An unnatural situation for capital markets

The third quarter of 2020 kept investors on the edge of their seats. By the end of August, the S&P500 delivered its strongest five month return since 1938, shortly followed in September with the fastest technical correction sell-off of the NASDAQ in history.

In addition, of significance to Australian investors, the Australian dollar rallied from an intra-day low of 55.1 cents (March low) to approximately 72 cents to the USD which translates to an appreciation of over 30%.

Despite the intra-quarter volatility, the final outcome was a repeat of most quarters over the prior five years.

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Top Holdings (alphabetically)

Alibaba Group Holding LTD China Consumer Discretionary

Charter Communications Inc United States Communication Services

Cigna Corp United States Health Care

Houlihan Lokey Inc United States Financials

Lumentum United States Information Technology

Mowi ASA Norway Consumer Staples

Rakuten Inc Japan Consumer Discretionary

Tencent Holdings China Communication Services

Thermo Fisher Scientific United States Health Care

UnitedHealth Group Inc United States Health Care

The third quarter of 2020 kept investors on the edge of their seats. By the end of August, the S&P500 delivered its strongest five-month return since 1938, shortly followed in September with the fastest technical correction sell-off of the NASDAQ in history.

In addition, of significance to Australian investors, the Australian dollar rallied from an intra-day low of 55.1 cents (March low) to approximately 72 cents to the USD which translates to an appreciation of over 30%.

Despite the intra-quarter volatility, the final outcome was a repeat of most quarters over the prior five years.

The MSCI World Index finished up 3.7%, primarily driven by US large-cap growth stocks with just seven of these companies (Apple, Tesla, Amazon, Nvidia, Facebook, Salesforce, Mastercard, AMD) accounting for 47% of the total return. We think it astonishing that seven large-cap US tech companies accounted for almost 50% of the total return of an index composed of 3000 stocks.

We believe a combination of extremely loose monetary policy by central banks adding trillions of dollars of liquidity combined with ever-rising and potentially unmanageable debt levels on every balance sheet from consumers to governments has created an unnatural situation for capital markets.  This environment is one where investors are faced with few alternatives for allocating their capital, and in a small field of few choices, equity markets still offer some relative value. On an absolute basis, we believe equity markets in the US and in particular large companies are expensive. Given the alternatives (cash, bonds, etc), an argument could still be made to own these stocks.

However, our strong valuation discipline prompts us to look elsewhere leading to our decision to sell down our remaining positions in Alphabet and Microsoft. This is the first time since Pengana commenced managing the Portfolio that it has had zero exposure to any of the US technology behemoths.  By crystalising these gains we have been able to deploy this capital to companies with more attractive risk/return characteristics. The portfolio on aggregate still enjoys similar levels of growth potential with comparable quality without compromising on price.

Over the coming months, we see the potential for heightened volatility and a drawdown in equity markets.  However, we believe the Portfolio is well positioned and in our view on aggregate, our companies offer stronger growth characteristics, with cheaper valuations and higher business diversification than the typical global benchmark.  The Portfolio overall is out of the “crowded” companies and holds a number of positions that should benefit from a rise in uncertainty.

Portfolio Positioning

Some of the powerful long-term tailwinds behind companies in the Portfolio include:

• Emerging market consumption growth investments that are aimed at benefiting from the middle-class population growth. Examples include Bharti Infratel and Airtel (Indian telecommunications) and Chinese gaming and e-commerce companies (Tencent, DouYu, Nexon).
• Novo Nordisk, Medtronic, and Biotelemetry are examples of companies that are benefiting from an aging demographic trend.
• Green economy examples include those in plastic replacement and green buildings like SIG Combibloc and Stora Enso, as well as renewable energy players like Vestas.
• In the shorter term, and to address market disruption, we have invested in companies that would potentially benefit from heightened market uncertainty and the rise in volatility. For example, the quasi-monopolistic exchanges like CME, Deutsche Bourse, and market makers like Flow Traders who benefit from increased trading activity.

Long-term growth tailwinds are helping many of our holdings sail smoothly through the various choppy waters that undoubtedly lie ahead, and we maintain a long-term outlook when investing in companies.

We engage an independent third-party supplier, Sustainalytics, to help us assess the sustainability of companies in our portfolios based on their environmental, social, and corporate governance (ESG) performance. As at 30 September 2020, all the companies in our portfolio were compliant with the principles of the UN Global Compact and the portfolio had a “low ESG risk” rating, based on the aggregate weighted score of the Portfolio’s holdings.

During the quarter, the Portfolio returned 5.1% (net of fees) and the Benchmark returned 3.7%. This was a pleasing result given our underweight position in US and US large-cap tech stocks which were a strong driver of the Benchmark’s return. As at 30 September 2020, the Portfolio had a 92% exposure to equities with 8% in cash. The Portfolio has 31% allocated to companies across Europe ex UK, versus the Benchmark’s 15% and 41% in US versus 69% in Benchmark.

Pinterest, Vestas, and Alibaba were notable contributors to the Portfolio’s relative return while Bharti Infratel, Mowi, and Bharti Airtel detracted.

The Portfolio holds 38 companies that are on an aggregate free cash flow yield of 5% and an aggregate forward revenue compound annual growth rate of over 7% (as at 30 September 2020), offering investors a highly diversified portfolio of quality, growing and reasonably priced businesses. These measures provide us with confidence that the Portfolio is positioned well to outperform over the long term.