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ASX All Ordinaries Movement FY 2021/22. Click to expand.

The Market

In terms of the financial markets, the 2021/2022 financial year has drawn to a close in a spectacular fashion. The ASX All Ordinaries Index has decreased by 11.1% over the full year, as a result of a 13.4% decrease in the last quarter. This is in a stark contrast to the astonishing growth that occurred in 2020/2021 when the index increased by 26.4%. The US equity market recorded its worst first half period in 60 years (calendar year to date), shifting the market into bear territory and, unfortunately, the Fed has signalled more rate hikes are to come, noting the difficulty of bringing down inflation without triggering a recession. This is a similar problem facing central banks globally, with the Eurozone under even greater pressure due to the ongoing Russia-Ukraine conflict.

Given the current macro climate, it will be interesting to see what is written about the financial year 2021/2022 in five or ten years’ time: is this the beginning of an inflation-driven global recession or is this a dint due to interest-rate speculation that normalises and rebounds?

EOFY 2022 Wrap Up

“In the real world things fluctuate between pretty good and not so hot. But in the markets they go from flawless to hopeless” – Howard Marks

Given the last two to three years this quote seems as true as ever and taking a long-term approach allows us to see the turbulence as a normal part of the market. This cycle through periods of excesses and then corrections can be seen in the movements of the ASX All Ordinaries Index, which is down 11.1% this year and over the past 24 years has returned an average of 3.8%. However, the annual return in any one year has never been within 10% of the average, instead, we have five years where the losses are greater than 10% (the lowest being negative 26% in FY2009) and nine years where the gains are greater than 10% (highest being 26.4% in FY2021), the remainder fall somewhere in between, but nowhere near the average. If you’re wondering, the FSI portfolio has generated annual returns of 11.8%, with only two years of losses of more than 10% (lowest was negative 24.1% in FY2008) and 14 years of gains greater than 10% (highest was 40.7% in FY2021).

Quarter by Quarter

In the first quarter of the financial year, the outlook was positive. Monetary policy was favourable, corporate earnings were strong, consumer spending was buoyant and labour markets were resilient despite numerous COVID-related restrictions. The only red on the score card appeared from concerns in China’s property market.

In the second quarter despite a rollout of vaccines, the new COVID strain caused some concern. Supply chains were still constrained and persistent inflation raised concerns over central bank policy settings. “Transitory inflation” was the term used frequently, allowing central banks to hold interest rates and remain upbeat in their forecasts.

In the third quarter, Russia invaded Ukraine. The West was quick to issue sanctions and multinationals started closing down any operations linked to Russia. However, the war amplified energy and food price issues straining an already constrained supply-side environment and pushing inflation higher. Central banks began raising rates and forecasting future increases. Particularly for growth-orientated stocks, the rising interest rate environment drove declines in equity valuations across the board.

By the fourth quarter, the high inflation readings were a major detractor for all sectors of the financial markets. Despite numerous interest rate increases during the quarter, with low unemployment continuing, retail sales remained resilient. In addition, there has been little done to improve supply-side inflationary factors such that the current environment is likely to continue in the near term.

Over the Long Term

“Time is the friend of the wonderful business, the enemy of the mediocre.” Warren Buffett – Letter to Shareholders 1989

While market uncertainty continues, it is more important than ever that one has a strict investment process. It is vital not to get caught up in the hype and noise of the daily market movements, and instead invest with a long-term approach. A sound investment philosophy sets out a number of ‘rules’ or ‘procedures’ to fall back on when the market noise gets too loud. Companies that have a sustainable competitive advantage will always be well-placed to withstand short-term headwinds, regardless of market conditions, maintain market share and ultimately find new ways to grow.

It can be challenging to recognise the potential in companies, particularly those that are in the growth stage of their life cycle. It can also be difficult to evaluate the ‘narratives’ that some companies are telling about themselves. To invest in a company in the growth stage of its life cycle it is important to balance the company’s narrative alongside its numbers.

By drilling down into a company’s financials and growth plans in a careful, considered and committed way, it is possible to identify the quality growth stocks that will prosper over the long term. Their ability to be flexible, to move quickly to take advantage of opportunities as they arise, and to capitalise on market trends and demand, will continue to support the ongoing success of such businesses, and provide significant long-term opportunities for their investors.

The financial year has drawn to a close, and it is remarkable to consider the current position against the outlook from 12 months ago. Thinking back to July 2020 we had witnessed an unprecedented market decline and hopeful recovery against the backdrop of a worldwide pandemic. The future prospects of the economy, at home and abroad, relied heavily on the development and rollout of vaccines and the ongoing coordinated stimulus from government and federal banks. Health officials were nervous, businesses were defensive, consumers were cautious, we braced ourselves for an unknown future.

Keep Calm and Continue On

And what happened? The world kept turning, particularly in Australia, which lived up to its title of “The lucky country”. With comparably minor interruptions from intermittent lockdowns (my sympathies to the Victorians), the Australian business environment has been positive. Job keeper and job seeker packages have helped maintain employment and targeted stimulus in housing and infrastructure have assisted key areas of the economy. The delivery of the budget in October 2020 highlighted the government’s commitment to stimulate the economy and monetary policy remains favourable for spending and growth.

In the US we witnessed the end of the Trump administration. It was always going to be a dramatic affair, but I don’t think anyone expected the civil unrest that occurred. In spite of this the Dow Jones Industrial Index was up by 39% over the past twelve months Of particular interest was the activist nature of retail investors in the US against companies that had been targeted by short-sellers. In addition, during the last 18 months, the number of individuals getting involved in the financial markets has increased dramatically however the mob-like behaviours of the WallStreetBets crowd have been a truly unique phenomenon.

ASX All Ordinaries Movement FY 2021. Click to expand.

Throughout Europe, the control of COVID has been problematic with continued outbreaks occurring. Particularly in the first half of the financial year, the pandemic wreaked havoc on local economies while leaders of the EU and UK progressed with the Brexit deal. In the third quarter, like in much of the world, there was optimism surrounding vaccine progress and economic recovery with forecasts suggesting that the UK and Eurozone economies are on track to reach pre-pandemic levels by mid-2022.

In the Australian securities market, the ASX All Ordinaries increased by 26% over the financial year as vaccine-related news generated optimism, the Reserve Bank of Australia lowered the official interest rate to 0.1% and Biden won the US presidential election.

Twelve months ago, we forecast a substantial increase in the earnings for our portfolio companies which did occur and is in part the cause of our out-performance as compared to the market and of which we are incredibly pleased. This year’s annual performance of 40.7% adds to the since inception performance of 13.5% which is 9.0 percentage points higher than the ASX All Ordinaries over the same period of time.

Even though we are now coming off a much higher base, we expect the earnings of our portfolio companies to increase by approximately 12.5% per annum over the next five years. This provides some reassurance as we begin the new financial year where valuations (PE multiples) are stretched and which we expect are likely to contract by around 5.5% over the next five years from current levels. While it is almost certain that there will be further COVID outbreaks in the months ahead despite the vaccine program, the past year has shown how resourceful and resilient quality growth companies can be and this provides us with the confidence to face the new year and to make the most of the opportunities ahead of us and the ongoing volatility in the financial markets will provide us with welcome opportunities to deploy our capital.

In the last six months, the phrase “new normal” has been used to describe the overhaul of every element of daily life. Since the world’s introduction to COVID-19 every activity that was part of our day to day life has been disrupted, cancelled or reimagined in the name of public health and safety. And as the financial year comes to a close we are left to think, is this our new way of life? Or, is there more to come?

In terms of the financial markets, the impact of COVID-19 couldn’t be more dramatic. Every major index has shown some depression point as a result of the pandemic and the ASX All Ordinaries is no exception. As shown in the graph attached, the index in the first half of the year actually reflected the expected forecasts of moderate growth without upward pressure on inflation. In December 2019 there was excitement and relief about a potential result in the US-China Trade war and a Brexit date of 31 January 2020. In the first two months of 2020, the index climbed slowly higher until the Wall St drop on 21 February precipitated the crash in the ASX All Ords. It was the ongoing spread and impact of COVID-19 that had nations and markets worried, businesses were starting to flag the impact on earnings growth, it was clear that this was going to be a major event.

ASX All Ordinaries Movement FY 2020. Click to expand.

The Advantages of Unfranked Dividends

Governments around the world stepped up to determine the best course of action, medical and safety considerations were given utmost priority and a string of social distancing restrictions were put in place. Following these restrictions were financial stimulus packages, announced by the government to soften the impact on business viability and household incomes. So while schools, shopping centres and hospitality outlets shut down, the population trialled working from home and sanitising their hands every 15 minutes.

The market reaction to the distancing measures was dramatic, with the All Ords gaining 12.5% three days after the low point on 23 March 2020. And, slowly over the quarter as COVID-19 cases reduced the All Ords has increased to close at 6001.3, 31.5% above the March low and 10.4% decrease for the 2019/2020 year. The quarterly gains provided some reassurance to investors, however if investors were simply tracking the index then they will have suffered in the short term. At the end of this volatile period the Flagship Investments’ portfolio was up 31.8% and over the financial year has increased 8.4%. This is only a short term view though, so we consider the 5 year, 10 year and since inception performance as our preferred yard-stick.

Underlying Portfolio Performance. Click to expand.

There remains plenty of uncertainty around what’s to come and therefore we expect volatility will continue. On the positive side, the stimulus measures may have been enough to keep businesses afloat such that as restrictions are released consumption and earnings can rebuild and grow back to previous levels. On the negative side, the stimulus has been likened to a Kugel Fountain, a steady flow of money that is holding up businesses and markets, but, shut off the money and watch the ball plunge back to earth with significant consequences…

Time will tell which view is right, however like most periods in history, with time, things will improve. The priority of Flagship Investments remains focusing on the long term earnings potential of our investee businesses and remembering that even during times of turmoil a high quality, sustainable business with a competitive advantage will produce superior investment returns over the long term and in that sense, the “new normal” is the same as the “old normal”.

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