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Weekly Market Report
6 September 2022
US dollar surges but no Plaza Accord on the horizon.
Warren Buffett’s Investment Style: 85% Benjamin Graham and 15% Phil Fisher.
Global and local indicators.
By Nick Downing
US dollar strength has been a feature of global markets this year. Year-to-date, the dollar index has, gained from 95.67 to 109.97. This is an increase of 14.94%. The index tracks the strength of the dollar against a basket of major currencies. The index was developed by the Federal Reserve in 1973 and despite representing the world’s reserve currency has shown substantial volatility over the years. It peaked in 1985 at 160.41 due to severe monetary tightening as the Fed sought to slay the inflation dragon. Then, recognition that excessive dollar strength was destabilising for the world economy resulted in the Plaza Accord in September 1985, when leaders of the G5 group of nations agreed to coordinate efforts to weaken the currency. The dollar had strengthened by 50% over the preceding 5 years but by December 1987 the dollar index had retraced all the way back to 85.42 and years later hit a record low of 71.74 in March 2008 in the middle of the US sub-prime crisis.
The dollar gyrates according to economic cycles, interest rate differentials and capital flows. Against the euro, the dollar hit $/€1.57 in March 2008 compared with $/€0.84 in May 2001 and $/€0.99 today. The pound bought $2.41 back in 1980 but by February 1985 the dollar had appreciated to £/$1.08 only to weaken again to £/$2.05 ahead of the sub-prime crisis in December 2007.
What is powering the dollar today? It is the US economy, which helped by its energy self-sufficiency, is expected to escape recession. By contrast the energy supply shock stemming from the Ukraine war is wreaking havoc on other economies, especially in Europe and the UK, while China’s property market is entering a deep depression.
Interest rate differentials are also at work. The Fed is sounding increasingly hawkish and committed to beating inflation at whatever the cost, whereas other central banks are more circumspect due to the enormous burden being placed by energy prices on households and businesses. Gas prices in Europe have increased more than tenfold compared with immediate pre-pandemic levels. The level of energy costs as a share of US GDP is currently 5.8% whereas in Europe it is 18.3%. With the BOE less willing to do “whatever it takes” to beat inflation and with surging energy prices, Goldman Sachs predicts UK inflation could exceed 22% in 2023. The ECB will face similar pressure to dial back its inflation fighting policy measures. As a result, interest rate differentials with the US will widen.
Europe and the UK are in danger of severe energy supply disruptions in coming months. The answer to this is additional fiscal stimulus. Newly elected British Prime Minister Liz Truss has pledged tax relief worth £130 billion, which would exceed Covid furlough scheme support. Added pressure on the fiscus will further undermine the attraction of European and UK government debt. During August, the yield on the 10-year UK gilt increased surged from 1.81% to 2.88% amid wholesale selling by foreign investors. Where did these investors flee? Probably to the greenback.
Unless a global crisis is home grown as it was in 2008 with the US sub-prime crisis and Lehman Brothers bankruptcy, any hint of a global recession causes the dollar to strengthen amid a flight to safety. Investors flock to the world’s reserve currency in troubled times. The world is in trouble. Besides surging inflation and an energy supply shock, there is a war in Europe and tensions are rising between China and the West.
Emerging market currencies tend to suffer the brunt of any currency volatility especially those affected by substantial dollar denominated debt. However, developed currencies are also vulnerable. As Europe enters a deep energy induced recession, the spotlight will once again fall on the weaker members of the eurozone. The ECB will be under pressure to shore up the Italian sovereign bond market, which will require bond purchases rather than a reduction of its balance sheet. The pound is particularly vulnerable due to its burgeoning public debt but also its widening current account deficit, which in the first quarter of this year surged to a record 8.3% of GDP. The rapid increase in imported fuel costs is the main culprit. Under the Truss leadership, not only will the British fiscus deteriorate but relations with the EU are also likely to sour further.
Whereas the ECB may be forced to continue quantitative easing to protect eurozone solidarity the Fed is on track to accelerate the pace of its Quantitative Tightening programme with the aim of reducing its balance sheet from $9 trillion to $6.5 trillion. The price of the dollar is bound to appreciate further as the actions of the Fed and other central banks diverge and the pool of global dollar liquidity continues to shrink. Capital Economics forecasts the euro will weaken to $0.90 and the pound to $1.05 but some economists believe further depreciation is inevitable with the pound likely to reach parity with the dollar.
Divergence in economic growth, interest rate differentials, capital flows and dollar liquidity should continue to support dollar appreciation, but the currency’s strength could be a double-edged sword. A strong dollar will certainly benefit savers and Americans buying properties in Europe, but it may not be good news for US equity markets. The US will lose export competitiveness and overseas earnings will be worth less in dollar terms, whereas equity markets in the UK and Europe, already at their biggest discounts to US markets in decades, will receive a substantial boost from their more competitive currency valuations. A strong dollar will be a handbrake on US equity markets, but it will assist in lowering imported inflation, which for the time being is the Fed’s overarching priority. Hence it is unlikely there will be another Plaza Accord anytime soon.
By Gielie Fourie
INTRODUCTION: Warren Buffett, CEO of Berkshire Hathaway, describes himself as 85% Benjamin Graham and 15% Phil Fisher. He has often said that they were the two people who have had the most influence on his investing style. Who are Benjamin Graham and Phil Fisher? In what regard is Buffett 15% Phil Fisher, and would it be wise for us to emulate Buffett?
BENJAMIN GRAHAM: Graham (1894 – 1976) is known as the “Father of Value Investing” and was the mentor of Warren Buffett. Buffett knew Graham very well. Graham’s book, The Intelligent Investor, is described as the definitive book on value investing. It is regarded as the stock market bible ever since its original publication in 1949. According to Buffett it is the best book on investing ever written, and chapter 8 of the book is the best essay on investing ever written.
PHIL FISHER: Fisher (1907 – 2004) is lesser known. He authored the book, Common Stocks and Uncommon Profits, in 1958. Buffett met Fisher only once, but Fisher had an enormous impact on Buffett’s investment style. Fisher was one of the early proponents of the growth investing strategy. Warren Buffett said of Fisher: “I sought out Phil Fisher after reading his book. I am an eager reader of whatever Phil has to say, and I recommend him to you. Using Phil’s techniques enables one to make intelligent investment commitments.”
CHARLIE MUNGER: It was Charlie Munger, vice chairperson of Berkshire Hathaway, who really liked Fisher’s style, and he preached the Fisher doctrine to Buffett. Buffett explains: “I met Charlie in 1959, and Charlie was sort of preaching the Fisher doctrine to me. So, I was sort of getting it from both sides (a combination of value investing and growth investing). It made a lot of sense to me. Fisher’s basic investment style was to invest in a small number of companies with tremendous outlooks and do nothing.” This is how the mixture of the investment styles of Graham and Fisher (value investing and growth investing) developed. Charlie Munger coined the catchphrase: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
VALUE AND GROWTH INVESTING: Deep value investing is based on Graham’s theory of Margin of Safety. Margin of safety is a principle of investing in which an investor only purchases securities when their market price is significantly below their net asset value (NAV). In other words, when the market price of a security is significantly below your estimation of its NAV, the difference is the margin of safety. Cigar Butt investing is similar. You buy a company that is ridiculously cheap, but you think there is one good puff left in it. Buffett commented: “Though the stub might be ugly and soggy the bargain purchase would make the puff all free.” Value investing suggests that you buy low and sell high, but these companies normally needed to be turned around. They required too much time, energy and resources. Buffett discarded this strategy. Following Fisher’s advice, Buffett gave more attention to growth potential, and management. He favoured buying a wonderful company at a fair price and then holding it for a long time. “If you don’t feel comfortable owning a stock for 10 years, you shouldn’t own it for 10 minutes”. Graham would hold a stock for a year or two.
DISCOUNT TO NET ASSET VALUE (NAV) VS GROWTH: Fisher wrote: “The reason why growth stocks do so much better is that they seem to show gains in value in the hundreds of percent each decade. The cumulative effect of this simple arithmetic should be obvious. In what other line of activity could you put $10,000 in one year and ten years later…be able to have an asset worth from $40,000 to $150,000? In contrast, it is an unusual bargain that is as much as 50% undervalued.” Fisher’s strategy was to accept less on the value side and more on the growth side. In other words, rather buy a stock trading at 0.6x of its NAV than one trading at 0.4x of its NAV if you think the former stock is going to grow at 6% or more per year while the second stock will grow at 4% per year.
BOTTOM LINE: A strict Benjamin Graham value strategy, of buying a stock trading at the sharpest discount to NAV with no heed to whether it is expected to grow and selling it after a year, worked well during the Great Depression. Over time, Buffett gravitated towards lower maintenance stocks. He combined Graham’s ideas with Phil Fisher’s strategy of investing in a small number of companies with tremendous outlooks and keeping them for the long run with minimal interference. Aside from the fact that following Graham’s strategy subjects you to more taxable events and can keep you very busy, value investing is not nearly as self-propelling as buy-and-hold growth stocks. Stocks like Reinet, Remgro, Old Mutual and Growthpoint are good examples of stocks that you can buy-and-hold. They trade at discounts to their NAVs, but they also have good growth potential and good management. If you are interested in investing, contact one of our highly qualified consultants for a consultation.
The Bottom Line: Innovation and the Magic of Compounding
By Carel La Cock
The oldest investment trust listed on the London Stock Exchange can trace its beginnings back to the surging demand for rubber at the advent of the car industry. Following the Panic of 1907 when the New York Stock Exchange fell nearly 50% from its peak, credit markets dried up and realising the opportunity to lend to rubber plantations in Asia, Colonel Augustus Baillie and Carlyle Gifford established The Straits Mortgage and Trust Company Limited that would ultimately become the behemoth: Scottish Mortgage Investment Trust (SMT), a constituent of the FTSE100.
Baillie Gifford & Co, the investment management company that stewards SMT, oversee total assets in the fund of £16.67bn as at the end of February 2022. Outgoing manager, James Anderson, defined his career with early investments in Amazon and Tesla, which propelled the fund to cumulative growth of 696.8% in the last 10-years, compared to 220.4% for its benchmark, the FTSE All-World Index. Anderson’s investment philosophy has always been based on the belief that technological improvements will drive innovation and that even picking a small number of these successful future companies and holding on to them long enough to let the magic of compounding work, will lead to exceptional returns for clients. Tom Slater, co-manager since 2015, will take over the reins at the end of April and believes that it matters less failing to sell the holdings you should sell, than selling the holdings you should not sell. When they go long on investments, they remain long offering support as patient investors often nurturing private holdings until they go public.
After a stellar performance in 2020 which saw net asset value (NAV) grow by 106.5%, 2021 was more subdued by its own standards, up only 13.2%. This year the share price has come under severe pressure from rising inflation and the rising interest rate used in discounting long duration income flows on many of the growth stocks in its portfolio. Moderna, the manufacturer of Covid-19 vaccines and the largest holding in the portfolio at 8% is down nearly a third year to date, while Tencent, the Chinese e-commerce giant, at 4% of the portfolio is down nearly a fifth this year. Others in the top five holdings: ASML (-13%), Illumina (-9.6%), Tesla (-13%) and NVIDIA (-10.4%) have all been downgraded due to expectations of a steepening yield curve.
Is now the time to panic and if not now, then when? Geopolitical risk is at an all-time high, the US federal reserve has just hiked interest rates for the first time since 2018 and global inflation is running rampant while oil and gas prices have spike on supply fears. However, listening to manager, Tom Slater and deputy manager, Lawrence Burns discuss the current environment and the outlook for the portfolio in a recent investor presentation, you don’t get the sense that now is the time to panic, or indeed ever. Their strategy is long-term, and they have positioned the fund to participate in structural changes and technological advances in society. They have incredible deal flow built on decades of strong relationships and a reputation for stability and patience. Entrepreneurs are keeping companies private for longer and having early access to investment in these opportunities often leads to extraordinary returns.
As for its current top holding, asked if Moderna is a “one-trick-pony” with reference to the major windfall from the Covid19 vaccine, but recently downgraded as investors see the end of the pandemic and the Covid-19 vaccine franchise, Lawrence answered “Moderna is a one trick pony, but that one trick is a broad and important one and that trick is mRNA.” The biotechnology behind the Covid-19 vaccine is a powerful one with programmes to cure zika, HIV, cancer and a range of other ailments making the recent windfall unlikely to be a once-off.
Regarding the tightening of regulation in the Chinese technology sector and its impact on Tencent, the team thinks that the Chinese government is ahead of the curve in terms of regulation and that democratic western nations will eventually implement similar regulatory changes. They believe that companies that “go with the grain of society” and who are aware of their broader impact on society will find it easier to prosper. In this regard, Chinese tech companies are further along the route of enlightenment.
Lastly, Tom Slater does not agree that higher inflation and rising interest rates should lead to lower valuations on growth stocks. He cautions investors to also consider the impact of pricing power on some of these high growth companies as they become market leaders in their field. Therefore, with higher expected future inflation, one should also adjust the future cash flows that will yield a better current valuation. Looking past the current volatility, the fund has invested in some ground-breaking technology and the managers are excited by the intersection of computing power and biology calling the opportunity set “large and varied” They have 49 investments in private companies, and it is not difficult to imagine the next Amazon and Tesla coming from that pool.
Spend some time with our team to find out which one of our portfolios is best for you.