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Will 2022 be the year for quality companies?

I have previously written 2022 will be a good one for equities. Historically, the performance of equities, especially growth equities, innovative companies, and those with pricing power, during periods when deflation (consecutive years of lower rates inflation) coincides with economic growth has been consistently strong. I believe 2022 will reinforce that historical track record.

Markets have experienced a great run

Since the GFC, we have all been beneficiaries of an ‘everything bubble’. And over the last decade-and-a-half, thanks in particular to sharply-declining interest rates and the advent of unconventional monetary policy, that bubble has accelerated.

From technology shares, that in aggregate have advanced more than 10-fold, to the tripling in price of low digit number plates in less than three years, and from digital currencies advancing 16,000% in less than eight years to boring old US Treasuries returning 250% over 15 years, it is easy to fall into the trap of believing one is a genius.

As John F. Kennedy once observed, a rising tide lifts all boats, and for many, the rising tide, not the boat captain, has been responsible for the wins. For this reason alone, investors need to be aware that all bubble’s, even ‘everything bubbles’, eventually pop.

If 2022 proves to be the year the bubble pops, investors, depending on where they’ve ventured, must consider their response.

Quality falls less and recovers first

You see, the optimistic combination of economic conditions – deflation and economic growth - doesn’t remove the ever-present risk of a setback. One should always operate on the assumption the market could pull back 10 or 15% and occasionally much more.

At one end of the spectrum are the investors who have ignored speculation and focused their portfolios in the securities of the highest quality companies – defined by the aforementioned characteristics and to which we can add little or no debt, and sustainable high rates of return on incremental capital. Their response will always be the same; do nothing. Their securities will be dragged down in any sell off; however, they should fear nothing because their securities tend to fall less and recover first.

This has hitherto been the case for the highest quality larger issues. And for investors in these highest quality issues – I might count Reece, ARB, Cochlear, REA Group and CSL among others in this group – and with additional cash flow, the temporary period of price weakness should be used to add more securities to each holding.

As Ben Graham once observed, buy stocks like you buy groceries.

'Profitless prosperity' will be treated harshly

Towards the other end of the spectrum are those investors who have strayed from quality and drifted up the risk curve, purchasing riskier securities such as those I refer to as ‘profitless prosperity’ stocks. These will be treated more harshly in any rush for the exits and falls of up to 95% should not be surprising.

These investors must consider their weighting in such securities and 2022 is as sensible a year as any to rebalance. Some investors, especially those guided by wise advisers, will have appropriately allocated a relatively small portfolio weighting to riskier issues. The everything bubble of course will have enlarged that weighting and now might be a wise time to bring it bring it back to its original position.

At the extreme end of the spectrum are those who have ventured into asset classes that are purely speculative: today, it might be cryptocurrencies or NFTs (Non-Fungible Tokens) such as those by Bored Ape Yacht Club, CryptoPunks or RTFKT. Younger investors, in particular, have been lured into this realm, driving capital gains, which have subsequently attracted older and wiser investors, even some institutions.

I believe there is merit in the long-term disruptive power of the blockchain. At the extreme, there are legacy technology companies today that are dead men walking. They will cease to exist when blockchain technology reaches its full potential.

But there is also merit in the argument many of the current crop of blockchain beneficiaries are nothing more than speculative junk, playing on hype and celebrity to attract further acolytes to drive prices even higher. Sprouting terms like Web 3.0 - an amorphous mess - to justify their ‘investment’ and in some cases of hundreds of millions of dollars, many have forgotten their gains are based on nothing but popularity.

The metaverse and decentralised blockchain technology is promoted as taking power away from centralised financial institutions, Facebook and Google and returning that power to the masses. But the reality is that the financial gains from this decentralised phoenix remains firmly in the hands of those who control it and those who issue the tokens. According to Chainalysis and Flipside, 80% of the NFT market is controlled by just 9% of accounts. In cryptocurrencies, 95% of Bitcoin is owned by just 2% of accounts. The more recent Web 3.0 projects are launching with the same concentration of control, voting power and ownership as the technology IPOs of yore.

Popularity is not investing

With Facebook renaming itself Meta, and with companies like Nike and Adidas issuing NFTs of their own, it is easy to succumb to the hype. But popularity is fickle and many investors in this space, amid a deflating bubble, if they aren’t nimble, will find themselves holding valueless digital art. With NFTs, one cannot own the physical art but is instead paying huge amounts of money to merely have their name listed as the owner on a digital distributed database. So what?

If 2022 proves to be the year of a setback, any pain will be temporary for some but permanent for others. It might be wise today to review your portfolio and where you sit on the risk spectrum.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.

 

5 Comments
Mike
February 03, 2022

For me there are 2 key variables....a key metric such as PE and possibly more important Sentiment. Overlay this with your risk level and portfolio. PE 's of many quality stocks are high however i see more uncertainty ahead so sentiment is the dominant concern .Long retired but hoping for atleast another 10-15 years i still need growth as well as income flow. What to do? Retain core holdings,rebalance the remaining holdings with a no more than 15% in high risk and ensure the rest is invested with recognised ,ethical, well managed company's with a steady cash flow,limited debt ,,growing productivity and good staff relations. Not such an easy exercise! Research suggests there is a small group of company's meeting this criteria however they are not easy to find.So my strategy is monitor, not be greedy and spread my moves over time .

Rob
January 23, 2022

Good article Roger. On quality stocks yes, cream always rises to the top and stays there unless shaken or stirred. However, what you forgot to mention was the significant PE premium re-rating quality stocks have been priced at, post the Covid crash, as part of the “ Bubble of Everything”
While the market barely reacted to Omicron, the recent sell off triggered by the Fed early warning of impending liquidity tightening and acceptance that “ normalisation /mean reversion “ may not be too far away, some of the quality stocks you mention still trade at significant PE premiums to what was regarded as bubble pricing, before Covid hit in mid Feb2020. Mean reversion for quality stocks will happen, but will take longer. Examples are :
>CSL post Covid PE around 40x versus Pre covid 30 to 33x.
> Cochlear post Covid PE around 60x versus Pre covid 40x COH pricing also doesn’t fully reflect negative operating leverage from high fixed costs that required the large capital raising shortly after Covid struck.
>ARB post Covid PE around 33x versus Pre Covid 25x max.
Good luck to those who choose to live in the Metaverse, and put real money into Crypto and NFT’s.
A few may have some fun, but many will get burned. Someone bought a block of land next to Snoop Dogg in the metaverse for $450k ??
Hopefully they venture out into the real world, without VR headsets, to see the sun again.

Cryptoaussie
January 23, 2022

You are buying verifiable ownership of an item, thats what an NFT is. Any1 can download the Jpeg but when its comes to who actually owns the provenance of the item it's clear cut and can only be a single wallet at any one time. It's more about what that ownership grants you in terms of exclusive community access, airdrops and what not.

Hal
January 20, 2022

Reasonable RM statement: With NFTs, one cannot own the physical art but is instead paying huge amounts of money to merely have their name listed as the owner on a digital distributed database.
How about this variant? With crypto-currency, one cannot lay claim to the linked real currency, but one is instead paying huge amounts of money to merely have one's name listed as the owner on a digital distributed database.

Paul
January 21, 2022

Essentially you are buying a derivative with no income stream.

 

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