01 Dec 2022 outlook, Is the music still playing?
Make no mistake there is a very noisy chorus of doomsters in financial markets. Some so negative that they are either sitting in 100% cash or using financial products (options, bear funds, buying the volatility index) to protect their portfolios against a 20%+ downside sell off in stock markets.
Quoting the respected David Rosenberg, former Chief North American Economist at Merrill Lynch:
“I have to say that in my 35 years in the business, I have never seen such a widespread consensus convinced that it’s smarter than those “dumb” central bankers and that inflation is here to stay indefinitely.”
I make no claim to having the level of expertise of Mr Rosenberg, but with a similar time of experience in stock markets, I tend to agree. Apparently, we are living in the time when central bankers have no idea what they are doing, and we are back to the 1970s when it comes to inflation.
Whether global inflation will be permanent or transitory remains to be seen. Politics and the emergence of the omicron variant of the coronavirus is adding to the uncertainty. Respected commentators such as Mohamed El-Erian believe stagflation (higher inflation and lower growth) risk has been heightened with the new variant threat, through increased supply chain problems and reticence of workers to come back from the Great Resignation.
What I do know is that if central banks, such as the US Federal Reserve, decide to take a more aggressive stance to withdrawing the QE (bond buying program) – as cited by Chairman Powell on the last trading day of November – and commence a tightening cycle (rising interest rates) than is sooner than anticipated (second half of 2022), then stock markets will most likely respond negatively.
Higher rates and less liquidity will create sell offs, and valuations of stocks will adjust downwards compressing valuations.
Remember, as a rule of thumb, growth stocks perform better with lower interest rates and cyclical/value stocks (think resource, material, energy, and financials) perform better with an expectation of higher interest rates as economic growth is robust.
But, as the last two years have shown, investors could be in for an unexpected ride in 2022 and making direct comparisons to historical financial conditions can be misleading as history never repeats in the same way.
With the potential for more uncertainty around the raising of the US debt ceiling that had a temporary reprieve from the October deadline, combined with a more hawkish Fed at the mid-December meeting and virus worries about the impact on economic growth, markets are likely to remain jumpy.
Australia will not be immune to the US stock volatility so, at best, strap in for the ride.
Looking to 2022, I think it is safe to assume US rates will go up, the question is when.
The head of the Reserve Bank of Australia, Philip Lowe, remains steadfast in his position that interest rates will not rise before late 2023 at the earliest. Under this scenario the Australian dollar is likely to remain weak.
Navigating uncertainty: valuation versus stock price
For the stock pickers out there, you will be challenged again to navigate uncertainty and volatility. In last month’s BLOG post I emphasised how important it is to understand the company you are investing in.
The recent reporting season has provided a strong reminder to investors that results can be in line with expectations and the outlook unchanged, and yet the share price falls.
Technology One, National Australia Bank are two examples where the post earnings response had more to do with valuation, than fundamentals. Commonwealth Bank in comparison just straight out disappointed and the valuation was excessive. The stock is trading some 15% below its recent high of $110 at around $93.80.
Whether you decide to buy any of these stocks will depend on your own portfolio, your weighting if you already hold the stock and whether you see value.
Just because a stock price falls doesn’t immediately equate to value.
Hey what? I can hear you saying.
This is the nub of share investing.
Even companies that are afforded high valuations, either in the form of a price-to-earnings (PER) or price to sales (P/S) multiple, cannot expect to maintain those high valuations if the company is not making money, and the ‘growth’ part of the story starts to flag.
The growth can be real or perceived by investors and can work for both an increasing valuation for shares and a decreasing valuation.
Ford versus Tesla (again!)
Tesla is probably the poster stock for such debates.
As when I wrote in the first chapter of Shareplicity 2 – A guide to investing in US stock markets (free to download here), I remain of the view that Tesla versus the others is the best analogy to explain the changes happening in our world and the challenges raised for investors.
Looking at Ford versus Tesla (a year on); Ford has benefitted from a new CEO and a new vision, including the move to embrace and expand the company’s EV offering.
The shares have more than doubled whereas Tesla’s shares are up a lazy 88%.
Sarcasm aside, I have a hunch you would have been happy with either of those 12-month returns.
What about the future?
I know some value investors will tell you the world never changes and that a stock with a PER valuation of 10x is worthy of buying. But, if you invest in that world (which a lot of people do), you would have missed out on the leading changing-making, millionaire/billionaire creating stocks in the last twenty years. More on this soon.
A snapshot comparison between Ford versus Tesla reveals some stark differences, across every metric. Tesla is growing faster, has almost double the gross margin and a level of gearing that is a less than a tenth of Ford’s debt to equity.
The valuation based on a raw price to earnings multiple is 14 times higher.
|Company||PRICE ($)||1 Year EPS (%)||Gross Margin (%)||PER (forward x)||Debt/Equity (%)|
|Ford Motor Co||19.67||3.7||10||10.2||423.8%|
Do those metrics, based on earning growth, margins and debt levels, justify the Tesla valuation versus Ford?
How you answer the question will to a large degree depend on how you envisage the future earnings potential for both companies.
In the Tesla camp, you have a company generating US$5billion in free cash flow quarterly that has two new giga factories coming on stream at the end of 2021, in Austin, and Berlin. There are no guarantees that the ramp up of production will be seamless in 2022, but the optimists will be betting that post the Model 3 scaling production, a lot of the teething problems are well known and have been factored in.
The Tesla brand is becoming increasingly synonymous with buying an EV, in the same way as iPhone is interchangeable with smart phone and zoom has become a verb.
Then there is the debate around the software services of the business and the energy side of the business.
Ford in comparison comes with a legacy brand (not always good) but it has the bestselling truck in America, the F150, and a new electric model to support the electrification transition.
The transition for incumbents like Ford to electrify their production is not without challenges. The most fundamental is managing the cashflow problems from forsaking existing ICE vehicle production as the switch to EVs takes place. The company recently announced an US$11.4billion capital expenditure plan to develop three battery factories and a truck plant with the Korean SK Corporation. Ford has a lot of debt and Tesla is de-leveraging and bringing in US$5billion in free cashflow from the existing plants in Freemont and Shanghai, and has two new giga factories coming on stream.
Tesla’s software services are the most advanced on market as its electric vehicle production rate moves beyond one million in 2021. Industry experts, such as Alex Potter from Piper Sandler, estimate 10 million EV production for Tesla by 2030 is achievable.
Ford has a US$78billion market capitalisation and remains the largest vehicle seller in the US. Tesla has a US$1trillion market capitalisation and is the largest EV seller in the US and the world.
Ford will survive the transition to electrification of vehicles, if only for the fact that it is too politically unpalatable to let the company go under.
However, where you place your investment, really depends on how much store and faith you have in the leaders of Tesla and Ford and the culture they have created to be a winning company and execute successfully on their corporate goals.
Shareplicity is a Tesla investor for the long term and happy to forsake short-term performance for the multiyear gains that the company (I believe) can deliver. Equally, I remain firmly of the view, irrespective of the inflation scare narrative that technological change and disruption from innovation will continue to drive cost cutting and even productivity gains. Any pull back in stock markets is an opportunity to add to stocks such as the Teslas of the world who are in sync and part of the changing world we are living in.
What I have been buying in the US stock markets
During the October selloff in the US, I bought in Adobe, Intuit, Automatic Data Processing and MSCI. All have performed well and have the added appeal of generating profits and paying dividends – not too shabby for technology companies.
I would also not hesitate to add to these companies on a selloff.
My super stock performers in the second quarter have been chip companies AMD and Nvidia, both of which have businesses exposed to major secular themes such as DATA centres, EVs and the now popular meta/omniverse theme.
The recent pullback in specialist Dutch chip-making equipment supplier, ASML, is on my shopping list as is topping up on my Microsoft holding.
In the month of November, my total equity portfolio rose 1% versus a 1% decline in the ASX200 and the S&P500. In the last 10 days of the month, I took some profits in Australia and sold some US stocks that I felt were facing some uphill challenges, namely Disney and Mastercard.
My cash position has risen to just over 20%, which is relatively high, and the US stock portfolio benefitted from a decline in the Australian dollar. I will be looking for opportunities to put the cash back to work.
Here is a list of characteristics to help you with your stock picking into 2022:
- Companies with large TAMs (total addressable markets). Great examples are decarbonisation, EVs, cybersecurity, DATA centres, digitalisation, cloud computing.
- Price makers not takers. You want to invest in companies that can maintain demand whilst increasing prices. Tesla is a great example of a company that has been increasing prices, but demand remains robust.
- Look for industries that have deflationary forces at work that can be managed and boost margins. Speaking broadly, technology companies with less exposure to lower paid workers should fare better. Much of the income inequality is at the lower end of the pay scale and that is where wages pressures have been building.
- Be alert to a compression in valuations with rising interest rates, hence why I have increased my exposure to companies that make money and generate dividend income versus loss-making, high-tech flyers.
- Remember that the Covid virus and many of its emerging strains will continue to create supply chain problems until the world is more vaccinated, so look to companies that are handling their supply chains more efficiently.
- Stock markets are likely to remain volatile, so if you are feeling nervous, remember to keep some cash on the sidelines.
The changing world for investors
The buy, hold and sit narrative for long-term investors can create negative returns. I spoke at length in Shareplicity – A simple approach to share investing about the problems with the so-called ‘blue chips’, think banks, financial stocks and energy companies.
In the US stock market, the changes in the top performing money makers have been even more pronounced. The below screen shot from a presentation by Adjunct Professor of Columbia Business School, Michael Mauboussin, “Expectations Investing”, shows that excluding Microsoft, the Top 10 Largest companies in 2001 have lost US$461 billion in value over the 20 years and only Microsoft remains in the Top 10.
The story gets worse. If the Top 10 in 2001 had just kept up with the S&P500 index then their value would be US$6.7trillion higher – quite the opportunity cost.
To give you a sense of the wealth creation, Apple was worth US$7billion (now US$2.5trillion), Microsoft US$300 billion (now US$2.3trillion) and Amazon was worth US$7billion (now US$1.8trillion). Tesla wasn’t even a thought at that stage and is now worth US$1trillion.
Professor Hendrik Bessembinder has also done extensive work on how a concentrated number of stocks over time have delivered the positive returns you want to grow your savings. I cite the Professor in Shareplicity 2 and his works can be found online.
As stock picker, I cannot stress how important it is to understand the changes the world is experiencing and how you can make the most of those opportunities.
My enthusiasm extended as far as writing a book for you, Shareplicity 2 – A guide to investing in US stock markets, to help you on this journey.
The book remains as timely and relevant as when it was published in July 2021 during lockdowns. So, to quote Molly Meldrum “do yourself a favour” and grab a copy for yourself or a friend/relative as a Christmas treat to help you navigate the challenges of 2022 investing. Author signed copies are available on my website or online at Booktopia and Amazon and some good bookstores.
Wishing everyone a Happy safe holiday. Thank you for your interest and support for Shareplicity. I am taking some time off to recharge the batteries. See you in late January 2022 with hopefully a new addition to the Shareplicity stable. In the meantime, I will be on Twitter.
Disclaimer: Shareplicity offers information that is only general in nature. It does not take into account your personal financial situation, needs or objectives. Nor does it take into account the financial needs of any specific person. You should consider your own personal financial situation and needs or seek financial advice before making any decisions based on this information.
The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. Past performance is not a reliable indicator of future performance. Investment involves risks. The value of an investment and any income from it can go down as well as up.
Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass.