Valuations have been rebased across most asset classes – opportunities are starting to present themselves with quality that should shine in the future – Rhett Kessler

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We have been discussing for some time now the 40-year deflationary rate cycle that began in 1981 after the yield on US 10-year bonds peaked at nearly 16% and bottomed in the depths of COVID in 2020 when the yield reached almost zero. This cycle has created a tailwind for long-term asset prices for more than a generation of investors, culminating in the unsustainable valuations, particularly of “tech” or “growth” stocks, in recent years.

In addition to rates approaching zero, the ultimate end of the cycle in this case was brought about by the final onset of inflation and the unsustainable inflation of “real” negative interest rates globally. A prolonged period of “money printing” by central banks, government subsidies to manage the impact of COVID-19 on national economies, and widespread global supply shortages as a result of COVID-19 and war in Eastern Europe all combined to form a perfect storm where far more money in the system was chasing far fewer goods and services – the ultimate definition of the start of inflation.

At the start of the new calendar year, the Fund was strategically positioned to manage our assessment of these risks. As always, there was a strong preference for defensive business models. We held notable positions in financials (including banks), which we had identified as beneficiaries of a rising rate environment, larger than usual exposure to resources – mainly Evolution Mining for its hedging characteristics inflation linked to gold, and modest protection against put options.

On a stock specific basis, our larger holding in Telstra offered defensive cash flow supported by an unappreciated inflation hedge through its NBN income stream (not to mention the recent announcement of linked pricing to inflation in the mobile division). Our exposure to health insurers (NIB and MPL) gave us an improving industrial structure after COVID-19 and our holdings benefited from a higher rate environment via their investment floats. A new position in Amcor gave us highly defensive and diversified global cash flows at an attractive entry point, and BHP was trading at very attractive cash yields, providing a substantial (larger than usual) headroom ) to potential movements in the price of iron ore. Each of these stocks and strategies ultimately proved effective in weathering the market correction and were among the top positive contributors to performance for the year as a whole.

Unfortunately, their contribution was not enough to compensate for the massive and almost blind selling that impacted the market and the Fund as a whole. Generating a negative performance number is above all a disappointing result. However, what disappoints us the most is that in these market conditions we would normally expect the Fund to outperform the market. We have reflected on the many lessons learned over the past 12 months, but in summary, we would make the following observations:

  1. Compared to previous cycles, our liquidity was relatively low before the market correction. In what is perhaps evidence of our bottom-up approach to managing our cash, we had simply been able to identify what we saw as attractive opportunities to deploy cash through the end of the year. calendar year 2021 and we were generally comfortable with the valuations of existing holdings. Our cash was further depleted by the early January distribution to unitholders. This resulted in higher than usual exposure to the subsequent equity market correction.
  2. Put options put in place in the new year had an unfortunate expiration date days before the market correction began in January. We had assessed the pricing of new positions to replace them, but by then volatility had already peaked and the cost of new premiums was at a level we considered too high. This resulted in a lack of protection against the market downturn in January/February. We note that subsequent puts proved to be extremely profitable and were a key driver of the Fund’s “outperformance” in the June quarter.
  3. We experienced high levels of volatility from a number of our less liquid small cap positions. Although there is no significant weighting in the portfolio individually, we suffered a disproportionate negative impact from a number of our less liquid holdings. We remain comfortable with the underlying business models and cash flows of these holdings, which we believe will prevail over the medium to long term, despite their recent volatility.
  4. Finally, the Fund’s performance relative to the market suffered significantly due to its significant “underweight” position in the Materials and Energy sectors. Since inception, the Fund has had minimal exposure to the resource sector based on too many variables and therefore higher forecast risk associated with their business models. The Energy sector generated a return of +30% in FY22, while Materials declined -1.5%, both significantly outperforming the market. Together these sectors make up >25% of the ASX300 index, compared to a total mid to high single digit exposure for the fund (mainly Evolution Mining). As such, these sectors provided significantly more positive compensation for the market correction than they did for the Fund during the period. Of course, the reverse is true when these sectors are out of favour, which was to some extent the case in the opening week of the new fiscal year.

Looking ahead, we continue to plan for an environment in which economies around the world face the double whammy of having to digest the removal of unprecedented levels of quantitative easing and other stimulus, while adjusting at the inflection point of a 40-year period. interest rate cut cycle, with global interest rates once again rising at a healthy pace. The cost of silver is rising again while the availability of silver is falling, a troubling formula for investing in long-lived assets, to say the least.

We continue to position the portfolio to meet these challenges, ensuring exposure to business models with pricing power and low levels of price elasticity (to combat inflation) as well as those that benefit from a rising interest rate environment. In addition, our cash balance has increased from a low point earlier in the year – primarily due to elevated geopolitical risk and uncertainty – and we continue to benefit from our short position in the portfolio, which the value has increased significantly given recent market developments. movements.

Despite a high level of volatility in the markets, we remain more focused than ever on our main objectives of preserving capital and generating a reasonable real return for our investors. We continue to believe this is best served by a disciplined approach and consistent investment methodology. A variety of good businesses led by honest and competent management teams at the right price will create a well-diversified portfolio of ever-increasing cash income streams.


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