September 2021 Monthly Update

Updated: 4 days ago

Our funds underperformed the benchmark over the past year. Still high double digits, consistent with the history of the fund, but below the broader index. The last 12 months’ market returns were characterised by strong price appreciation for economically sensitive and high revenue (less profitable) growth companies. Once again, lifting of pandemic restrictions has generated an overly enthusiastic view that economically sensitive companies will rebound quickly across many business sectors. Insync deliberately has no exposure to stocks of this ilk. We favour companies that not only are some of the most profitable companies in the world but are also expected to consistently grow their earnings at high rates regardless of how the global economy performs. In this edition we explain why this works for longer term investors.

As the earnings growth across our portfolio continues to compound at high-rates, the gap grows ever wider between their stock price and their valuations (currently circa 50%+ below valuations). In these shorter periods of relative underperformance, a tension permeates in markets. This creates ideal conditions for entry as a sudden ‘snap-back’ in stock prices can occur very quickly. Snap backs are triggered by a change in market conditions, an event or simply the market recognizing the big disparities between the companies promising to deliver to the ones actually delivering.

We liken it to an elastic band. The more you stretch it (the widening of the gap between valuation and share price), the greater the likelihood of a rapid ‘snap-back’. Whilst it’s impossible to time exactly when the snap back will occur, when it does do so, it delivers strong outperformance to those stocks with the real underlying earnings and profits to support a sustainable uptick in their price. At the same time, the reverse occurs for those presently leading this latest bout of exuberant price growth.

We like value but we are not value Investors.

We recently had an extensive meeting with a fund researcher where we took him through our valuation approach. One of his key conclusions was that Insync is a ‘value investor’.

Whilst we would not describe ourselves as value investors based on conventional metrics (just buying companies based on low Price/Earnings ratios), an important part of Insync’s process includes building a high degree of confidence in understanding the worth of a company’s future cashflows beyond its present state.

To make money involves finding companies where the value we see is significantly greater than the price we have to pay. The current investor exuberance around

chasing returns in hyped up sectors has the Insync portfolio of quality growth companies trading at circa 50% below our assessed valuations.

A question to ponder is this…..

Would you buy into highly profitable businesses if you could buy them at such a large discount? And after doing all your investigations and crunching the numbers, its forward earnings were compounding strongly. Or would you buy a very richly valued popular business whose forward looking numbers don’t support its price but everyone was enthusiastic about it today? This is the choice that investors face and this sets up perfect conditions for the Insync portfolio to deliver strong returns.

P.S. Insync is of course categorised as a ‘Quality Growth’ Investor.

Traditional valuation metrics are losing their predictive power.

PE (Price/Earnings) and PB (Price/Book) ratios have been declining in their ability to predict value. The main reason is in the “E” part of the P/E ratio.

Our modern global economy is increasingly driven by intangible assets. Items such as intellectual property, R&D, brands, and networks. In the last decade or so this has accelerated to dominate in many key industries. In the past capital equipment and other tangible assets used to figure large on balance sheets.

‘Intangibles’ now represent 84% of the market value of the S&P 500 as depicted above. The old focus supported the old P/E and P/B ratios suitability. The problem occurs when it is applied to this new world - to the industries and companies that invest heavily in intangibles. It creates a misleading and distorted picture.

By example, when Pfizer invests R&D in a new drug for Covid-19 (forecasted to generate sales of US$45.7 Bn this year), or Amazon spending on building their cloud capability (sales of US$60 Bn expected from this division), these investments are classified as intangibles.

They have to be expensed through their income statements. This means it significantly depresses their earnings today despite these ‘investments of expenditure’ creating significant sales and profits for many years to follow. Their resulting P/E and P/B ratios are thus negatively impacted. This is important to remember when investing for the future. Beware of using the rear-view mirror. Life has changed. Fastest decline in history.

By way of contrast, old-industry companies, say a steel company, has to invest heavily in property and machinery (tangibles). The accounting rules treat these investments as capital expenditures. It immediately goes onto the balance sheet and does not detract from that year’s earnings unlike intangibles. Effectively this inflates its present earnings and the book value. P/E and P/B ratios look good.

This inconsistent treatment of the drivers of future growth between intangibles and tangibles leads to wrong conclusions on what actually represents good value and what does not. P/Es are thus not a useful indictor for industries with high intangibles, and even more misleading if taking an average across a broad index.

The key driver of future earnings - intangibles, is not being appropriately reflected in the income statements and balance sheets in a rapidly changing economy. Accounting rules have not yet adapted. This, we strongly contend, is a key reason for the long-term underperformance of Value indices post the Global Financial Crisis.

Intangibles- a key to investing in today’s world

Even though it is impossible to measure the value of intangibles precisely, it is essential for investment professionals to come up with a logical approach to incorporate intangibles into their decision making; otherwise, they risk being relics in this new age of information.

At Insync we have developed a systematic way of incorporating the cashflows that intangibles are delivering into our valuation methodology. This results in a more accurate assessment of the value of a business and a key reason of our successful stock selections.

Travel Revisited

Travel. Remember that? Long plane flights, new places, new people, new ways, new sounds. Whilst many of us look forward to travel once more, is it time to invest in travel? At Insync we believe yes but…… it all depends on how and where.

The Experience Megatrend, of which travel is a component, is one of 16 megatrends in the Insync portfolio. Like a giant tidal wave, megatrends tend to be very large, long lived and unstoppable. Therefore, it is unusual for us to sell out of stocks benefitting from megatrends. However, after an extended period of lockdowns and travel restrictions from a one-off global event reaching into the very heart of travel, it had become clear to us that the nature of travel was going to change in the post Covid world. We sold out of the pure play travel companies and studied deeper into what was probable in the years to come in travel.

The extent of the fall in travel has been unprecedented as seen in this next chart. Destinations worldwide lost a staggering 1 billion fewer international arrivals in 2020 than in 2019. This compares with the 4% decline recorded during the 2009 global economic crisis (GFC).