Introduction: In a happy coincidence, in the same week that Anton Tagliaferro of Investors Mutual was honoured in the Queen's Birthday 2022 awards for services to charities and the investment sector, a reader sent us an article written by Anton in 2006. It is remarkable that the four reasons Anton gave for caution are the same as warnings given today. We all know what happened in the GFC of 2007 and 2008. As a counterpoint, we have transcribed new comments made by Anton at the recent Morningstar Investment Conference to bring his views up to date. I was reminded of the classic lyrics from John Fogerty's 2004 album, Deja Vu (All Over Again).
Did you hear 'em talkin' 'bout it on the radio?
Did you try to read the writing on the wall?
Did that voice inside you say, “I've heard it all before”?
It's like déjà vu all over again
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By Anton Tagliaferro, written in May 2006
The Australian sharemarket, as measured by the S&P ASX300, had risen sharply and almost without pause since the beginning of 2006. The index reached a record high of 5,366 on 11 May 2006. The most recent phase of the rally was fuelled by a very narrow concentration of companies, particularly those related to the commodities sector. In recent months the moves in the prices of many commodities were actually accelerating, the higher they went. These almost-daily price gains were pushing many commodity spot prices – already at historical highs– to levels that defied any fundamental explanation.
Since peaking on 11 May the ASX300 index has fallen back to around the 5,000 mark last week, a drop of just over 6%. This fall has been primarily focused on the commodities sector and accompanied by a sharp increase in volatility of share prices.
Reasons behind the recent sell-off
What triggered this sell-off in IML’s view can largely be attributed to speculative market participants realising that there were a growing number of factors that warranted caution. In aggregate these factors, which can no longer be ignored, should serve to make investors more cautious in their outlook for world economic growth rates.
In particular, IML believes some of the following factors are reason for caution for growth prospects going forward:
- The end of cheap money as the US Federal Reserve Board has increased interest rates 16 times in the last 2 years, from 1% to 5%.
- US bond yields have also risen sharply, particularly over the last six months due to investors concerns over inflationary pressures.
- High energy prices also appear to be slowing consumer spending – thus for example recently, the world’s largest retailer, Wal Mart, noted that sales growth was slowing due to high energy prices.
- Record high commodity prices which are feeding into high raw material prices, which is inflationary.
What drove markets to recent record levels?
Since the start of 2006, commodity prices have been driven to their current levels largely as a result of a frenzied level of speculative activity by hedge funds in commodity markets. While overall demand for commodities remains firm and in some cases supply is being slow to respond. IML believes that a lot of hot money has taken many commodity prices to levels well above their fundamental value.
This frenzy was covered in a release recently published on our website (The Commodities Casino – 5 May 2006). Such events occur in all markets from time to time and are always obvious after the event, but much harder to identify during the period that a speculative bubble is forming.
Many commodities have bounced back in the last week, but in our view they continue to trade well ahead of their true value due to continued large positions held by financial players.
How are IML’s portfolios positioned?
Over the last year or so IML has maintained a below-index exposure to the Resources sector of around 10%. We believe this level of exposure is prudent for our Funds; we cannot justify any greater exposure than this given the extreme volatility of the income streams of many of the participating companies. We expect that given the above uncertainties that we are likely to see volatility in the market will continue to be higher going forward, than what has been experienced for much of the last few years.
That said, while parts of the share market have in recent months become quite irrationally exuberant, IML as a disciplined value-style manager has been focused on taking advantage of emerging value opportunities as stocks ignored by many investors in the recent frenzy become more attractively priced.
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Anton Tagliaferro, Morningstar Investor Conference, 2 June 2022
It's a difficult time for the market. We had come through, not just the last two years but the last decade since the GFC, when things have been weird. We haven't really had a normal economic cycle since the GFC, with governments throwing money at problems. When COVID happened, it looked like we would have a slowdown but then we had more spending and cuts in rates and we had another spurt in growth. So where are we today? It’s a difficult question as we are facing a slowdown, inflation is going up, interest rates are up.
Companies are jostling to put up prices. They know their costs are going up, do they wait and then it's too late? Inflation is not going away in a hurry. The big thing now is whether it starts turning up in wages inflation, and it has to at some point. The inflation number in the UK came out recently at 9%. Anybody who's lived in the UK would know that a teacher or a train driver or a nurse is struggling anyway. If their costs rise 10% from a year ago, they must receive a pay rise of 5% or 6% or 7%. Then inflation becomes a cycle, ingrained within the system, and that's the bit we haven't seen for decades. Not long ago, central banks were talking about inflation in the 2% range? Well, it seems like decades ago already.
We're always defensive in our stock selection, but I think now you have to be extra defensive because there's so much uncertainty. Now clearly, inflation is too high because of oil prices and supply chain issues. Some of those things are temporary so inflation will come down, but interest rates have to go up now. How high, nobody knows because it's whether inflation gets ingrained in the system through wage rises. The economy will probably slow but it isn't really showing yet. So to us, defensive companies are the way, we’re not even thinking about cyclicals like James Hardie or Seek because we don't know how hard the economy will slow.
I remember when I joined Perpetual in 1989. My boss always said, don't take extreme views. It's easy at points like this in the cycle to take extreme views, things are gonna go down or everything's gonna be fantastic. It's normally somewhere in the middle.
Climate change is a very complicated issue. It’s very strange that a country like Australia with all the gas and coal and uranium in the world and we've got an energy crisis. We export gas and oil to every part of the world, they can use it but we are not able to use our own. What baffles me is everyone's talking about shutting coal-powered power stations but what's going to replace them? People also want electric cars, which adds 30% of electricity usage to the average household. Where will the electricity come from if we shut out coal powered stations? We've sold all our gas for the next 20 years. What's the alternative? What’s the plan? Someone has to have enough guts to say the transition is going to take much longer. This is not a matter of whether you believe in climate change. We all want to have air conditioning, we all want our electricity. Obviously, burning fossil fuels is having a bad impact on the environment and things have to change but we just can't do it overnight.
There are opportunities. We own New Hope Coal, we own Aurizon that transports the coal in Queensland. Aurizon will be shipping coal from mines to ports for the next 20 years, countries in Asia such as India and China need it whether we like it or not.
When you get market downturns as we've had in recent months, everything falls and the market doesn't tend to differentiate between companies. If you look at some of the REITs, the property trusts, they were at ridiculous valuations with huge premiums to NTA when interest rates were at record lows. Well, now a lot of the REITs have gone to discounts to NTA. If you can find a reasonable REIT at a 15% discount with a yield of 6% with bad news factored in, I'm heading towards them again. Same with Sky City, a casino in Auckland with a new one in Adelaide. It's trading as if it's never going to recover. These are opportunities we are finding, pockets of value.
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And congratulations to other members of the investing community for their awards in the Queen's Birthday honours list 2022, including Ann Byrne (Unisuper, STA, ACSI, Women in Super, LUCRF Super), Joe de Bruyn (union leader and former Director of Rest), Mans Carlsson (Ausbil) and Andy Kuper (LeapFrog Investments).
Anton Tagliaferro is Investment Director at Investors Mutual Limited. This information is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock.