By James Thomson
Sean Farrington, portfolio manager at the Bahamas-based global fund manager Holowesko Partners, isn’t surprised that the rally that set markets alight in January and early February is running out of steam.
“In our view, that’s now running up into the reality of what’s going to happen with earnings as we go into the rest of the year, and the reality of what’s going to happen to consumers as we go into the rest of the year.”
Farrington, who was in Sydney last week to visit with local clients, says many investors convinced themselves the S&P 500 index looks reasonably valued, given it is trading just above historical averages on a price-to-earnings multiple of 17 times. But the market is trading on a higher price-to-sales multiple than it was during the dot com bust of 2000.
“The reason that the index doesn’t look so bad relative to PE is because the margins are so inflated. We’re sitting at peak margins, historically, at a time when all the things that led to those peak margins – lower interest rates, offshoring of labour costs overseas, the ability to outsource a lot of your capex to other countries – are reversing.
“If you look at the cost of goods sold in the US, it’s increasing at a faster pace than revenue. So the consequence of that is likely to be margin pressure as we go into the second half of the year.”
Holowesko is a value investor and is coming off a cracking year; its long-short strategy beat the MSCI All Country World Index by 26.5 per cent in 2022.
That performance also benefited the ASX-listed Future Generation Global investment company, which added Holowesko to its roster of fund managers last year following a review of investment performance. FGG announced on Tuesday it had delivered a 4.2 per cent investment return in the December half, beating the MSCI World Index by 0.5 per cent; its full-year dividend jumped 16.7 per cent to 3.5¢, representing a fully-franked yield of 5.9 per cent.
Farrington says the focus of Australian investors during his trip has been around the sustainability of the shift from growth to value that markets have experienced over the last 12 months.
He expects the shift to continue, but argues the definition of value is likely to change given the way markets have been disrupted. A great example of this is one of the positions Holowesko has recently added to its portfolio: Google owner Alphabet.
A FAANG stock isn’t usually where you’d expect a value investor to play, but Farrington argues that at about $US90 ($133.45) a share, Alphabet looks attractive. It has about $US9 a share worth of cash on its balance sheet, and Holowesko reckons its cloud business and its “other bets division” are worth about $US25 a share each.
But it’s Alphabet’s flagship advertising business, which accounts for 80 per cent of the company’s revenue, where Farrington sees the most value.
“Everybody’s worried about the slowdown and growth on the ad spend side. And it’s true that Google is now such a big player in the ad market that inevitably if you get economic weakness that’s going to spill over into their revenue, but we still think there’s a long runway for them to grow that top line. If you look at where ad penetration is in the US for online digital advertising, it’s about 60 per cent of the market. In China, it’s about 80 per cent of the market.”
Farrington believes the ad business can keep growing in the mid-teens into the future. “And if you’re paying 10 times for that, that’s pretty attractive.”
Europe, where markets are trading at a 25 per cent discount to the US on price-to-earnings, a 50 per cent discount on price-to-book and twice the dividend yield, is also attractive to Holowesko, with Farrington pointing to British banks as top pick; they trade on P/E ratios of around 6.5 times, but could hand back as much as 40 per cent in dividends and buybacks in the next two years.
The firm has also done well riding the rally in Hong Kong stocks recently, but it’s the cash-rich companies of Japan that hold even more allure. Farrington gives the example of little known manufacturer Nabtesco, which has a 60 per cent share of the global market for gears used in robotics – and 20 per cent of its equity in net cash. While all eyes are on the Bank of Japan’s next monetary policy moves, Farrington says opportunities like this are divorced from those macro ructions.
Holowesko has long had a position in Australian giant BHP, particularly for the group’s exposure to rising copper demand amid the energy transition. But Farrington isn’t going near our expensive banks.
He expects interest rates will eventually have to get above CPI to bring inflation back to target levels, but in the US, consumers are protected by the fact most mortgages are long-dated fixed-rate loans. Not so in Australia, where the mortgage market is dominated by variable-rate loans, meaning central bank rate rises hit sooner and harder.
“I think it’s going to be an issue for markets like Australia, unfortunately, that have this variable issue on rates.”