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Printed: 05 December 2022 11:59 AM

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01 Feb 2022 - Why I think 2022 will be a very good year for investors
By: Montgomery Investment Management

Why I think 2022 will be a very good year for investors

Montgomery Investment Management

05 January 2022


A year ago, I wrote an article in The Australian which set out the factors I thought would make it a very good year for equities. So far, the local market has behaved as expected - despite all the turmoil in the world - with the All Ordinaries up 13.6 per cent for the 12 months to 31 December 2021. Looking ahead, I think markets will continue to reward investors, particularly those who invest in quality businesses.

Significant price moves are always determined by the magnitude of surprise. The bigger the surprise, the bigger the move. And so, in the absence of a black swan - something completely unexpected - market returns will be determined by earnings growth. And, completing the idea, the best returns will come from those companies whose earnings grow faster than currently anticipated.

For those who believe the market will crash, it is worth remembering such events are typically triggered by the unexpected, the black swan. Those who profited greatly from the Global Financial Crisis were so few and far between a book was written about them. The logic on which they established their trades at the time of the crash was not widely known. When the idea a large cohort of subprime borrowers might be unable to make their first loan repayment was published, it was not widely embraced as a market catalyst. Generally, it won't be what we already know that brings on a correction.

For now, we can probably rule out a correction from inflation or the current Omicron strain of COVID-19 because there are as many adherents of these ideas as there are detractors.

Most of the headlines warning inflation isn't transitory cite manufacturers and retailers who state emphatically prices aren't coming down. But that isn't tantamount to accelerating inflation. It just means there will be no deflation. If US inflation this year is seven per cent but next year 6.5 per cent, the retailers and the manufacturers will be right - prices aren't going down. It is also true however that price increases are decelerating and that's called Disinflation.

Disinflation, when it coincides with economic growth, is historically very good for equities, especially growth equities. Innovative companies and those with pricing power, which tend to be those with sustainable competitive advantages do best in a disinflationary economic expansion. Read any of our documentation and you will find we have always preferred businesses with sustainable economic advantages because it is these companies that produce attractive returns on their equity.

Supply chain bottlenecks have impacted almost every corner of commerce and while these bottlenecks remain, inflation will be elevated. Our channel checks of impacted businesses, which include wholesalers, hospitality and retailers, digital, healthcare, IT and advertising, suggest the bottlenecks are lingering. And while that is true it isn't tantamount to further acceleration in the inflation rate.

With respect to the inflation discussion, I currently believe only a surprise acceleration would be negative for the market in aggregate. Even fears of such an acceleration won't cause a crash because those fears have persisted for a year now. And don't forget inflation has surged without crashing the market.

Following the virus, I believe, is more imperative than following inflation.

A new definition for fully-vaccinated is emerging - three doses. On that definition, about one per cent of the world is fully vaccinated, including me. Of course, that means plenty of opportunity for variants to emerge. Understandably, Main Street is worried a variant emerges, able to undermine the current crop of vaccines. Trading at near record highs, market prices suggest such an outcome is not anticipated, so such a development could be an unmitigated disaster.

As investors we do have to keep a close eye on the progress of COVID-19.  Transmissibility appears to be increasing with each variant. The original variant had a basic R number of about three, followed by Alpha, estimated to have an R0 of 4-5 and Delta, with an R0 of 6-8. Omicron appears to be even higher. Measles has an R0 which has been estimated to be as high as 18 and is therefore one of the most infectious human-to-human diseases. COVID-19 may yet have a long way to evolve. Such developments aren't being widely discussed, so it is these developments, investors should be tracking closely.

But of course, through every crisis the highest quality companies, by definition, have fallen less and then rallied first and fastest afterwards.

I suggest the same pattern will emerge during and after the next crisis.

Take a look at the Buy Now Pay Later (BNPL) sector. We have warned investors about this space since 2018.  Describing the players as nothing more than factoring businesses we pointed to three things that investors were missing or deliberately ignoring:

  1. Factoring businesses make frightfully thin and unattractive margins,
  2. The BNPL companies would be unable to accelerate their growth without rising dilutionary capital or debt, and
  3. US based companies not even operating in Australia were falling over themselves to list in Australia, suggesting the prices investors were willing to pay here were out of sync with the rest of the word and therefore a bubble.

Since we published those many warnings, Afterpay is now down about 49 percent from its 2021 highs and the rest of the field has fallen a minimum of 70 percent from their highs.

Investing in quality, avoiding the rubbish and not jumping at the shadows that are already a part of the investment landscape are the keys to navigating markets and it will be no different in 2022.

There is the ever-present risk of a 10-15 percent correction but in the absence of a COVID-19 Black Swan, I think investors have little to worry about in 2022. Indeed, if disinflation also emerges, we may just find markets record another strong year. And longer term (sooner if international borders open to migrant workers), I currently expect we will return to structurally lower wages growth and therefore structurally lower inflation and interest rates. All very positive for markets.

Written By Roger Montgomery


Funds operated by this manager:

Montgomery (Private) Fund, Montgomery Small Companies FundThe Montgomery Fund

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