“Eya, nobis annus est” (1)
The Hosking Partners portfolio enjoyed a strong second half of the year after relative underperformance in the first two quarters of 2023. The year-end rally, whilst impressive, was not quite enough to produce benchmark beating performance by the portfolio for the year as a whole. The robust 11% advance in the benchmark in Q4 was a synchronized affair, albeit led by the US as investors upgraded dramatically the probability of a soft landing, previously an outcome regarded as ridiculously impossible given the vigour with which central banks had been pushing up interest rates over the previous 18 months.
The quarter saw negative contributions from regional allocation (namely the underweight to the US and the overweights to Japan, UK and Emerging Markets) largely offset by positive stock selection. Given the positive shift in investor expectations regarding the economic prognosis, a much better showing by value stocks was unsurprising. For much of the last two years their valuations have been repeatedly hit hard by recession fears. Initially this was because of the Covid economic downturn, later the result of relentless increases in interest rates in all major economies bar Japan. As such a “hard” landing is all but discounted in prices and a better outcome, such as that which began to emerge in Q4, would produce positive valuation improvement. Growth stocks also did well, emboldened by the perception that interest rate increases (from here) are less likely given the moderation in the inflation rate.
Of course, these quarterly fluctuations are of questionable relevance given the long-term nature of the investment horizon. The headline conclusions for the quarter were equally valid for the calendar year as a whole. Regional allocation was a negative and was largely offset by strong stock selection. The great exception to this overall summary was in the US where growth stocks in general, particularly the “Magnificent Seven”, led the market. So the strange conclusion for the quarter and twelve-months, is that growth investors had the better returns in the US, but a value approach more than held its own elsewhere.
In the quarter just ended it was encouraging to note that the financial sector overweight benefited relative performance. The underweights to defensive sectors like healthcare and consumer staples also proved beneficial. On the other side of the ledger, the long standing underweight to IT was a drag on performance as “growth” segments enjoyed investor optimism concerning the more benign interest rate outlook. The longer standing overweights to energy and materials, which together amount to 27% of the portfolio, underperformed on a relative basis. In the case of materials there were continuing concerns about the effect of economic slowdown on commodity prices. The energy sector, where there is a three-times benchmark exposure, took a breather in line with oil prices. The longer-term capital cycle dynamics remain positive, in our view, and the sector contributed handsomely to the year’s performance.
It is also appropriate in this report to draw attention to portfolio turnover. This was c. 20% on the year, low by industry standards but up on what Hosking Partners generally reports. This reflects the move to three multi-counsellors. The transition which has taken place has reduced the number of holdings in the portfolio, but at the same time has increased the intensity of the active investment bets made by the firm. For example, the overweight to Japan is increased as is the energy sector overweight. Active share has increased to c. 86%, average market capitalization has declined, and non-benchmark securities are now around 37% of portfolio exposure. Overall, the effect of this transition has been to increase the value attributes of the overall portfolio, which we hope will pay off in the years ahead.
This continues a trend over the past several years during which the portfolio has progressively increased its value bias. This is the result of a more systematic adherence to the traditional Capital Cycle investment model across the team as well as a reaction to the last few years’ increasing divergence in relative valuations between so-called growth and value styles. The swing of the portfolio’s pendulum towards value accelerated somewhat during the recent Covid pandemic when low interest rates, digital workstyles and working from home all spoke in favour of a major spike in technology-related company valuations. During 2023, the “errors of omission” i.e., underweights to the mega-growth trend continued to hurt the portfolio. That this did not materially affect relative return is testament to signs of life in unloved and undervalued sectors of the market. But it also reflects the valuation headwind problem which affects the most loved stocks in the global benchmark. Take Apple (not owned in the portfolio) for example, a firm with an enterprise value (EV) of $2.8 trillion with an annual sales figure of $380 billion. This EV multiple of seven times is a useful way to understand this. For Apple to be worthy of its benchmark weighting, investors expect the enterprise value to rise by, say, 10% and $280 billion. At the current valuation of seven times this implies sales growth of $38 billion in just 12 months. This is a tall order for any firm, let alone for one with a mature product line as the iPhone 15 product label inadvertently signals. For context, Tesla (not owned), itself a miracle firm, took 20 years to build annual sales to $80 billion. If Apple fails this hurdle, investors require the share valuation to stretch further to justify its portfolio inclusion.
By contrast, in the unloved value parts of the global equity markets, tailwinds are gathering strength. For instance, Japan represents, with a few exceptions, a stock market synonymous with undervaluation, but now with a tailwind of government diktat that shareholder performance must improve. Orthodox monetary policy (positive rather than negative real interest rates) underpins a market rotation toward valuation, as does persistent underinvestment in sectors such as banking, energy, shipping and mining which points to return on capital movements in these sectors’ favour. A re-assessment of the ESG agenda, which we believe has thus far approached a complex problem with a blunt set of tools, will also help the value factor whilst mitigating against the fantasy-appeal of some growth investments. As Alice memorably remarks in ‘Through the Looking Glass’, “One can’t believe in impossible things”, whether that is a $38 billion annual increment in Apple revenues or a global economy entirely dependent on solar and wind-produced electricity generation. A more balanced assessment of the investment merits of various sectors is long overdue. Finally, more pre-conditions for this have been established.
Investing with a value bias, as our capital cycle approach has directed us for the vast majority of the team’s 40-year history, requires a degree of stoicism. One of our favorite practitioners is Admiral Stockdale, the highest-ranking officer held (for eight years) in a Vietnamese prisoner of war camp. The ‘Stockdale Paradox’ is a model of persistence that comes from confronting the brutal facts of reality whilst retaining unwavering faith that one will prevail. The team at Hosking Partners have been living a geared version of this – the realities of the situation (to wit the 460bps of missed performance from the “Magnificent Seven”) compound our faith that the next decade will look different to the last. And we finish it with an idiomatic translation (thank you resident classicist Luke Bridgeman) of the quote we started with – Eya, this is our time!
1 - Benedicamus Domino (an anonymous 15th century Latin poem)
31 December 2023
Q4 2023 - Quarterly Report Commentary