In our July newsletter we said that despite the rally, we continue to believe that caution is warranted for the coming months and that we would refrain from aggressively deploying capital for now.
Unsurprisingly to us, the market’s mood reverted abruptly again in the middle of August. In July, H1 results lifted investors in Europe, hopes of less tightening by central banks, and they were also a little quick to believe that the worst was behind us.
This positioning proved short-lived as the harsh reality returned when the Federal Reserve reminded us that the urgency of the situation requires the continuation of a long and painful monetary tightening. It is also worth noting that members of the ECB have called for a significant interest rate hike in September faced with continuing high inflation.
The message from central bankers at Jackson Hole has been crystal clear and stocks didn’t like it: fighting inflation remains a top priority. Long-term rates reacted to the comments with the 10Yr US Treasury ending the month up 54bp and stock markets immediately nosediving in a similar fashion to the June capitulation – indiscriminately: without significant market volume; with limited outflows from investment funds; and only a very benign spike in volatility indicators.
The H1 reporting season confirmed our views expressed in several letters this year. Corporates’ results are visually OK… when spotlighting P&L numbers.
Companies were prompt to raise prices and were able to successfully pass inflation on to their customers, for the moment. They can also capture a positive margin impact by selling inventories acquired in prior quarters. The increase in revenues is mostly price driven with almost no volume impact.
Unfortunately, the picture on the cash front is far from being as rosy. Rebuilding inventories are costly and could eat away the full P&L improvement, and sometimes even more. Albeit partially explained by seasonality effects, working capital levels (hence inventories) appear to be too high across the board, with many companies promising hefty working capital declines before year-end.
The reduced inventory targets in H2 will, in turn, trigger fewer orders at a time of continued inflation, exacerbated by the gradual increase of energy costs as prior hedges expire. Passing on inflation when everyone is rushing to build inventories seems like an easy task. Doing so while everyone is looking to reduce stockpiles will be a whole new ball game.
Because of the high prices of natural gas and electricity, companies are switching to other energy sources, reducing output, but also shutting down production facilities. This demonstrates their inability to continue passing on inflation, triggering a sizable drop in output. In our opinion, the margin squeeze in H2 is likely to be more pronounced than expected.
In such an environment, more than ever, investments in companies with strong balance sheets and strong free cash flow generation should be favoured, adopting a survival of the fittest mindset.
Fortunately, the market comments above do not apply to all companies, and this is one of the clear benefits of a concentrated portfolio. Take Ipsos as an example, the Fund’s largest position: active in a counter-cyclical industry, no energy bills and no inventories.
The thoughts highlighted above simply do not apply. Ipsos may be impacted temporarily by the mark-to-market phenomena, such as in June or August when active managers deserted the market to leave it in the hands of top-down passive flows, but this will not last though, as cash flow conversion remains close to 100% with full P&L improvement translating into deleveraging.
The Strategic European Silver Stars Fund‘s performance for August was -7.14%. The year-to-date return stands at -17.61%, a 3.22% outperformance compared to the benchmark at -20.83%.
The largest contributors to August’s performance were: Einhell (+0.05%), Pierce (+0.05%) and AKWEL (+0.05%). RevolutionRace was the largest detractor during the month (-1.26%), followed by Bekaert (-1.09%) and Ipsos (-0.90%).
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.
Please do not hesitate to contact us or visit the Strategic European Silver Stars Fund Page.
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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 07/09/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.
Morningstar™ Ratings Disclaimer
The Strategic European Silver Stars Fund – A EUR share class has a Morningstar rating of 4 stars overall and 5 stars over 3 Years. Morningstar Rating™ as of 31/05/2022. Past performance may not be a reliable guide to future performance. Returns could be reduced, or losses incurred, due to currency fluctuations. The Strategic European Silver Stars Fund received a Morningstar 3 Globe Sustainability Award. Sustainability Rating as of 30/04/2022. Out of 789 Europe Equity Mid/Small Cap funds as of 30/04/2022. Based on 98.92% of AUM. Historical Sustainability Score as of 31/03/2022. Sustainalytics provides company-level analysis used in the calculation of Morningstar’s Historical Sustainability Score. Data is based on long positions only.