FPM-Comment Reducing the Noise by Martin Wirth: 2/2023 dated April 19th 2023

Where does the road lead once shortages and crises are overcome?

• Defying inflation with stocks
• Our thoughts on inflation, interest rates and valuations
• A look at America
• Banks in the focus of negative scenarios
• European banks are better than their reputation!
• What does the market offer?

In the first quarter of 2023, the previous year's losses on the German stock market were partially offset. In this context, large-cap stocks fared more favorably than small and mid-cap stocks, which had to make up for higher losses. In general, however, the development was not compelling at first glance given the news situation.

The war in Ukraine continues, geopolitical uncertainties have not abated, inflation seems to be getting out of hand, and at the same time more and more signs of economic weakness are emerging, with the U.S. leading the way. Accordingly, many sentiment indicators are at low levels, so the development took place without much enthusiasm from market participants.

Defying inflation with stocks

On the other hand, and from our point of view as value investors, this was the decisive factor: equities are generally valued lower than they have been for a long time - not all of them, but a great many. And while companies across the board have been able to pass on cost increases to customers and thus keep the real damage from increased inflation in check, this has not been possible with nominal investments as well as with investments in real estate. Given the general conditions, it is no wonder that enthusiasm is not overflowing, quite the contrary. However, you might also ask yourself when you want to invest at all: You can buy lots of companies at a more or less significant discount to their net asset value, even if you don't believe in the sustainability of their current profits.

We certainly agree on the latter. Fortunately, the shortages created by the pandemic and later the energy crisis are finite. To that extent, excess returns will disappear again, starting with freight rates, energy prices, car prices and the like. Only: Who believed that this could go on forever? Even if the earnings estimates were still based on an extrapolation, the valuations of the companies showed that no one really dared to believe this.

The exciting question now is whether the focus will return to companies with a stable business development that is rather independent of the economic cycle, but which still tend to be fully paid, or whether people will accept cutbacks in business quality and go on the great bargain hunt. Since the market obviously prefers to look at the trend in profits rather than what one has to pay for them, one could tend toward the first thesis. However, this market area is now much smaller than in previous years, after some former high flyers in particular were massively punished. In this respect, the distinction today is somewhat different than it was in the last few years. Favorites could rather be those companies which are considered boring, reasonably valued, which do not arouse much imagination, but which are also not substantially undervalued and in the best case free of scandals. And on the other hand, likewise solid companies, but whose earnings power can fluctuate significantly within a few quarters and for which investors fear price losses under these circumstances. In short, on the stock market 1+1+1 is worth more than 2+0+2. This means that investors would rather forego earnings in exchange for peace of mind.

Our investments cover both of these categories, with a bias towards low valuations. On the other hand, we continue to be uninvested in top quality (at least companies perceived as such) for valuation reasons.

Our thoughts on inflation, interest rates and valuations

What drives us? In addition to looking at the sustainable earnings strength of a company, which is precisely not reflected by quarterly results that fluctuate more or less in the short term, one cannot neglect the influence of the permanently changing underlying conditions. Since the Covid crisis, these fluctuations have reached dimensions previously unknown. Therefore, they also have an impact on our investment decisions, and hence now our view of things (which may or may not be shared).

First, inflation: it is obvious in our eyes that the peak has been clearly passed, that inflation is on the retreat, and that these developments will run through the entire value chain. The laggards are collective bargaining, which will ultimately cost companies money, which is obviously already factored into the markets' implicit expectations. After inflation rates roll over they will probably fall significantly in the course of this year and the next. However, no one can seriously claim that there will be a comparatively narrow corridor as felt in recent years. And it is more than likely that inflation rates will remain in a range that is too high for central banks for longer, at least if you want to follow their statements.

This has implications for the valuation of companies that are dependent on the level of interest rates, first and foremost real estate companies in the negative sense, banks and insurance companies in the positive sense. This also applies to companies where, for example, retirement provisioning has been inflated in recent years. Here, one should not assume that the old interest rate levels will be reached again, especially not after the unpleasant experiences with regard to the distribution effects of inflation, which can be read in any textbook on basic economics, but which were obviously not really appreciated as reading in the decisive places.

This will therefore lead to an increasingly restrictive monetary policy for the next few quarters after the damage done has to be compensated. However, and we are probably in the majority camp here, monetary policy will tend to loosen again as soon as possible albeit not to the same extent as in recent years and not before next year.

Until then, in addition to the slowdown that is underway anyway, the fading of the post-Covid boom and the decline in scarcity prices will be headwinds for companies. In Europe, at least the absence of the Armageddon of the energy crisis has created a slight additional tailwind that may help avoid recession. The distortions were already partly borne last year, as can be seen from the full stop in the chemical industry, so that the height of the fall has been significantly reduced. And what was calculated at the time has turned out to be far too pessimistic from today's perspective. The rise in gas prices, for example, is costing Germany less than 0.5 % of national income compared with the lows of a few years ago, which is so little that policymakers are not even seriously considering Germany's natural gas reserves, which would cover most of the country's gas needs until the “energy turnaround” is finally complete.

A look at America

Instead, things are looking less encouraging in the USA this time around. This, too, is more of a disillusionment that follows excessive monetary policy and the issuing of helicopter money to citizens. In the U.S., too, the wisdoms of economics are only gladly followed if they are politically communicable, i.e., if they please the citizen. And at some point, this comes to an end. But here, too, it is relatively simple: Once the excesses have been reduced, things move on. And the excesses this time were very manageable compared to the times of the financial crisis: Only a few percent of national income given away, instead of several years of redistribution like before the housing and banking crisis. In this respect the world should look more "normal" again in a year's time: Employees will be easier to find, the economy will get used to the nominally higher interest rates, which are not high at all in real terms, and companies will have adapted to the changed conditions in their markets. Anyone who still does not believe that this is possible within a reasonable period of time has not drawn any conclusions at all from the extreme conditions of recent years.

Banks in the focus of negative scenarios

If all this seems plausible, which it just should after the experiences of the last decades, there still remains a wild card for the bears (besides war, geo-crisis, climate change, a comet impact):

Candidates for a new Armageddon are once again the banks. The following can be said about this without giving the final guarantee: the comparison with the financial crisis of 2008 is completely absurd, and this is particularly true for European banks. (Some) banks are suffering from an unwillingness to adapt to the changed environment and were ultimately poorly managed. The sooner this brought a bank to the brink of ruin the better in hindsight. UBS from 2008 or Deutsche Bank from 2017 are just examples of how business models were transformed when things could no longer go on and the neglect of business practices was no longer tolerated. The last one to bite is the dog, and in this case it was Credit Suisse, which after all managed to slide into ruin in a very short time as a solvent bank with weak earnings but without huge operating losses. Cause: complete loss of confidence. If Volkswagen no longer gets any steel delivered or Aldi no longer gets any food, then these companies will also go under. The only difference is that the trust there does not vanish into thin air in the shortest possible time. A terrific lesson for all other market participants. And bad luck for Credit Suisse, which had previously been the one-eyed man among the blind. Life punishes those who come too late (Gorbachev).

The following is all I have to say about the U.S. banking crisis: What was handled there as a business by some banks, which for unclear reasons are no longer subject to proper regulation, is not intended to be so according to Fundamentals of Banking Management Part 1: Investing short term deposits in long term government bonds and hoping that the different yields will bring the big payoff. Until the next inversion of the yield curve. For once, some good news: In Europe, this is no longer conceivable at this level.

What is conceivable or even a fact is that investors in government bonds lost a lot of money last year. The amount that was a burden on banks' balance sheets at the peak was more than € 600 billion. A lot of money, but only a fraction of the equity. In the meantime, it has fallen again significantly as a burden, especially in the U.S. and the U.S. dollar. This has not stopped depositors from withdrawing their money, essentially unsecured deposits, from Silicon Valley Bank, since the benefits and returns of holding deposits with an insolvent bank are completely asymmetrically distributed: There is no additional benefit compared to an account held at a stable bank. In the case of other banks these burdens from the rise in interest rates were much lower or were refinanced on time. In this respect this is on the one hand an individual problem. On the other hand, however, and this is much more relevant, this has nothing whatsoever to do with a financial crisis like the one in 2008. It is rather another consequence of the misguided central bank policy of recent years, albeit a consequence that does not lead to insolvency, but could essentially cost some banks a portion of their earnings - or has already done so.

European banks are better than their reputation!

From our perspective, the situation is actually the exact opposite of what is served up in the media: Thanks to years of pressure from regulation, additional charges and low interest rates, banks are perceived as notoriously low-yielding. In many ways, we are at a tipping point here and have probably already passed it. Roughly outlined: Regulation will obviously no longer be tightened significantly, bank levies (nonsensically not even deductible for tax purposes in Germany) will fall, and most importantly, the normalization of interest rates will make normal banking profitable again, on both the deposit and the asset side. Unlike in 2008, it is obvious that banks have a clue what they have on the balance sheet and are documenting it. Unlike their supposed observers, who fabulate wildly about risks without even once taking note of simple facts. Events such as the demise of Credit Suisse undoubtedly weigh on sentiment and the willingness to invest in the sector. But it should also be certain that other banks will benefit from this unraveling. The demise of Credit Suisse was ultimately the result of a decade in which the bank earned nothing, unlike its employees. If this serves as a blueprint for how not to do it, then there is something good about it. Consolidation has never hurt any industry, and it will be no different here.

What does the market offer?

Short-term uncertainty, high but falling inflation rates, a weakening economy with the potential for recession, at least in parts of the economy, are the framework for the coming months. At the same time, sentiment and valuations are where one might expect them to be in a recession, as opposed to still current earnings expectations.

Shares of even rock-solid companies are now trading at significant discounts to their substance in many cases, to the extent that the recession has just been priced in and the earnings power that can then be expected is seen as permanent. At the same time, dividend yields are at record levels. This is not necessarily a reason for many investors; as is well known, dividends can also be cut or cancelled. What is more relevant however is that ratios such as dividend yields in relation to P/E ratios are at levels that were only surpassed during the global financial crisis and the pandemic crisis.

More and more companies are starting share buybacks due to sustained low valuations, which in recent years have often been seen as a bankruptcy of entrepreneurial idea creation. In this respect, there is obviously a point at which one cannot resist after all. From a mathematical point of view, all this is quite easy to understand.

Without going into details: Many companies have valuations according to a wide variety of criteria that price in completely different, and indeed worse, underlying conditions than are likely from today's perspective even if one does not want to regard the current earnings estimates as a sustainable basis. In our view the reason for this is that in recent years many investors have simply capitulated to the volatility of the stock markets and preferred to retreat to nominally stable investments. Additional regulation, but also trading according to more or less trivial algorithms instead of the most comprehensive understanding possible of the complexity of the economy, may have exacerbated the volatility ...

The fact that private equity investors pay twice as high valuations for the same investments as those demanded on the stock market ultimately only makes sense if they can procure the capital much more cheaply than is the case on the stock market. As long as interest rates were low, these investments could be sorted into the range of volatility-free investments by the financial investors, which was then also useful for risk assessment. Pure accounting that has nothing to do with economic reality. This was similar with bonds and especially with real estate. Here, too, one can see the differences between the fungible (stock market) and non-fungible markets: While transactions with real estate are carried out at significant but understandable discounts (10-15% are regularly quoted) to the former peak prices, real estate stocks were literally slaughtered.   Price losses of more than 70 %, which would represent a discount on the debt-free calculated real estate of 40 %, with simultaneously rising construction and replacement costs: this is largely senseless. And not to mention the many "unicorns" that are practically turnover-free but valued in the billions: The great returns have then often only been on paper, but presumably properly audited. Here, too, things have obviously changed.

The turnaround in interest rates has probably hit like a fox in a henhouse. Obviously, it's not just the generally subdued mood that's getting to investors. By all accounts, the interest rate turnaround is also an issue that has damaged the solvency of many investors. In this respect, it is clear that risk appetite is reduced for the time being. And this, unlike recession fears, is what we see as the main reason for the modest valuations and, in our view, obvious large investment opportunities.

What appears positive in this light is the fact that many companies, while not among the darlings of the investment community in recent years, have performed stably to decently in this difficult environment. Share buybacks have already been mentioned, but obviously there are also valuation levels at which, interest rates or recession aside, people no longer want to part with investments. And prefer to wait until the smoke clears. If there are setbacks buyers will quickly come out of hiding as long as the valuations are not excessive. In this respect, we believe that there is a lot to be said for the fact that we are somewhere in the area of the bottom for many stocks. And that these stocks will perform when things develop the way they always do: slowly forward.

Sincerely yours,

Ihr Martin Wirth

FPM-Comment Reducing the Noise by Martin Wirth: 1/2023 dated January 19th 2023

Check off the year 2022 and look ahead!

• Looking back at the market and the FPM Funds
• What counts now for looking ahead?
• Many companies well prepared
• Crises and their impact on prices and valuation
• Competitiveness and the banished risk of insufficient energy supply
• Positive outlook - despite it all

The year 2022 is history, and the vast majority of market participants should be happy about it. With most asset classes, one had the best chances of losing money. However, the differences in performance were massive, with the result that many rather manageable price declines are likely to be temporary, while some investments may have brought permanent losses. This makes the difference in the longer term: Are you still in the game, or have you been knocked out?

Looking back at the market ...

On the German stock market, the few winners were the companies that benefited business-wise from the outbreak of war and previously had a low valuation, as well as the companies that benefited from rising interest rates, first and foremost of course banks and insurance companies.

The majority of shares recorded noticeable double-digit losses, even if the development of the actual business was solid. On the other hand, the former high-flyers, especially from the growth sector, were hit particularly hard when high valuations met with weaker-than-expected business developments. In such cases, it was possible to experience a share price loss of 50 to 90 %, in some cases without the business model of a company being fundamentally impaired. Here, the effect of value investing was on full display: Nothing is so great that you should pay any price for it. However, we now see greater opportunities in this area again, to be clear.

... and on the FPM Funds

Last year, the FPM Funds recorded losses in line with the various indices. The range of performance of the investments was significant, from significant gains to significant losses. Furthermore, from a relative point of view, the funds were hurt by the comparatively good performance of stable equities, which we have been avoiding for years in view of their high valuation. The performance of a number of second-tier stocks was also poor. Although their business performance was decent, many market participants sold them in order to reduce risk, mostly only because they were second-tier stocks. In relative terms, on the other hand, it was very helpful that the formerly expensive growth stocks and the profiteers of low interest rates, such as real estate companies in particular, were only represented in the portfolio to a below-average extent: In some cases, the losses there were very heavy. All in all, share prices fell and so did valuations, with the result that portfolios are now even more attractively valued than they were a year ago.

The big picture: Putting it into context

Looking at the general framework, the losses on the German stock market are even almost bearable. In the past, far smaller problems have caused significantly higher share price losses and, as I said, a whole series of not exactly small companies have even been able to record share price gains.  In our view, this clearly speaks for a sustained low valuation of the asset class "German equities", which has obviously been abandoned for good by many investors last year, i.e. until the next strong performance of the market.

Among the obstacles are first and foremost the war in Ukraine, then the whole combination of rising energy and food prices, skyrocketing inflation figures, central banks throwing their zero interest rate policy overboard, and of course continued Corona restrictions, especially in China, affecting global value chains, as well as geopolitical tensions everywhere. This should actually be enough for a veritable crisis, and this was then also the case: However, not so much on the stock market, where one could get used to distortions in the last two decades, but on the bond markets, where one could otherwise always feel comfortable even in the darkest hours and where the central banks helped out in case of need. On the German bond market, the gains of almost the last ten years have gone up in smoke within a few months. As a result, attractive interest rates are now by no means being offered, as should actually be the case after price collapses: Interest rates continue to be more or less significantly below current and expected inflation rates. Real losses are therefore almost guaranteed for the next few years.

What counts now for looking ahead?

In an extremely difficult situation, Germany and Europe have so far come out of the woodwork far better than feared. The consistent stance against Russia and the support for Ukraine as well as the cohesion in NATO with the USA are a remarkable political development that could not necessarily have been expected a year ago. The associated cessation of Russian gas supplies was largely compensated for in the short term, with the state stepping in to compensate for short-term hardship. A looming nightmare turned into an opportunity to dynamize the energy transition, perhaps to reduce the rampant bureaucracy and focus on the essentials, which was perhaps grasped even more quickly in the private sector than by many in politics and administration.

Many companies well prepared

The looming recession feared by all sides has been anticipated for at least six months, measures taken, inventories reduced, fewer risks taken. This should noticeably slow down the recession, if it does come: A recession is always most unpleasant when no one saw it coming and no preparations were made. On the negative side, many companies are still benefiting from the order backlogs accumulated during the corona pandemic, which are now gradually running out. Rising interest rates will also take their toll on debtors, often only gradually as low-interest loans expire. On the other hand, creditors are the winners of this development (in nominal terms, not in real terms, see above) on the one hand, and the fact that interest rates are still not high in the longer term on the other: Companies that are already having problems under the current circumstances should perhaps fundamentally rethink their business model.

Inflation and the role of China

Two key positive aspects from an equity market perspective are the inflation outlook and the lifting of corona measures in China. Inflation dynamics are pointing steeply downward, and last year's price bubbles have largely disappeared. Gas in Europe costs about the same as before the Ukraine war, oil prices, transportation and logistics costs, used car prices are all in reverse. As the chaotic lockdowns in China come to an end, supply chains will continue to normalize and shortages will be eliminated or reduced. This should put downward pressure on interest rate expectations, which in turn will be good for stocks. In China, growth is likely to accelerate again, which will also support global growth.

Crises and their impact on prices and valuation

Like everyone else, we don't know how the next few quarters will play out. What we do know is that, despite the recent recovery in prices, a great many stocks are still valued quite low under reasonably normal circumstances. Thus, the recession, should it come, should already be reflected to a large extent in prices, but a recovery should not. As already mentioned, this is supported by the fact that German and European equities have performed reasonably well despite the extremely difficult conditions and have outperformed U.S. equities for the first time in more than a decade. No comparison with the losses of, for example, the dot.com crisis 20 years ago, which was actually a non-event from an economic point of view, or the banking and European sovereign debt crises, which could be solved by simply "printing money". Today, as in the Corona crisis, the actual and feared problems are and were more existential. And this has also been reflected in the valuation: The price DAX, i.e. the DAX, which is calculated in a comparable way to the S&P index, namely without the dividend payments, has just exceeded the high of 2000. German national income has almost doubled since then, and the fact that German companies are now much more international than they were then and have been able to benefit from higher global growth is also not reflected in the share price performance.

Dividends are at record levels, as are dividend yields, and here companies tend to be reluctant to cut back unless they absolutely have to. Many stocks, even with very solid business models, are trading at a discount to book value, something that used to be reserved for companies that were losing money. The fact that inflation is expected to be higher than in the last ten years is also in favor of equities: companies are the ones that can raise prices. In this respect, nominal growth is achievable for more companies than was the case in the last ten years, which in turn argues in favor of "value stocks". The scarcity premiums for stocks that can achieve growth in an environment with very low inflation should thus fall, which makes these stocks look less attractive in view of the still high valuation premium after, as already mentioned, the winners of low interest rates such as real estate or growth companies have already incurred noticeable losses. So to speak, stable growth stocks are "the last shoe to drop".

Germany's competitiveness and the banished risk of insufficient energy supply

The greatest threat to German companies in recent years has been the risk of insufficient energy supply. This problem has been solved for the next two to three years anyway and, in all likelihood, for this winter and next winter as well. The perception of Europe and of Germany, especially by the rest of the world, is far too negative from our point of view, even though this does not mean that all problems should be talked down. Germany's success and prosperity are by no means - contrary to what is often said - essentially dependent on cheap energy imports. And that of globally active companies is certainly not the case. Energy is very cheap in the developed economies, especially in the USA, where specific consumption is correspondingly higher because energy savings bring lower benefits. Now we can ask ourselves which of the American megacaps owe their success to cheap energy. Energy is processed and consumed locally, either directly or in many products. The number of end products that are transported around the world with a high value energy content is very moderate. In this respect, all of this only affects Germany's external competitiveness to a limited extent.

Positive outlook – despite it all

Who it will affect: It's the consumers. That's annoying, but we're talking about an order of magnitude increase in the cost of energy imports, which should ultimately amount to perhaps 40 to 60 billion euros for Germany. That's 1 - 1.5 % of national income, or roughly the annual increase in productivity. I will bet that a consistent reduction of senseless bureaucracy should bring many times that amount in savings. Now that the whole country seems to be rejoicing that liquid gas terminals can be built in ten months instead of ten years, that would be a good time to consider the latter. But again, none of these are good reasons to buy or sell stocks. The only reason that makes sense in the long term to make an investment is the attractive valuation of a stock. And here, after a year of chaos and confusion, there is plenty of choice to be had across all industries and sizes of companies. And so, despite all the recession fears, we expect 2023 to be a much better year.

Sincerely yours,

Martin Wirth