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  • Eugen Neagu

Q1 2023 Review

The first quarter continued with increases in interest rates by ECB, FED, and Bank of England. Generally these increases were expected and did not affect the markets that much. Equities (as per MSCI World All Countries index) were up by 4.39% and Sterling Bonds (as per Bloomberg Sterling Aggregate Index) up by 2.2%.


Markets were led by a recovery in technology, some discretionary, and semiconductor companies, the companies which were beaten up in 2022. Healthcare, materials, real estate, financials, have performed negatively, with industrial sector barely positive, and consumer staples a bit under 0%.

As a result, our portfolios have performed well, both the models’ using funds, but also the stock picking portfolios, used mostly for clients who are a U.S. person.


As mentioned, financials were all affected in March by the banks’ issues (Credit Swiss, and Silicon Valley Bank), however, we think that not all financials need to be tarred with the same brush. For example, insurers and some other financials are growing their revenue and earnings, and some of them are also cheaply priced. Even Berkshire Hathaway, Visa and Mastercard were dragged down as a result.


In our last investment committee meeting, we decided to reduce the Utility exposure from 2% to 0%, due to the fact most are regulated, and the “value” which it offered was already extracted. We are also slightly reducing the Oil and Gas exposure, although the Oil price seems to be able to remain a little higher due to efforts from OPEC to reduce its production.

Overall, we are also reducing equity exposure between 3% to 5%. There would also be a fund change, where we will follow the investment manager to another fund he runs, given he decided not to run the fund we were using for financial reasons. The fund which has a “value” tilt performed very well last year and in the first quarter.


Inflation seems to remain stubbornly high, and this would lead to further interest rates increases in May and over the summer. Apart from the possibility of a recession, which would affect stock prices in many sectors: financials, tech, and other cyclicals (industrials, materials, real estate, etc.), stock prices are at relatively high valuations. For some companies, the possibility of a recession is priced in, others seem to be priced for perfection.


Also, we have the first example of bad behaviour from the Oil and Gas industry, which instead of focusing on returning cash to shareholders, developed some new areas to drill, or focus on renewable (we do not know yet, if Oil companies are able to make this transition, something we are keeping an eye on), Exxon Mobile has made an offer to buy outright a smaller shale exploration company (Pioneer Natural Resources) at a high premium.


Going forward, as explained above, by reducing the overall equity exposure, we are going to reduce exposure to tech and semiconductors, sell the utility exposure, and some exposure to Oil and gas to the point we are underweight the MSCI ACWI index on these sectors.


Why do we not invest passively?


We are asked this question by a few people, often by new clients. We believe in the concept of long-term investing and the fact that beating the market over long periods of time is hard, close to impossible.


However, long term means a period in excess of 35 years, even longer. In the same time our clients are in what we name the “fragile” period, the period of 5 years before retirement, and 10 years after. In fact, a client who is age 55, and retires at age 60, would have at most 22 years of investing period. By age 77, consideration for purchasing a pension annuity should be given due to increase in mortality drag. In fact, by that time there could be a deterioration of mental acuity, and sometimes for clients older than 77 the last thing they would like to do is to vet financial advice and take important financial decisions.


The ”fragile” period is characterised by a need of real return, around 2% - 4% per annum compound after charges, depending on how adventurous the financial plan was drafted. Most important is achieving real investment return, not to get the market return. If the market return is very high as it was from 2009 until 2021, and if we underperform by 2% per annum, your financial objectives would not be affected. However, if market return is persistently low and some years negative, you would need to outperform and try to get a more resolute return.


We have looked at evidence, and how different equity “factors” have performed historically, with a view to tilt portfolios towards more persistent factors, to be able to deliver that explained in the paragraph above – real investment return of around 3% per annum, to allow for a withdrawal rate of 4% after charges, increasing with inflation.


Dimensional has done a Study looking at persistence in performance of the three main factors they use: small cap, value, and Profitability/quality.

Our portfolios use a “High quality” factor approach, and a “value” screen when starting investing. The value screen is maintained, especially for periods like now when “Growth” factor trades at very high multipliers.


To explain this better, I present the valuations for the main 5 (five) constituents of the MSCI World Index. You have the Earnings per share (EPS) for the last 5 years (ending in 2021) which were very high due to pandemic tailwind, the EPS for 2022 where with the exemption of Apple and Microsoft, the others three companies had lower earnings, the EPS for 2022 Q4 versus 2021 Q4 (all five had this negative), the estimated EPS for 2023, and the Price to Earnings (P/E) ratios for these companies.

*All figures with the exception of Amazon.com are Generally Accepted Accountancy Principle (GAAP) figures from the company reports; for Amazon, due to changes in value of the partial owned Rivian business, which is also a listed company, Amazon has posted a loss of $0.32/share in 2022, as that business lost around 65% of the value, and this is reflected in the Price and Loss (P&L) account for Amazon.


I have adjusted the numbers to take this effect out, so last year the adjusted EPS was down by 51% to $1.12 from $2.50, and this year, it is expected to go up by 28% to $1.43/share, still well below the adjusted EPS from 2021 of $2.50/share.


Amazon.com is a bit more complicated, as it recently invested greatly in fulfilment centres, and the U.S. tax law allowed it to apply a higher depreciation rate in the first two years, which led to lower net profits (EPS). It is difficult to calculate an exact EPS if for example a straight 1/30th rate for depreciation would have applied. At the other end, Alphabet (Google) has checked the state of some of its servers and intends to use them for at least one more year. Unsure if this will have an influence on the bottom line, in terms of less depreciation or depreciation which will apply as normal, but certainly deferring with one-year new purchases will increase the free cashflow.


These 5 companies have already had a horrendous 2022 in terms of their stock price, and it is possible that from 24 April 2023, when they start reporting for 2023 Q1, some of them may not meet EPS consensus and stock prices may go down further. The risk is increased due to higher multipliers these companies trade at now. We are underweight these companies, as we think the multipliers are very high and expected return is limited.


In terms of what worked for us, I would mention this time our allocation to healthcare through funds or direct stocks did very well. Novo-Nordisk A/S was 14% up this quarter, and it needs a special mention as from the time we started N2 Asset Management in January 2020, the stock price went 202% up, not to mention that it paid a small dividend too. Its huge “moat” in fighting diabetes allows it to earn very high returns on capital employed. The others: Intuitive Surgical was down 4%, Idexx Laboratories was up 22.5%, Edwards Lifesciences was up 12%, Zoetis was up 12%, Stryker was up 14%, Thermo Fisher Scientific was up 3.5%, and Lonza Group Ltd was up 18%, versus -1% for Legal and General Health & Pharmaceuticals Index trust measured in USD.


The difference is that we avoid companies which produce molecules covered by a patent (which expire sometime in the future), and instead we focus on companies making laboratory equipment, surgical robots, and prosthesis. These tend to have a better “moat”. There are very few exemptions, like Novo-Nordisk where the insulin molecule is very hard to be produced and there is no competition, or in case of Lonza Group, a Swiss company which offers “the picks and shovels” for the biotech industry. Also Zoetis is a vaccine manufacturer for pets and animals. A new addition to our healthcare portfolios is DexCom Inc which produces equipment for monitoring and delivering insulin automatically when needed for people with diabetes.


Meta Platforms (Facebook) recovered a lot of ground in the first quarter, up by 76%, bringing the company at a price at which we think it is fully valued.


A special mention is also given to Crox Inc, an U.S. discretionary consumer business with a market cap of $9 billion, which produces the Crocs plastic sandals and the Hey Dude shoes. It went up by 18%, and we think the business would continue to do well, as its products are attractive for teenagers and young people. It also trades at an inexpensive P/E ratio of 16x for a business which is expected to grow its revenue by 24% per annum, and EPS by 27% per annum in the next two years.


I will close by reminding you that most likely you are in what we name the “fragile” period (age 55 to 70) where real investment performance is very important. Your financial plan has clear growth assumptions and not meeting those, would mean that financial objectives around retirement will have to change. We are working hard for you to avoid this happening.


IMPORTANT NOTE: The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.

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