The final quarter of 2022 delivered positive market returns in stark contrast to investors’ loss-making experience in the first nine months, but overall this was a year that many market participants would rather forget. The portfolio’s strong quarter on both a relative and absolute basis helped recover almost all of the underperformance that resulted from the writedown of its Russian exposure in February following Putin’s invasion and the consequent international sanctions.
At the end of a year in which headlines were dominated by the war in Ukraine, China’s seemingly never-ending Covid clampdown, and almost daily inflation updates accompanied by false reports of a Fed pivot while the pace of interest rates hikes barely slowed (the Fed overnight rate rising by 4.25% during the year), the fourth quarter was characterised by a glass-half–full response by markets. The prospect of an eventual China reopening and the positive effect of rising interest rates on the earnings of financials outweighed concerns about the credit impact of higher rates (in contrast to the previous quarter) and the scaling back of valuation multiples for growth stocks.
Breaking down performance by sector, the greatest contribution was from Materials, with copper a key exposure. Financials benefitted from both Insurance and Banks generally. IT and Consumer Discretionary stood out among the winners thanks to absence of exposure to large index constituents. On the other side of the ledger, underweights towards Biotech and Pharmaceuticals were detractors. In regional terms, the US was the stand-out performer despite the c. 16% underweight, chiefly thanks to the aforementioned Big Tech underweights, along with the UK owing to a number of the global miners being listed in London.
Activity saw continuing additions to Japan in the form of midcaps at cheap valuations (some even with negative enterprise values) and often with an activist already on the share register. Additions were also made to the basket of offshore drillers. Turnover was 1.5%, relatively elevated this quarter because of the changes between the portfolio managers’ individual sleeve allocations, an important lever which in future will likely be used more incrementally.
Looking back over the year’s performance, a few themes stand out. Energy was a key source of alpha, with contributions from fossil fuel producers, refining, shipping and royalties. Materials helped too, with broad exposure to the big miners as well as more selective names. The underweight to Megacaps was a strong tailwind of similar size as perpetual growth came into doubt and was repriced, while negative nominal yields (i.e. no dividends) provided little support in the absence of the prospect of capital gains. Against this of course must be set the loss arising from the portfolio’s Russia exposure which took away approximately 4% of performance during the first quarter.
As we step over the year’s threshold into 2023 and consider what future might lie before us, there is much talk of regime change, paradigm shifts and inflection points, and discussion of all these makes for good editorial copy. As with all forecasts, the timing and extent of any outcomes are uncertain. A forthcoming US recession has been described as the most heralded in history, yet this is yet to be reflected in earnings estimates. Inflation is called out by many as having peaked, yet the Fed appears adamant that interest rates will not fall in the coming year. The war in Ukraine certainly holds lessons for China and its attitude towards Taiwan, yet it is not clear which ones.
As ever, the Hosking Partners portfolio is not positioned for any particular outcome in mind, nor to generate editorial copy. The number of stocks in the portfolio remains over 400, and this diversified collection of ideas, based in each case on a bottom-up, supply-side approach is definitely not attempting to express a macro-themed investment thesis where the chances of being right may not be that different than 50:50. We prefer to look for easier, stock-specific wins. At the same time, the portfolio contains a number of ideas which are enjoying a powerful boost from the elastic of mean reversion which had become increasingly stretched: our capital cycle approach reinforces contra-cyclical behaviour, so as growth stocks were chased higher the portfolio actually increased its value tilt. Likewise, we added to energy and materials against the background of “capital-lite” being the sine qua non, and we picked up off-benchmark names which had been ostracised for not being listed in the index.
If the era of narrow stock market dominance by a small cohort of US Megacap tech names really is coming to an end, the Hosking Partners portfolio will benefit. The so-called FAANGM stocks peaked as a percentage of the S&P500 market cap at 26.2% back in September 2020 and now stands at 18.5%. Meanwhile, the passive-driven momentum phenomenon, which saw the big get bigger at the expense of almost everything else, may have peaked too - the size of S&P500 index ETFs hit $1.1 trillion in January 2022 and have since declined to $939 billion. Against this backdrop, the portfolio’s value tilt remains pronounced, evidenced by a forward p/e of less than 10x.
If the Megacap momentum trade is over, it should come as little surprise that the portfolio’s exposure to the US was around 45% at the end of 2022, a c.16% underweight relative to its MSCI ACWI yardstick. In other respects, too, the portfolio has a very different feel from its benchmark, not least in off-benchmark names amounting to 31% of the portfolio. As the baton of market leadership passes from the FAANGMs, it is noteworthy that names with market caps of less than $15 billion represent c. 42% of the portfolio, compared with just 13% for the benchmark. Indeed, of the ten stocks which delivered the greatest contribution to the model portfolio’s performance in absolute US dollar terms in the course of 2022, six had a market cap of less than $5 billion (measured at the end of the year).
Two themes in the portfolio are worth mentioning at this point. The first, energy, is one we have written about extensively already, in particular the gap between the amount of energy the world’s economy needs in order to grow and the limited increase in energy that is being delivered at current investment levels. Despite the humbling of Tesla during 2022, not to mention ARKK, Bitcoin and the S&P500, all have performed better than the energy sector (XLE) since 2015, suggesting the runway is long. Our capital-cycle focus on energy leads to an overweight in the portfolio - its c. 12% energy exposure is around 6% greater than the benchmark, and the fact that it is not greater reflects an awareness of how rapid a supply-side response can be thanks to shale technology. Viewing the world from an energy perspective is helpful for providing a differentiated view on familiar questions, for example the risk that high energy prices may trigger a commodity-led recession, or geopolitical instability arising from energy and food shortages. These are lessons we are keen to pay attention to in light of the losses inflicted on the portfolio following Putin’s invasion of Ukraine earlier in the year.
The second theme to mention is Japan, as during the quarter the portfolio’s exposure to Japan went overweight relative to the benchmark (c.7.0% versus 5.6%) for the first time since inception. It currently contains 43 Japanese stocks, with our capital cycle lens resulting in recent additions offering some combination of deep value, a supply-side angle (capital discipline being unsurprisingly stronger in Japan than in more frothy markets) and activist involvement to provide a catalyst. The market is under-owned, and cheap. Foreign investors sold a net cumulative $242 billion of Japanese equities from 2014 up to 2021, since when just $20 billion of purchases have been made. The market p/e is 11.6x, more than one standard deviation below its long-term average. The country is a Covid-reopening laggard, but as activity does recover it appears the dragon of deflation may finally have been slain. The recent policy changes by the Bank of Japan anticipate those which would have been introduced anyway when the governor changes later this year, providing further catalyst for some of the deep discounts to intrinsic value in our Japanese stocks to be closed.
We leave 2022 relieved to have finished the year strongly, but disappointed that relative performance was not significantly greater, given how in so many cases the market came round to agreeing with our investment ideas. We have already invoked the Ukraine invasion as one of the major factors holding back performance. The other we have identified is that the portfolio’s rotation into energy was more gradual and less dramatic than would have been justified by hindsight. We draw comfort from the thought that if past transitions from growth to value phases of the market are anything to go by, value has a multi-year ascendancy ahead of it. Meanwhile, the prospect of so-called ‘non-linear events’ arising from geopolitical tension makes us glad of the valuation margin of safety in many of our positions. Guests at the recently-ended Megacap Growth party may look across at the more sedate Value-themed session which has just got started, asking themselves whether it is worth joining or is it too late, but what they do not realise is that the punchbowl at the Growth party was spiked with the over-proof spirit of QE, and their hangover has only begun to kick in.
30 December 2022
Q4 2022 - Quarterly Report Commentary