In the previous post, we summarised the main points of our investment thesis, outlining our thinking and setting the stage for future publications. In this first part of our investment thesis we will outline the underlying trends that make us seek value in commodities and commodity producers' shares. In the second part we will look into each sector we're invested in in more detail, however, for the sake of brevity we won't explore them fully. We will refer to the research that supports our beliefs for those interested to dig deeper, and elaborate in future publications.
We believe that the economical environment we live in, characterised by expansionary monetary policies and fiscal stimulus (Investopedia, “Fiscal Policy vs. Monetary Policy: Pros and Cons”) employed by governments to deal with the consequences of the actions taken to tackle the COVID-19 pandemic, will be highly disruptive. Inflation, structural supply deficits, disinvestment from fossil fuels, green energy investment and increased energy demand are some of the trends we've been paying attention to over the past few years.
Inflation
Since the beginning of the COVID-19 pandemic many governments have increased their monetary and fiscal stimulus, enacting policies in the form of MMT (Refinitiv, The Big Explainer, “What is Modern Monetary Theory?”). In a post from 2020, Goehring & Rozencwajg were pondering what would the effects of increased fiscal and monetary stimulus be (emphasis ours):
The obvious effect would be a shift from the deflationary psychology that has gripped markets over the past decade to a new period of inflation. Very few investors are positioned for such a move. The other effect could be a rerating of real asset prices generally and particularly commodities. (Goehring & Rozencwajg, “We Are Entering Into A New Era Of Inflation. Are You Prepared?”)
In a more recent article, they observe (emphasis again ours):
... the creation of new money is already finding its way into the economy. M2 growth is now surging at unprecedented rates — 27% at last look.
The inflation signal, first delivered by the April 2019 BusinessWeek/Bloomberg cover story, is now being confirmed by underlying economic and financial data. Money supply growth is surging and physical shortages are developing. The banking system is in excellent shape and stands ready to lend. (Goehring & Rozencwajg, “Is Inflation Here to Stay?”)
In many western countries we have already witnessed higher than expected inflation (The Guardian, “US inflation hits 13-year high in June”), which some attribute to the reopening of the economy and believed to be transitory. One of the narratives is that once the supply bottlenecks and increased demand, thought to drive prices higher, get resolved inflation will come back down within acceptable levels. We believe it might be more nuanced than that. Some supply shortages will be resolved, however others will take longer, as there are underlying structural deficits that drive them. We will look at these in future publications.
Regarding transitory inflation, Lyn Alden in her article, “The Ultimate Guide to Inflation” (well worth reading) writes:
However, there’s a big difference between inflation that is only transitory in rate of change terms, and inflation that is truly transitory in absolute terms.
Inflation that is truly transitory in absolute terms would mean that a lot of prices temporarily go up due to a temporary supply shock, and then come back down when the supply shock is over. (Lyn Alden, “The Ultimate Guide to Inflation”)
Inflation might well prove to be transitory, we can't possibly know, but we do see a number of trends that point us towards more persistent higher prices; border and trade restrictions, disinvestment from fossil fuels, structural supply shortages, increased energy demand to name a few. These will be the subject of future posts, as we believe they are the drivers of various prolonged supply shortages, offering opportunities in various sectors and protecting us from the effects of inflation.
If inflation proves to be transitory we have investments that will perform well, however we like to cover our bases and hedge against it. This is the purpose of “The Haptón Portfolio”. So how do we protect ourselves against inflation? There are a few ways; gold, commodities, real estate, equities to name a few (Investopedia, “9 Assets for Protection Against Inflation”). We highlight some research from the Man Institute and Factor Research that demonstrate how commodities (and some commodities more than others) offer a great hedge against inflation.
Summary Performance of Assets in US Inflation Regimes
We see how energy, among all commodities, performed the best. We also observe how energy equities didn't perform as well as the underlying commodity, with the exception of 1977-1980 and 1987-1990 periods.
Real Monthly US Equity Returns: 10 Best Sectors Excluding the Oil Crisis of 1973 to 1986
Some research highlights that commodities themselves are the best hedge, versus commodity producers' equity. Others however, note that commodity stocks are a good proxy (Investopedia, “Commodities: The Portfolio Hedge”, IG, “How to hedge against inflation”). This divergence highlighted between the performance of commodities vs commodity producer equity, is something we need to explore more. However, we've seen enough evidence that supports some correlation between higher commodity prices and higher commodity producer stock prices. Thus, we chose to invest mostly in commodity producers' equity, especially since they are undervalued compared to the broader market indices.
Commodities Undervalued
This leads us to the fact that commodities and commodity stocks have never been as undervalued as they have been today. We refer to the following chart from Janus Henderson Investors, pointing to a “turn in commodities through the 2020’s” (Janus Henderson Investors, “Are we entering the next commodities supercycle?”), highlighting the potential upside in commodities and commodity related stocks.
US commodity price index 1795 to present
The forecasting in the chart above should be taken with a grain of salt, as is true with all forecasting, however even if we don't reach the projected highs and only move halfway there, many commodities and related stocks' prices will increase multiple times. In addition, we refer to the following chart from Goehring & Rozencwajg's “We Are Entering Into A New Era Of Inflation. Are You Prepared?” article, which we mentioned in our first publication:
Of course this doesn't mean that commodities have to necessarily go higher - we could have reached an era where the world doesn't need as many, or technological innovation has made higher prices a thing of the past. Ultimately, we don't know. What we do know is that commodities are cyclical, moving in bull and bear markets and that they are the most undervalued they have been in the recent past. Finally, we're observing structural supply deficits that could take years, even decades to resolve which is what drives commodity super-cycles (Refinitiv, “Is this the start of a commodities supercycle?”).
Growth to Value Rotation
Before we close this part we want to mention the growth to value rotation we noticed towards the end of 2020, which could be the beginning of a new investment paradigm shaping the next decade. This is of particular interest to us, since a lot of the sectors and stocks we're investing in could be classified as “value”, using traditional valuation metrics such as P/E and P/B ratios (Investopedia, “Value Stock”).
Around November of 2020 we noticed that rotation to value stocks, with industrial, financial, energy, consumer discretionary, and materials sectors outperforming (Markets Insider, “The rotation trade is only halfway through, and these 5 sectors will continue to outperform until it's over, Goldman Sachs says”). FT, Sectors and Industries provides a more detailed and up to date view of each sector's performance so far. Once again there are arguments to be made whether this is a long term theme or simply transitory, only time will tell.
We observe that, similarly to commodities, for over a decade value investing has consistently underperformed growth investing, which led many investors to question the validity of such strategies: buying shares of companies that appear underpriced based on some fundamentals (P/E, P/B ratios, dividends, etc). In the following chart from Vanguard we see that since the Financial crisis of 2007–08 (Britannica, “Financial crisis of 2007–08”) growth has consistently outperformed value strategies, with value hitting the lowest point in 2020.
Difference in annualized total returns over rolling five-year periods
To conclude, we see higher than expected inflation that might prove to be more prolonged than what is expected, driven by structural inefficiencies which could take a long time even decades to resolve, leading to the next commodities super-cycle. Many commodities have been in a long bear markets, making them the most undervalued they've been in recent history. At the same time value stocks, that a lot of commodity producers could be classified as, have consistently underperformed the broader market indices and would benefit from a potential super-cycle.
For these reasons we believe there are higher probabilities for value and commodity producers' stocks overperforming the already overvalued tech and growth stocks in the next decade, offering us a good protection against inflation.