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MarketUpdate – 4 June 2020 BY ANDREW CLIFFORDWe are certainly...

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    MarketUpdate – 4 June 2020 BY ANDREW CLIFFORD

    We are certainly living through anextraordinary period. As restrictions are being eased in much of the developedworld, we provide an update on our view on markets, how the portfolio ispositioned and performance.

    I can’t emphasise enough howimportant it is to understand the moves in individual stock prices that aredriving the market indices. Despite the economic backdrop, or perhaps more accurately because ofit, we are in the midst of a raging bull market in a relatively small number ofstocks. Arguably, the rest of the market is in a prolonged and deepening bearmarket. This is giving rise to extraordinary opportunities to not only makemoney in stocks, but at the same time an extraordinary opportunity to dopermanent damage to your wealth.

    Our view is reflected in the way wehave been positioning our flagship global equity portfolio, the PlatinumInternational Fund (“Fund”). On 3 June 2020, the cash levels in the Fund hadfallen to 6%. This is a result of the opportunities that this crisis haspresented in both new and existing holdings. However, this change inpositioning understates the movement in the portfolio, as we have also soldother holdings, predominantly those that have performed well, to fund thesepurchases, in addition to drawing down cash. Please do not interpret this asoutright bullishness. These positions are predicated on a long and slow grindout of the deep recession we are likely facing. Indeed, many stocks we havebeen buying have risen sharply and are reaching short-term price targets andmay be trimmed or sold. Markets are moving very quickly.

    The short positions have beenreduced significantly in recent weeks and as at 3 June’s close were at 10%,with a resultant net exposure of 84% for the Fund. Again, this is not a sign ofbullishness or a view that we are over the worst. It reflects a reluctance toremain steadfastly short in the face of:

    1. 1. A high degree of cautiousness byinvestors. There are many, including ourselves, who would argue that when amarket index, such as the S&P 500, is down less than 10% from what wereenthusiastic levels reached in February, when we are facing what is likely tobe one of the deepest recessions on record, that this makes little sense. Most days, the front page of the Australian Financial Review carries articlesoutlining the cautious views of fund managers, many of them with extraordinarylong-term track records. When such cautiousness is pervasive, even from capableand experienced investors, markets have a low probability of falling dramatically.

    2. Secondly and more importantly, we, aswould many others, attribute the level of markets and asset prices generally,to the creation of new money in the system resulting from the various fiscaland monetary initiatives of governments and central banks around the world. Atsome point, this support for asset prices will fade, perhaps as economies startto recover and this new money is absorbed by economic activity. We shall see.However, for the moment, it is likely that we will continue to see new initiativesfrom governments, as we are now seeing being discussed in Europe, the US, andhere in Australia, which will potentially create more money and further supportasset prices. As always, these type of variables are near impossible topredict.

    So, for the moment we have cut backon our shorts, but again, please do not take this as a bullish stance. We havea long list of potential short ideas, companies whose businesses have beendamaged by this crisis, and yet whose stock prices are back near, or even above,previous highs. We continue to look for potential catalysts for these stockprices to break lower, either individually, or in aggregate. We will continueto look to protect the very real downside that investors face as a result ofcurrent market conditions through the use of individual stock shorts and indexshorts.

    It is important to carefully examinethe bifurcation that is occurring in the performance and valuation of stocks.It is not the first time this has been experienced in stock markets and asusual at this point, there are many reasons being put forward as to why “thistime is different”. Among them, is the transformative impact of the internet,the cloud, and ongoing technological developments. Yet, this same phenomenon ofstretched valuations can be seen across industries, not just in technology. Inthe past, I have mentioned the extraordinary valuation of consumer staplesstocks, such as Colgate and Nestlé, yet these types of stocks have generallymoved higher. Within the technology sector, it is not just about theextraordinary monopoly power that has accrued to the likes of the FAANG stocksor Microsoft. Indeed, the valuations of Facebook, Alphabet and Microsoft arefar from the most challenging within technology. In past commentaries I havediscussed the extraordinary valuation of the software-as-a-service (SaaS)stocks that defy basic mathematics and probability, though many of these havemoved significantly higher in recent weeks. I will not go through these again,other than to say that these differences in valuation are not at all explainedby “it's different this time” theories.

    I appreciate that some of ourinvestors will be questioning our position, after all, we have been talkingabout this at length for over two years now and the valuation differentialshave continued to widen, and very dramatically so in the early months of 2020and in the COVID-19 period. For anyone who is interested in an alternativeapproach to examining this issue, I suggest the following article “Is (Systematic) Value Investing Dead?” by AQR, one of the world’s pre-eminent hedge funds.[1] I do recommend reading this article, while they approach markets from a purely quantitative approach, they conclude similarly to our qualitative approach to finding value. (I should add, our very capable but much smaller quant team has delivered the same findings internally.) The high-level conclusion of their paper, is that the differences in valuation between the highly rated (or growth stocks) and the lowly rated (or value stocks), are more extreme now than they were in 2000. We all know what came next.

    If it is not the beauty oftechnological change that is driving this phenomenon in the stock market, thenwhat is it? It is simply risk aversion of investors forced into the stockmarket by low interest rates. And here is the problem for owners of the fanciedgrowth and defensive stocks today. They have made good money, partly because ofthe strong performance of the underlying business in some cases, not in all,but largely they have made money because of falling interest rates. Is this abet one would want to continue with as rates approach zero in the UnitedStates? Most investors can’t bring themselves to buy the US 10-year Treasury at0.74%.[2] But if you can’t do that, why expose yourself to thesame risk by owning stocks whose high valuation is predicated on rates at thatlevel.

    To return to the portfolio, at theindividual stock level, the crisis has provided an interesting set of newopportunities. One of the obvious areas, which you would expect us to belooking at, is travel. This industry will face a long recovery period, withsignificant unknowns around the opening of borders. There will be some changearound behaviours with respect to business travel. However, as the fear of thevirus passes, which will be accelerated if a vaccine becomes available, travelwill return. It is a hard-wired part of human behaviour and it will recover andthen continue to grow. Our timeframes in assessing the potential of these travelbusinesses are based on recoveries that take at least three years. We are nottalking about entering the dark den of buying airlines or cruise companies thatface the potential of bankruptcy if the recovery is slow. We are buyinghigh-quality businesses with pristine balance sheets, many of which werepreviously valued as high-flying growth stocks. Examples of current holdings inthis sector include Booking Holdings, the owner of the world’s largest onlinetravel agent Booking.com. Another area of interest, is aerospace andspecifically the aircraft engine manufacturers, who operate classic razor andblades style business models, where engines are sold at near cost, but profitsare made on spares and maintenance. Generally, these are highly predictable businessesthat generate strong cashflows, but the growth in the spares and maintenancebusiness is a function of how many engines have been sold and the number of hoursflown. Clearly, they have taken a hit on both fronts. General Electric is oneof the Fund’s holdings in this sector that we have added significantly to inrecent weeks. Other new stocks include biotech and healthcare names, and asoftware-as-a-service business, all of which were sold down significantly inMarch and April. We also took advantage of attractive prices to add to existingpositions in semiconductors, such as DRAM producers, Micron and Samsung, whichwe have discussed at length previously in our quarterly reports, and electricvehicle plays such as battery maker LG Chemical. In Europe and China, one areaof likely government spending is decarbonising the economy, and as such theelectric vehicle story is likely to receive a significant boost.

    On currencies, we have beenmoving away from the US dollar. We did hedge 10% of the Fund back into theAustralian dollar (AUD) when it was trading below 60 cents. Unfortunately, thiswindow was brief and we have been surprised by the ongoing sustained strengthof the AUD since March. We also added to our euro exposure (now at 21%) andclosed our Chinese Yuan shorts.

    Over the last two years, performancein most of our funds has lagged relevant market indices, with a coupleof notable exceptions. I have little doubt that this is a cause of concern andfrustration for investors, as much as it is for us. While one can look atcontributions of longs, shorts and portfolio positioning through time, the mostsignificant factor in our lagging performance is this widening gulf between thenarrow group of stocks driving indices higher and the rest. We are being askedmore frequently if our approach is broken and whether we should change tack.

    My response is this. At the core ofour approach is the idea that our cognitive biases will cause humans to overdiscount the bad news and over extrapolate the good. While we are inextraordinary times in financial markets, I doubt very much that basic humanpsychology has changed at all. The times may be extraordinary, but they are notunique, not at least as far as the stock market goes. We have been here before,or at least somewhere quite similar to this on a couple of occasions in thelast 26 years and at those times our approach ultimately produced very goodoutcomes for investors.

    Now turning to an update on healthcare and Asia. Our inhouse virologist and portfolio manager for thePlatinum International Health Care Fund, Dr Bianca Ogden, noted that a numberof things are happening in relation to SARS-CoV-2 (the virus that causedCOVID-19). For example, global testing capacity continues to increase, withsome countries establishing ‘testing tents’ to regularly test employees andschoolchildren. Tracing is paramount to containing outbreaks and for monitoringwhen to increase containment measures. Her team is seeing some vaccines in thenext phase of human testing, while others are at the start of the human testingprocess. Many companies are expanding manufacturing capacity, sometimes withgovernment financial support and various collaborations with contractmanufacturers. Meanwhile, on the treatment side, several new therapies will betested and data is expected by the late Northern Hemisphere summer. Hospitalsare vigilant and doctors are better prepared, with much greater knowledge aboutthe disease. The pandemic has highlighted the arsenal of tools being developedby the biotech industry. It is a watershed moment for demonstrating swiftdevelopment and both scientific and commercial capabilities.

    With respect to China’s economicrecovery from COVID-19, Dr Joseph Lai, portfolio manager for the Platinum AsiaFund, noted that there has been a general pick-up in activity and this iscoming through in his team’s dialogue with corporates. Strong companies appearto be doing well and in some situations, it appears that markets areconsolidating more rapidly around a number of dominant players. The recovery isalso revealing pent-up demand in a number of areas, including smartphones, andimportantly, this is being achieved without the need for major governmentfinancial stimulation, which is a good thing, down the track. Whilegeopolitical tensions appear to be on the rise, this is often reflected in theshare price. It is sensible portfolio management to try and avoid those companiesdirectly in the “line of fire”. The portfolio has been focusing on ‘domesticchampions’ in China and looking outside in the rest of the region. There are anumber of companies that may indeed be direct beneficiaries of increasedtensions, if not simply immune.

    www.platinum.com.au/Insights-Tools/The-Journal/Market-Update-4-June-2020
 
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