2021 so far: The end of the year has come around again, and whilst 2021 has thankfully been less eventful than 2020, it has been far from what we would consider a normal year. In last year’s review, we laid out some predictions for 2021, which we feel have generally been confirmed, although there are a few things that have differed of course, as we are yet to find the ever-elusive crystal ball.
As mentioned above, 2021 was indeed less eventful than 2020, and with time, the vaccine rollout has allowed life to look and feel more normal than it has for a while. As a firm, we were able to return to meeting some investors and corporates face to face, although nearly all conferences have remained virtual events throughout the year.
Markets were less volatile and jumpy than we expected, with less discrimination and dispersion than in 2020. Polarisation remained elevated, although it was driven by themes (reopening vs staying at home, value vs growth, active vs passive, ESG…) rather than by bottom-up selection.
Following a drastic rotation in late 2020, the Strategic European Silver Stars Fund’s largest positions at the beginning of 2021 were characterised by low valuation metrics combined with sharp earnings growth prospects, for the next two years at least; a powerful cocktail. Interestingly, the economic recovery was much faster and stronger than expected. As a result, the upside potential for most of the Fund’s positions has increased. Despite the significant recovery, stock prices have failed to keep pace with EPS and FCF revisions throughout the year.
If there is a point of frustration for us this year, it lies precisely here i.e., to observe that stock prices have failed to reflect the much stronger than expected EPS and FCF growth for most of the Fund’s positions. At the same time, this will not be lost and represents a strong reserve of revaluation for the months to come.
Six of the Fund’s positions have recently initiated share buyback programs with the intention to cancel the shares. We have never seen this level. It results from sound balance sheets post 2 years of strong FCF and valuation levels not following the underlying earning’s growth.
This observation has other consequences, the most obvious one in 2021 is M&A activity which picked up significantly. As we approach the end of December, the value of all pending and completed deals in Europe stands at €1.8t for the year, according to data compiled by Bloomberg. This represents almost two years in one, and the highest level since 2007. The Fund was a beneficiary of this trend in three positions (Hunter Douglas, Sicit & Iliad), which all had a common theme where the majority owner took these companies private. This resulted in investors receiving significant premiums over the pre-deal market prices.
Some clouds also appeared during the year: COVID variants; raw material and energy prices; component shortages; Chinese real estate risks, and more recently, inflation and the associated tapering risk. All these issues have reduced visibility and increased risks since the summer of 2021. One direct consequence has been the underperformance of European small and mid-cap companies versus large caps this year with the gap widening since September.
So what should we expect for 2022 and how is the Fund currently positioned to accommodate this?
Pent-up demand, improvement in supply chain challenges, sustained capital spending and solid labour force growth should all contribute to another year of above-trend global economic growth in 2022. COVID related risks remain, and one cannot discard the potential for a policy mistake as the economy moves towards normalisation, but we believe the overall environment will be supportive of business growth – and ultimately equity markets.
Inflation will surely take centre stage in the months to come. Based on the conversations that we have had with corporates, we have less concerns surrounding its consequences in terms of margin squeeze. Notably, logistical shortages have helped corporates to pass on price increases so far. Corporates have also made significant investments throughout 2021 to address the bottlenecks that have led to supply chain disruptions. Inflation, in the way we know it today, should revert during the year because of a higher comparable base, but also over time, as corporates’ investments address the bottlenecks.
Longer-term, there seems to be an acceptance that inflation will be higher than in the past. Central banks also appear to be willing to take the time to deal with the existing inflation in the system and extend the period of negative real rates that we are experiencing.
The two unanswered questions at this stage relate to potential second-round effects on how salaries feed through to inflation, with a strong economic recovery already pointing to shortages in the labour market and energy prices. The OPEC+ cartel, who, following the pandemic, have gained a real ability to dictate oil prices. They currently look comfortable to maintain an $80-$85 per barrel range, but they have also demonstrated their ability to change their stance should they wish.
China, as shown this summer, is also able to increase volatility across markets, with the Evergrande situation referred to in some places as the “Chinese Lehman Brothers Crisis”. The Chinese government remains focused on the structural goal of creating a more sustainable environment for growth ahead, and has revived its long-standing effort to control leverage that was initiated in 2016 after being briefly interrupted by the COVID situation. It shall remain a point of focus for us, but here as well, messages received from corporates in recent months have been reassuring.
Positioning for 2022
The Fund’s top positions are currently very similar to early 2021 as stock price evolution has lagged the better-than-expected corporate results. As an example, the Fund’s largest position was up nearly 40% YTD, but since the 1st January, consensus EPS expectations have increased by approximately 120% for 2021 and 50% for 2022.
In recent newsletters, we discussed our decision to reinvest in several of our “COVID winners” that we held in 2020, throughout 2021. Our fundamental approach to investing often leads us to investing with contrarian views to the market. During September and October 2020, the significant market rotations led us to sizeably reduce our exposure towards “COVID winners” or “stay at home players” and crystallise our gains from earlier in 2020.
During 2021 those same “stay at home” stocks have been largely penalised by the market as economies reopened and vaccination campaigns have led other investors to believe that these companies will not continue to perform as well as they did throughout the COVID lockdowns. In 2021, we decided to redeploy capital in businesses that in our view, managed to implement the equivalent of three years of development in three months during spring 2020, without having to spend a euro on marketing – as unusually for this type of business, customers came spontaneously. Obviously, these businesses will not retain all the customers that they have gained now that the world has reopened, but our view is that many of the customer/business wins should remain in the future. It is important to mention that we did not reinvest in some of the many companies that escaped an inevitable bankruptcy due to COVID and physical store closures.
Another area that has become more of a focus recently is companies that are well-positioned for the debottlenecking of supply chains and the resulting disruption that has been caused, with specific attention to the automotive sector, which was the hardest hit due to the chip shortages. Worldwide production of passenger cars and light commercial vehicles amounted to around 75 million units both for 2020 and 2021, which compares to 89m in 2019 and 94m in 2018 – a gap of 33m vehicles has been created in two years, equivalent to 44% of 2021 production. The world’s vehicle fleet is aging and will need to be replaced sooner rather than later. Provided one can avoid companies penalised by the ongoing disruption of the power train and electrification trends, this sector seems extremely attractive to us for the next several years. Very few other investors appear to be positioned for this today.
As a summary, we can say that several themes have recently emerged from our bottom-up stock picking:
- Companies with strong pricing power capabilities
- Companies with sound balance sheets, sometimes even too sound
- Companies exposed to digitisation trends
- Companies with a circular economy model
- Fallen angels post reopening
- Companies positioned to benefit from debottlenecking of supply chains
As of today, we are very pleased with the portfolio of companies that we hold, as well as the other opportunities that we are evaluating in the market. This is a balanced and diversified portfolio, able to cope with a wide range of potential scenarios for 2022.
Based on the valuations that we are seeing, we feel that the next couple of years should provide us with plenty of opportunities for outsized gains.
As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolio. Download the latest factsheet of the Strategic European Silver Stars Fund.
Please do not hesitate to contact us or visit the Strategic European Silver Stars Fund Page.
+44 1481 742380
The views and statements contained herein, including those pertaining to contribution analysis, are those of Pascal Investment Advisers SA in their capacity as Investment Adviser to the Fund as of 14/12/2021 and are based on internal research and modelling. Performance data is based on the Strategic European Silver Stars Fund (A EUR Class). Please click on Disclaimer Page to view full disclaimers.
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