Rudi’s View: Regrets, 2022 Delivered A Few

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In this week's Weekly Insights:

-Final Weekly Insights For 2022
-Regrets, 2022 Delivered A Few
-Conviction Calls

By Rudi Filapek-Vandyck, Editor

Final Weekly Insights For 2022

Weekly Insights is taking a break until January next year, when we start preparing for the February reporting season.

I hope you all enjoyed reading my weekly writings as much as I enjoyed preparing and sharing them.

Merry Festive Season to you all!

Regrets, 2022 Delivered A Few

You just know 2022 has been an eventful, but certainly unusual year when you look back over your shoulder and conclude moving into Overweight cash early has been the best decision made in the year.

As the Federal Reserve in the US, and many central banks around the globe, abruptly reversed course and embarked on probably the steepest tightening path ever witnessed, it seemed appropriate to lift the portfolio percentage in cash to 30%-40%, where it has been until last month.

Cash makes up less than 20% in November, but serious considerations will be made whether it should be higher ahead of what promises to be another volatile reporting season in January-February (US and locally).

A decision to convert part of the portfolio into cash always meets with emotive resistance and fierce rejections among investors. Is it possible to "time" the market (including when to get back in)? Shouldn't investors simply take a long term view and resist the urge to respond negatively during times of extreme volatility?

Certainly, there is a class of investors who holds a strong belief that share markets always recover and post gains in the long run. Those investors have been busy buying more stock upon volatility and weakness this year. Judging from some of the data available, there has been a lot of such buying at lower prices this year.

Contrary to what many might expect, including experienced veteran market commentators, bear markets are never quite the same. 2022 certainly has not been one-on-one comparable with late 2018, 2015-16 or that dreadful 2007-09.

This year, the FNArena/Vested Equities All-Weather Model Portfolio found itself quickly on the wrong side of share market momentum. As an investor in long-duration, high quality and growth companies, owning shares in Goodman Group ((GMG)), Hub24 ((HUB)), REA Group ((REA)), Xero ((XRO)) and the likes was never the ideal starting point in early January.

While the pressure from rising bond yields was relentless and inescapable, we take comfort from the fact the portfolio sold shares and substantially lifted the allocation to cash.

But there's another observation that equally deserves to be highlighted: in my research I try to distinguish the higher quality companies from the rest. Not that high or low quality makes a lot of difference during the run-away bull market that preceded this year, but when times got tough, it most definitely did.

Whereas many a prior high-flyer got smashed to pulp in the first half of 2022, personal favourites such as Pro Medicus ((PME)), TechnologyOne ((TNE)) and WiseTech Global ((WTC)) stoically stood their ground, and not simply in a relative sense (though they did fall a lot less than most High PE peers); as we approach the end of the calendar year these stocks are sitting on a net positive return.

Yes, you read that correctly. 2022 has not all been about fossil fuels and large cap financials. One of the regrets for the year is the All-Weather Portfolio went cautious and conservative early, and this included selling out of Pro Medicus, Xero, Breville Group ((BRG)), Charter Hall ((CHC)), Seek ((SEK)) and Hub24.

We did not get back in. With perfect hindsight, there are no silver bullets when it comes to protecting one's capital. In light of next year's plausible ramifications from the international 2022 tightening frenzy, there are reasons to remain cautious on immediate prospects for Xero, Breville and Seek, maybe for Charter Hall too, but this year's regrets definitely include Pro Medicus, WiseTech Global and Hub24 no longer being part of the All-Weather Portfolio.

We will bide our time. Today's eerily calm is unlikely to be representative of what next year will look like for the share market. Opportunities will present themselves, exact timing unknown.

Moving a large percentage of the portfolio into cash is not a panacea for all conditions and circumstances, but my personal contribution to the public debate is that local fund managers saw their return slump to -20% or more, sometimes a lot more, and the All-Weather Portfolio has kept losses this year in the single digits.

Raising the level of cash was specifically aimed at exactly such outcome. Or as I like to respond when receiving questions about it: it's never an attempt to "time" the market; it's aimed at reducing risk. There's a difference between the two.

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Resources and other heavily levered cyclical companies remain off the menu for the All-Weather Portfolio and that's certainly no help in a year when shares in coal producers quadruple and earnings momentum, including massive dividend payouts, resides with closed shop fossil fuel producers (Ukraine-inspired or otherwise).

Bear market rallies, including the one that is currently still taking place off the October lows, have been fierce and powerful, and they too benefit the lower quality, small cap laggards most.

Somehow I feel we shouldn't be overly disappointed with the small portfolio retreat that will likely mark this year on December 31. Most portfolio constituents and companies on my radar have largely compensated for earlier losses in the opening months, in particular over the two months past.

CSL ((CSL)), for example, is trading in positive territory year-to-date, ex a small dividend, as is Amcor ((AMC)) though the latter made all gains early in the year. Overall, your traditional defensives largely missed out on sustainable market momentum in 2022, including supermarket owners Coles ((COL)), Metcash ((MTS)) and Woolworths ((WOW)).

The largest surprise, however, has been the significant outperformance of energy producers, which is not solely because of LNG exposure and not simply a local phenomenon either. Investors should always be mindful of the fact that share prices in producers do not by default blindly follow the price of the commodity, but this year's de-coupling of share prices when the price of oil succumbed to fears of global demand shrinkage is still remarkable.

There's no shortage in energy bulls in today's market, but history shows that gap between the price of oil and share prices in Santos ((STO)), Woodside Energy ((WDS)), et al will close, exact timing unknown, and there are, roughly, two scenarios:

-either the price of oil picks up again and share prices for the sector globally have been proven prescient, confidently focusing on underlying fundamentals rather than short-term volatility in futures markets;

-or share prices will fall to match the price of oil to the downside.

My favourite observation about bear markets is that of domino stones; ultimately the last ones standing will also fall. Note, for example, how shares in high flying coal producers quickly lost -25% and more in just a matter of weeks recently. The latest sector to be hit are currently the producers of lithium.

Of course, such short-term sell-offs tell us nothing about the longer-term up-trends, but it is probably wise to keep an eye on what is happening in those smaller markets for what might follow next for your typical fossil fuel energy producer.

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Among the beneficial decisions taken this year is the addition of the Vanguard Australian Property Securities Index ETF ((VAP)) to the Model Portfolio on the belief that, yes, inflation might stick around for longer and central bankers are not yet done with tightening, but bond yields might have seen their peak already.

This ETF was added on an implied yield above 5%. According to the Vanguard website, the yield has now shrunk to 4.6% (implying there has been a rally in the price).

Bonds no longer rallying has equally allowed the share price in the HealthCo Healthcare and Wellness REIT ((HCW)) to appreciate from a very beaten-down looking level in weeks past, though volatility remains high on a daily basis, and it has been a disappointing allocation overall.

We haven't lost faith and if next year brings us uncertainty over corporate profits and lower bond yields, we will welcome the prospective 5% in payout, hopefully with some price appreciation on top.

Telstra ((TLS)) remains another yield stock in the portfolio, to date generating a small capital erosion for a prospective 4.3%. Telstra's attraction remains the sale of infrastructure assets, while underlying the shares should benefit from the same bond market dynamics.

The portfolio also stuck with retailer Super Retail ((SUL)) whose come-back is currently in full swing. At just under $11, Super Retail's prospective payout should yield 5.5% in the year ahead, though a lot will depend on whether margins and cash flow can be maintained.

The latter might turn into a crucial question next year, as also suggested yet again by shares in over-sized women's wear retailer City Chic Collective ((CCX)) whose latest profit warning has caused the share price to tank by -50%-plus in two days, after the shares had already lost circa -75% since the all-time peak last year.

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The All-Weather Model Portfolio has had no City Chic experiences this year, which can be interpreted as a vindication of the quality company choices, as well as the decision to reduce risk.

Xero, for example, is still carrying the risk of significant further deterioration in the post-Brexit UK economy, while the geographic exposure to troubled economies stretches further for Breville Group. This is why both are no longer in the portfolio.

Inside the All-Weather Portfolio, companies such as Amcor, CSL, Goodman Group, TechnologyOne, Carsales ((CAR)), etc have mostly stuck with positive guidance for the year ahead. Disappointments have thus largely been macro-related, including negative impact from FX and bond yields.

With one notable exception…

Iress ((IRE)) used to be part of the higher quality ASX listings, which had gone through a tougher period dominated by margin pressures.

The dangers of investing in higher quality companies is that quality generally requires maintenance and constant investment. CSL, as a prime example locally, invests more than $1bn every single year to secure its product pipeline and guarantee future growth.

Iress, it seems, is today but a shadow of its former quality self. I wouldn't be surprised if in years to come, investors rank it in the same basket as the likes of AMP, Lendlease, Myer and Westfield. Maybe they already do and I have simply been too slow in catching up (?).

Compensating for the solidity elsewhere in the Portfolio, Iress has been forced to issue two profit downgrades in the year past. Time to remove this company from my research radar.

The Portfolio sold out of NextDC ((NXT)) early in the year, and returned at much lower price level, only to see the shares take another leg lower. It turned out, investors are worried about a potential capital raising assuming company management is still looking to expand into Asia.

We're comfortable with the market position and longer-term growth dynamics that support the investment thesis in NextDC.

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All in all, the key question that pops up as share markets seem hell-bent on finishing 2022 on a positive note remains: if one became cautious and defensive too early, does that mean the decision itself was wrong, or was it just that the timing was off?

By now, early in the year I would have expected corporate profits had wilted and central bankers would be closer to pause or pivot, but none is the case as we prepare for 2023 (though there's lots of speculation about the latter).

The market has simply split and polarised in 2022. While we can all make confident predictions about what might be in store for next year, I think it's important to keep an open mind.

Shorter-term, investors best not forget about the challenges that are hitting corporate margins and profits. Share price action this year has been mostly directed by bond markets and other macro-considerations, including speculation about central banks' stamina.

While the latter will remain with us for longer, investors might be forced to pay attention to corporate challenges in the not-too distant future.

When this happens, I think we'd want to be on the right side.

More Weekly Insights reading:

-Preparing For Bear Market Phase II:

https://www.fnarena.com/index.php/2022/11/24/rudis-view-preparing-for-bear-phase-ii/

-Re-Opening Opportunities In Healthcare:

https://www.fnarena.com/index.php/2022/11/17/rudis-view-re-opening-opportunities-in-healthcare/

-More Choice For Income Hunters:

https://www.fnarena.com/index.php/2022/11/10/rudis-view-more-choice-for-income-hunters/

-Technology's Moment Of Truth:

https://www.fnarena.com/index.php/2022/11/03/rudis-view-technologys-moment-of-truth/

Conviction Calls

Shares in Breville Group have come under pressure this month and the reason seems to be related to market updates by peer companies in the US.

Sector analysts at Wilsons and Jarden weighed-in on growing concerns last week.

Wilsons suggested with weakness popping up in Q3 market updades for the likes of Williams Sonoma and Best Buy, this might be an indication the US consumer is simply following into the footsteps of consumers in Europe.

Not colouring the overall picture any rosier, DeLonghi has signalled both increased discounting and strong growth in manual coffee machines, which might be an indication the Italian competitor is grabbing market share from Breville.

Jarden focused on the fact a number of US retailers is sitting on too much inventory; this raises the risk of general price discounting to reduce stock. As part of inventories are supplier funded, Jarden has scaled back its expectations for margins.

All in all, Jarden has moved to Underweight on the stock (downgrade from Neutral) also because of momentum concerns across the EMEA countries, with a reduced price target of $19.20.

Wilsons is still sitting on Market Weight with a price target of $22.10.

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When it comes to seeking exposure to the local lithium story, Macquarie's preferences are with Mineral Resources ((MIN)) and IGO ((IGO)).

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Goldman Sachs' A&NZ Conviction List consists of 13, all Buy-rated, ASX-listed companies:

-Charter Hall Social Infrastructure REIT ((CQE))
-Elders ((ELD))
-Fisher & Paykel Healthcare ((FPH))
-HealthCo Healthcare & Wellness REIT
-Iluka Resources ((ILU))
-Lifestyle Communities ((LIC))
-NextDC
-Omni Bridgeway ((OBL))
-Qantas Airways ((QAN))
-REA Group ((REA))
-Webjet ((WEB))
-Westpac ((WBC))
-Woolworths Group

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How low 2023? According to the latest investment outlook by Credit Suisse, global economic growth next year will slump to 1.6% only. And no major central bank is expected to cut its cash rate.

Credit Suisse believes investors should consider adding fixed income assets to their portfolios.

Other predictions made: the eurozone and the UK will see recessions, while China will experience a growth recession. All regions will start a weak, tentative recovery by mid-year, on the assumption the US manages to avoid a recession.

On freshly updated projections, GDP growth next year in the US is expected to average no more than 0.8%, but to stay positive nevertheless.

Economic growth in Australia is projected to decelerate to 1.6%, in line with international growth, from 4% this year. Local inflation is expected to peak at 8% and to have fallen to 3.5% by year-end next year.

Credit Suisse expects a muted performance for equity markets in the first half next year.

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The latest update on 2023 by Goldman Sachs essentially reflects the same blue print outlook as projected by Credit Suisse.

The numbers look slightly different, but Goldman Sachs also sees the US economy narrowly avoiding negative growth (i.e. recession) while the recovery in China is expected to be "bumpy" and underwhelming.

The Federal Reserve is expected to hike by a further 125bp to 5-5.25%. Inflation will come down. No repeat of the 1970s is anticipated. No rate cuts are expected in 2023.

Recessions in Europe and the UK are expected to remain relatively mild.

(This story was written on Monday, 28 November, 2022. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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