina prices, the feedstock into aluminium smelting. While aluminium has largely cyclical properties today, the metal is pivotal to a decarbonised world, with positive attributes such as the ability to complement or substitute steel, reducing the weight of a vehicle and carbon emissions. Aluminium is one of the most recycled materials in the world, with growing application in electric vehicles, solar panels and wind turbines. More recently, the acquisition of the Sierra Gorda copper mine increased S32’s exposure to green metal demand. Combined, S32 will derive 62% of revenue from copper, zinc/lead, nickel and alumina/aluminium at current spot prices.
Government intervention weighing in on gaming
The Royal Commission into Crown Resorts’ (CWN) Melbourne license concluded, which highlighted significant misconduct and illegal, dishonest, and unethical behaviour. The board and executives were found to have endorsed systematic failure and contravention of laws, in the pursuit of profits. The silver lining for investors was the Royal Commission recognised that cancelling Crown’s Melbourne licence could cause considerable harm to the Victorian economy, and that Crown could possibly remake itself to be suitable to hold a casino licence.
Our underlying thesis also considered that cancelling the licence would lead to a significant spread of illegal gambling, which is more harmful to society. Casinos exist today to facilitate legalised gambling, in full scrutiny of regulators. Gambling losses are then taxed, a portion then redistributed into society through state governments – something not achieved without a licence. We expect profits will be impacted by the adopted recommendations, which we have taken into account in our valuation. The end of capital expenditure programs should support a rebound in free cash flows back to shareholders, and the balance sheet is underpinned by significant property holdings. A stronger regulatory framework is positive for all stakeholders.
Fragile businesses are prone to disruption
On the short side of the portfolio, positive contributions were achieved from positions in infant formula producers, which have historically been dependent on a fragile distribution path to China. Chinese resellers, colloquially referred to as the Daigou trade, collapsed during the pandemic. Several reasons have been cited such as the halt in Chinese tourism and students from border closures, a growing preference for Chinese brands over foreign brands, and build up in channel inventory, making it difficult for resellers to earn a margin. The Daigou sales model is akin to a multi-level marketing scheme, where the next layer sales person is dependent on higher prices to make a margin.
A crack in this chain link can be devasting for end market pricing, as exporters such as Bellamy’s and Blackmores have realised over time. In a digital world, real time pricing can be tracked from various Chinese based eCommerce retailers, providing investors with pricing signals to predict the direction of Daigou trade. Without Daigou trade, the path to China is treacherous and requires lengthy licensing processes and expensive on the ground marketing and distribution. This is very different to Daigou trade, which are an indirect salesforce not on the company’s payroll. The collapse in earnings highlights just how fragile the business model is.
Our negative views on various contractor companies contributed positively to performance. Contractors employ asymmetric business models, where the downside skew is infinite, but the ability to earn a profit is capped. Especially intriguing is that publicly listed management teams have immaterial skin in the game. Therefore the pressure to grow revenue and earnings comes at the expense of shareholders, through writing risky contracts. In fact, many parallels can be drawn to the prop trading desk at large scale investment banks, where the poor shareholder wears the capital risk, while the glory goes to the executives.
Gold remains an uncorrelated asset class
Detractors during the period included overweight positions in gold producers Newcrest (NCM), St Barbara Limited (SBM) and Regis Resources (RRL). The significant underperformance of SBM and RRL relative to the gold sector stems from capital destruction due to poor M&A transactions and operational challenges. In the case of SBM, shareholders are still reeling from disappointing results at the Atlantic Gold operations, acquired in 2019 for $A 0.78bn. Operations have suffered, permitting delays which have pushed out production from the Beaver Dam pit to Q3 2024, leading to a year and a half of modest production from Atlantic Gold in the near term.
Similarly, RRL shareholders are still digesting the acquisition of the contested 30% interest in the Tropicana gold mine. Tropicana has a 10-year mine life based on current reserves but is experiencing declining head grades and cost pressures. Like all gold miners, multiple growth opportunities were being spoken about at the time of acquisition, but essentially the rationale behind the acquisition was to offset production challenges at the Duketon operations and lack of final approvals in the McPhillamys gold project. The securing of permits for McPhillamy’s will be positive for the company’s valuation.
Compounding these operational challenges has been a decline in the gold price from 2020 levels. In a world of financial repression and ever-expanding central bank balance sheets, we believe a modest gold portfolio position is warranted. Gold relative to most asset classes and money supply has had a disappointing performance and has low levels of correlation. We expect gold to outperform in times of uncertainty, particularly given shifting central bank policies. The gold price tracks closely to inversed real yields, which remain low due to rising inflation more than offsetting the rise in long term bond yields.
An underweight position in CBA also distracted from performance. Most of CBA’s outperformance has been driven by a multiple re-rating of the stock, which is now trading at a hefty premium to its major bank peers ANZ, NAB and Westpac. CBA, while having the highest ROE, trades at 20x PE compared to the peers at around 14-15x. On price to NTA, CBA is more than 2.5x compared to its peers at about 1.5x. Cheap money, thanks to the RBA, has provided a helpful tailwind to house prices and residential mortgage growth, which CBA is particularly leveraged to. These tailwinds are likely to subside in the near future, and the unwinding of bad and doubtful debts provisions looks to run its course.
While central bank policies have propelled markets, akin to Freddie Mercury’s words, ”I’m a racing car passing by like Lady Godiva”, policy winds are changing. The US Federal Reserve this month announced ‘tapering’, which is the reduction of asset purchases by $15bn per month, with similar reductions to be made each month. The RBA has ceased yield curve control (i.e. it has decided to no longer price-fix the three year bond market – Crown Resorts take notice!) and the Bank of England is expected to lift cash rates shortly. These measures will tighten liquidity, which is the oxygen of financial markets.
On the other side of the world, China’s President Xi Jinping is enacting his ‘common prosperity’ doctrine. This involves wealth redistribution and clamping down on property speculation. In fact, this is the reversal of settings that have been built up under western central bank policy. The difference is that China operates an authoritarian society and closed economy where changes can be made swiftly, compared to western global markets, which are beholden to fragile laissez-faire forces. These policy gyrations will eventually have second order market impacts, providing opportunities both from the long and short side of investing. A case in point is the wild swings in the iron ore price, Australia’s largest export, which has led to significant volatility in iron ore miner prices such as Fortescue (FMG), BHP and Rio Tinto (RIO).
The shifting sands of monetary and government policy do set a positive scene for the fundamental long short investor. Not so much for Freddy’s ‘Mister Fahrenheit’, the adequate metaphor for market euphoria, which has been powered by the steady march of higher asset prices thanks to easy monetary conditions. Against this backdrop, the opportunity to construct a portfolio of long and short securities has been rewarding, with the Schroder Australian Equities Long Short Fund delivering 11.8% above the ASX200 benchmark over a rolling 12 months, before fees.
We expect the outlook will remain fragile, as central banks did not consider the butterfly effects of COVID-19. These range from the surprise inflation spike caused by supply bottlenecks, the sugar hit from government stimulus programs, which is about to wear off, and the impact of climate change policies being adopted across developed countries. We believe central banks will be reluctant to aggressively begin ‘lift off’ of the cash rate, which could see a decoupling of inflation from short term interest rates, but more volatility in longer term bond yields. The reluctance to invest in fossil fuel generation is the wild card for inflation, as already evident from the surge in energy costs.