The year that has been
Everything is relative, we know. And so 2021 turned out to be a relatively easy year for equity markets after a 2020 worthy of a drama (but with a happy ending). The positive trend in growth continued, albeit more selectively. Cyclicals continued to recover from a three-year freak-out, culminating in Covid. The renewables bubble has burst and this sector can now offer attractive long-term opportunities, particularly through traditional stocks, perhaps not sexy but naturally positioned to benefit from the energy transition and with attractive valuations and limited downside. The recent incredible rise in fossil fuel prices provides a natural and powerful boost to renewables which, combined with legislative, regulatory, fiscal and ESG dynamics, will ensure their solid and sustained growth. The chain of renewables is long and areas that will benefit greatly continue to be neglected.
China was the most popular call at the end of the year. Indeed, growth in the region was strong, but the Chinese government’s attitude depressed the market from expensive to attractive valuations. However, when political dynamics are unclear, it is better to keep an eye on them and long investors will avoid increasing their positions here for a while.
Inflation has been in the news many times. Often in vain. A price shock due to supply chain disruption is different from inflation. We believe that, in the face of greedier prices for goods and services, supply will increase rapidly, but, unlike in the past, there will be no return to deflation. Fortunately. Deglobalisation and energy transition will reinvigorate economies, particularly the more arthritic ones like Europe and Japan. We expect that in 12-18 months negative rates will disappear and wage dynamics will finally get going again, not only for the privileged. We then expect greater participation in economic growth. More equity and less nationalistic regurgitation. This is the last call to move away from the extremism that has dramatically emerged in recent years. The stagnation of the 1930s led to the Second World War. History does not always have to repeat itself.
In Europe, Italy has seen a fine revival spurred on by a credible prime minister and Germany is electing a leader open to integration and far removed from the Calvinistic connotations of the Bundesbank. In Japan, nothing seems to be moving. A new, apparently conservative premier is elected. However, in the undergrowth, the rustle of change was heard throughout the year. The corporate governance of Japanese companies is evolving positively. Attitudes towards the foreigner (the deplorable Gaijin) are improving. Behind macroscopic cases of openness to hostile operations, such as Toshiba and Shinsei Bank, there were many smaller cases during the year. New investments from abroad have the potential to revive this market.
Covid always hovers and has created phases of panic and excitement. But less and less, recording decreasing excesses. Those who follow technical analysis should reassure us.
The FAIRR ( https://www.fairr.org/ ) is an association dedicated to animal proteins or rather their sustainability. Niche AM is a member of this association which, as every year at this time, produces an in-depth report on the main players in this sector. What emerges?
- Animal proteins from aquaculture are not only the healthiest but also the most environmentally sustainable in every respect;
- Half of the companies in the FAIRR index that produce animal proteins are now also exposed to alternative proteins;
- Most companies score very poorly in a) GHG emissions; b) Deforestation; c) Water use; d) Antibiotics; e) Animal living and slaughtering conditions.
- The best performing mammalian protein and alternative protein company is Maple Leaf Foods (Maple Leaf Foods | A Sustainable Food Company), which we have in the NEF Ethical Global Trends SDG portfolio.
- The aquaculture company that has improved the most this year is Tassal Tasmanian Salmon, which we hold in the NEF Ethical Global Trends SDG portfolio.
The two companies mentioned above are the only two that we hold in the animal protein producer universe. These two companies with which we engage combine the qualities we have discussed with attractive valuations, in line with our value approach.
FAIRR also produced another report on alternative proteins at the end of the year. These can be of different types:
1) Processed vegetable proteins that retain a distinctive taste from meat;
2) Vegetable protein products that are indistinguishable from meat (such as the Beyond Meat product);
3) Stem cell products that are, to all intents and purposes, meat but without the problems of sustainability (water absorption, plant absorption, GHG emissions), health (antibiotics, cadaverine, hormones) and ethics (animal suffering).
While point three will start to be attractive from a cost perspective from 2025, the other two points are already very attractive. Below is a histogram showing how the use of alternatives to meat has increased over the last year.
Finally, FAIRR has created the chart below which groups three cases of alternative protein penetration over the years by taking the range of some investment houses doing specific work on the sector. As you can see, there is a lot of variability but the direction is certain. Niche AM espouses the most aggressive case as does, we believe, anyone who has tasted Beyond Meat’s burgers. It’s only the beginning…
The term ‘punitive damages’ is used in law to refer to a sum set by a judge to punish the party found guilty, which is added to the part set as compensation for the material or non-material damage suffered. Punitive damages are usually huge, multiples of the sum fixed as compensation. The US is the cradle of punitive damages, where they were conceived and where they are applied on a massive scale. If one adds that lawyers in the USA are often paid with a part of the amount collected from the client and that most cases are decided by a, often very impressionable, popular jury, one understands how punitive damages represent for the big American law firms a greedy banquet to which they can aspire without budget limits. In other Western countries this category of damages is seen as a smokescreen, as it greatly increases the cost of doing business and exaggerates the incentive for law firms to impress the jury or manipulate the facts. The US Supreme Court has repeatedly lowered the amount of punitive damages to levels close to 4x the compensation for damages actually incurred.
Bayer in 2018 buys Monsanto, an agrochemical giant, for USD 63 bln. It also buys Monsanto’s ongoing litigation, including one over the carcinogenic effects of a herbicide, RoundUp, a litigation that Bayer considered low risk at the time. The herbicide had been on the market for almost 20 years and was one of the world’s best sellers. All major regulators had approved it. Thanks to the skill of a lawyer who finds an internal email in which a researcher informally and without elaboration expresses veiled doubts about the product’s safety for human health, Bayer in 2019 loses its first lawsuit against a gardener, Dewayne Johnson, who suffers from non-Hodgkin’s lymphoma. The judge there set the payment due to him at USD 289 million in compensatory and punitive damages. The company, after a couple of other defeats, despite continuing to be convinced that there was no basis for a damages claim, tried to arrange a final settlement, but could not agree on the amount to be allocated for future alleged victims. The company has set aside USD 16bn for ongoing litigation and has lost more than USD 60bn in capitalisation since this issue emerged. The company, which also has exposure to pharmaceuticals and over-the-counter products, trades at a P/E of less than 8x despite its exposure to growth and defensive businesses.
The stock today is already discounting dramatic scenarios related to this affair which therefore protect us on the downside. If the settlement closes at USD 16-20 bln, the company could appreciate by 50% over the next 3 years. In addition, there is an option that the market is not looking at at all, i.e. for free, which, if realised, could give us a further immediate upside of around 30-40%. So a total 3-year upside not far from 100%. The option is that the Supreme Court may find the case unfounded because the EPA, the federal licensing body, had approved the product and the instructions and warnings on the box. Punishing one company despite this would create a state of uncertainty in other companies leading to a rise in the risk premium and cost of capital that would ultimately be passed on to customers. So we believe that the possibility of the Supreme Court granting the petition and ruling favourably, however modest, is by no means priced in by the market.
Young Boric won. The left rises to power. The market goes down. Again. So? So good. Always respecting the geographical diversification of the portfolio, we have here an opportunity to accumulate weight on stocks we already know and follow in the country. Boric is not Che, he is not Chavez, he is not Kirchner. Boric is an intelligent person who wants to improve the country for too long in the hands of a few. A breath of democracy is due. Even the prestigious weekly Economist, which had expressed fears about his rise to power, has revised its positions. Chile is a solid country with large mineral reserves. The majority of Chileans are moderate. Boric will have no difficulty in replacing the support of the communists with other forces if they demand negative reforms for the country. The market has fallen a lot and so has the currency. In a world of emerging countries that are either too risky or too expensive, Chile represents an opportunity for those who want to diversify a little and know how to wait. We in Chile hold and continue to accumulate Enel Chile. This company has a reliable parent company (Enel), an extremely progressive renewables strategy and is worth a song. The company’s weakness largely reflects fears about the country, fears which in our view, as mentioned above, are now being exaggerated by the market.
Analysts are fascinating. Mythological figures between a man, an excel and a ruler, they often follow convoluted paths to define the desirability of a stock and its target price. Compared to a manager, they are usually less arrogant and more precise. But their precision often leads to metallic conclusions that make little sense. It is not unusual for them to be influenced by the trend and the market.
In the last month a well-known investment house that I won’t mention, Bank of America, a house whose research we nevertheless consider to be among the best, has downgraded two stocks that we copiously own, Orange and Credit Suisse, helping the already struggling stocks to fall further. We weren’t happy about this and went to look around the incriminated firms.
Orange. At the time of the downgrade, the stock was worth 9.5, with a dividend of 30 cents to be paid shortly, i.e. €9.2. The pre-Covid stock (end 2019) was worth between 14 and 15 euros. At the time, the company generated the same EBITDA as now, paid the same dividend (which today yields 8% versus 5.5% then) and had €3bn more debt. At that time, our analyst had a target of €15.5 with an FCF yield of 4% vs 6% expected today for 2022 and rising to 12% in 2023. The company now trades close to 4.5x EV/EBITDA with one of the strongest balance sheets in the industry giving us a 40% gross dividend yield for the next 5 years. Its large geographical diversification gives us some defence against regulatory risks, risks that we actually see as opportunities today (the regulator is clearly becoming milder). However, it is on the weak FCF yield of 2022 alone that the analyst advises selling. Downside risk he sees? 8%. How does he get to 8%? Frankly, we don’t understand…
Credit Suisse. Following the results the analyst puts an underperform on the stock with a target of CHF 8.8 (stock was trading at CHF 9.5). The downgrade comes on the back of a 29% earnings cut in 2022 linked to a known series of one-off events and an earnings upgrade for 2024 to CHF 1.39. This would take the stock on 2024 earnings to 6.8x earnings with a value to tangible equity ratio of 0.5x (CT1 at 17%). We are talking about tangible equity for a company that has a huge client-related goodwill value on its wealth management division. By valuing the WM division at a super conservative 1% of AUM (€1.5 trillion) and the rest of the bank at a paltry 1x tangible equity, Credit Suisse should more than double. A merger with UBS could pop up at any time. In a world of zero interest rates, this exceptional franchise should be sold, according to our analyst…
The year to come
With 2021 drawing to a close, one wonders what to expect from 2022. Expectations are fortunately tepid to dismal. Inflation, rising rates, sharply declining earning momentum, a business cycle that seems to have peaked, COVID recovery and restrictions, a creaking Chinese property market, serious geopolitical risks over Ukraine and Taiwan and a market that has come through an orgy of liquidity that has pushed it to very generous valuation levels. Why not get short and go to the Maldives? Why try to make a few more pennies on the back of solid greed when what’s at risk are the gains accumulated with hard work and patience that could quickly end up like the dugong?
There are many reasons not to sell. And even more reasons to move away from the indices that have given the most satisfaction in the past five years.
1.Inflation and rising rates. There are certain behaviours that come naturally. Turning away from a sudden noise. Rising at the sight of tasty food. Speeding up or slowing down if one is walking alongside. Desiring what one does not have. Taking for granted and not fully enjoying what one has. For the investor, the spontaneous gesture by definition is to lighten the equity portfolio when it smells of rising rates. Less liquidity around means that someone will have to sell. Why should today be any different? The answer lies in the fact that the inflation we see today is transitory and, as mentioned above, clearly linked to non-structural phenomena, and that the rate hike will be as limited as it is healthy for the economy. On the other hand, one does not kill an economy that is recovering to cure bottlenecks related to logistics, just as one does not cut off one’s big toe to cure an ingrown toenail. Moreover, there is so much liquidity around today that a few rate rises are unlikely to cause problems.
2.Earning momentum. The market can be divided into three categories. A) Stocks that do not have earnings but have high expectations and trade with a large proportion of these expectations, whether they come true or not. B) Stocks that do have earnings and are galloping fast. These stocks are now trading at very high valuations, which reflect a zero free risk. C) Stocks that make a lot of money relative to their stock market value, but show flat or negative earnings dynamics. While the former can simply be speculated on, the latter are definitely portfolio stocks, although any slowdown in their earnings could be very risky given their valuations. Finally, for those that are already cheap on flat or declining earnings, we do not expect that, excluding short-term volatility, there will be a lasting loss of value from a modest slowdown in economic growth. If they do, however, start to show stabilising or rising earnings the rerating can be massive and surprising.3.
3.The economic cycle is slowing down sharply because of the new COVID restrictions. However, today is different. The streets and shops are crowded. People want to get out and travel. And with vaccinations, hospitalisations and deaths are largely avoidable. Deglobalisation will bring in domestic investment in old Europe, the USA and Japan. In addition, huge fiscal stimuli are finding their way to stimulate the economy. The rebound will be strong again.
4.The Chinese property market is creaking because the Chinese government is making it creak. It is one of the tools to deflate a bubble while the economy is strong.
5.Geopolitics is unpredictable and always will be. Not investing for geopolitical risks is like not taking the car because there might be an accident. And then, in general, the volatility associated with geopolitical risks have always been buying opportunities.
6.Valuations. Valuations are irresistible. In our three funds with some 500 stocks on five continents, valuations are under 10x earnings and not far off net assets. There are large areas of the market that cry out for vengeance. It is criminal not to take advantage of them.
We believe that 2022 will bring us a lot of satisfaction, and the pessimism that prevails gives us serenity and confidence.
The newsletter will be back on 10 January.
Merry Christmas and a Happy New Year from Niche AM!