Quarterly Letter

Dear investor,

We come to the end of a quarter marked by the widespread roll-out of vaccination programmes across the globe. These efforts represent the beginning of the end of a journey fraught with personal and economic challenges that started just over a year ago. We wish all the best to the people hardest hit by the crisis and send our thanks to those who continue to fight, on behalf of everyone, to overcome it.

On the financial side, the global equity markets have performed well, closing the quarter with close to double-digit gains in Europe and the United States (in euros). There were more modest performances by the Asian indexes (Japan, +3.8% and China, +0.4%) and slumps in Latin America (-2.3%).

There has been considerable churn, which continues to benefit the sectors most exposed to the economic recovery to the detriment of those that are more defensive, including the technology sectors. Logically, in this context the shares making up global value indexes have fared better (+13.3%) than those in growth indexes (+4.1%). The differences in prices between the two groups are still significant, albeit much smaller than a few quarters ago.

Commodity prices, on the other hand, have continued to shoot up since the start of the year, while public debt has been the big loser in the markets over the first three months of 2021.

The markets appear to be protected against prevailing headwinds but, in our opinion, a large dose of prudence and restraint is the order of the day. This is because it is becoming ever more common to see
certain cases of excesses that are not reassuring. We are referring, for instance, to the speculative frenzy at the start of the year around a group of North American shares – including GameStop – sparked by a forum called WallStreetBets and fuelled by the frenetic use of a broker called Robinhood that offers commissionfree trading.

The boom of special purpose acquisition companies (SPAC) is also concerning. These vehicles are effectively a blank cheque for their promoters because they are entities with no specific business or commercial purpose other than to raise capital on the promise of using it in the future to buy or take over a non-listed company.

Of course, who also cannot forget the recent implosion of Archegos Capital Management: a family office that saw its assets ($10 billion) evaporate into thin air after a number of investment banks forced a sell-off of its investments to (unsuccessfully) recoup the money they had lent it (approximately $40-50 billion) – a veritable disaster.

These anecdotes form part of the speculative folklore we are referring to. Folklore founded on an economic recovery we can see on the horizon, supported by vast sums of cash that the central banks keep pumping into the markets and fuelled this quarter by the fiscal stimuli announced by the new government in the US.

A ghost called Inflation

A fabulous (and inflammable) combination for some investors who are very happy to join the party but, it must be said, have seen their enthusiasm dinted somewhat by the appearance of a ghost that has not raised its head in recent years. A ghost that has not managed to spook the equities indexes – although the churn of these has been epic – but has shaken other types of assets such as fixed income and commodities. A ghost called Inflation.

We are facing a new (old) guest invited to dine at the table of investments. A guest who could cause a change in direction for financing conditions that would require big changes to the recipe (and ingredients) used by the investment community to cook up savings over the last few decades.

We will discuss this threat with you throughout this letter, despite not having enough space to thoroughly reflect on such an interesting and, potentially, very important matter. We have therefore decided to publish a series of articles on the investment team blog (I, II and III) in which our team exhaustively analyses the truths and myths surrounding inflation and its impact on the investment world.

Marginal utility and the level of prices in an economy

First, we need to define exactly what inflation is. In short, inflation is the continuous and sustained increase in prices in an economy. In other words, the phenomenon that results in us being able to buy less with the euros in our pockets than we could before.

But what causes this? It happens because the things we want increase in value versus our euros or because the euros we have depreciate relative to what we want. Initially, it appears difficult to determine what is “guilty” of this alteration in the terms of exchange we are describing. The concept of utility therefore has to be defined; better still, the term “marginal utility”.

Utility is the satisfaction or benefit derived from consuming a product or service. However, this benefit is not always the same and does not increase forever. Imagine we are starving hungry. A burger is extremely “useful” in this situation (eating it is hugely satisfying). If we are still hungry, a second burger might also bring us a benefit but, clearly, less that the first. A third, on the other hand, would no doubt make us feel bad. Its utility would be zero or even negative. This “variation” in satisfaction is what marginal utility measures.

So how does this concept apply to our previous discussion? It is relevant because it explains the level of prices of goods and services in an economy. This level is nothing more than a reflection of the relationship between the marginal utility of “things” and the marginal utility of the money used to buy them.

This can be expressed mathematically as follows:

Level of prices in an economy = Marginal utility of the “things” / Marginal utility of money

But how do we go from here to explaining the concept of inflation? It’s simple. One only needs to understand that this ratio, like any, is higher when the numerator increases or the denominator decreases.

Inflation therefore occurs when:

1) The numerator increases, i.e. when the marginal utility of “things” goes up. And why does this happen? Because demand for those things rises or supply falls.

2) The denominator decreases, i.e. when the marginal utility of money goes down. When does this occur? When the supply of money increases or when demand to save it (or not spend it) falls.

Tense calm

Applying all these concepts to the present situation, we could describe it as a “tense calm”. Here’s why:

The demand for “things” has slumped due to the pandemic, so their marginal utility is low. At the same time, savings rates are extremely high – money has a high marginal utility – because of the clear barriers we are facing to spend and also because there is still somewhat of an aversion to risk due to the uncertainty sparked by this unprecedented crisis. Inflation therefore appears to be contained, despite the (massive) increase in countries’ liabilities (amount of money in circulation and public borrowing).

This situation may persist if the economy continues to struggle to return to normal (new strains of the virus, delays in vaccinations etc.) or we see prolonged unemployment because of the pandemic’s impact lingering on certain sectors. In other words, if the marginal utility of things remains low.

Equally, there will be no inflationary risks provided that, once the recovery is in full flow, the vast amounts of money in circulation are drained through more restrictive monetary policies (interest rate hikes) and/or the levels of public debt are pared back (higher taxes and/or less public spending). In such a scenario, the marginal utility of money would not decrease.

An unsettling economic recovery

The market is not too sure; neither are we.

On the one hand, there are signs the economy will rebound rapidly when vaccinations enable us to head out into the street. A recovery that would also be fuelled by the vast fiscal stimuli announced by the US in recent weeks: a first package of $1.9 trillion approved in early March, equating to 8% of North American GDP or 2% of global GDP (the US accounts for 25% of this), plus another $2.3-trillion package unveiled at the start of this month, equivalent to almost 10% of North American GDP (2.5% of global GDP).

On the other, there is also a monetary backdrop that does not help quell anxiety because during the pandemic, liquidity created by those responsible for the monetary policies of the leading economies in the world equates to 21% of global GDP. This liquidity continues to find its way into the markets every day, which we do not see will reverse in the next few years and can be described as a pile of extremely flammable fuel that would burst into flames from an inflationary spark in the future.

We are therefore facing a somewhat worrying economic recovery. What a paradox!

We deem it to be a concern because in the future, the vast piles of public liabilities could significantly drag down the marginal utility of money (reducing the denominator in the equation above), while the surge in demand – driven by fiscal policies that were absent a decade earlier – and destruction of supply caused by Covid-19 in many sectors may exert significant upward pressure on
the marginal utility of goods and services (increasing the numerator). The result (the ratio) would be high inflation that could last for several years.

This may be a somewhat simplistic, albeit realistic, summary explaining some of the shocks that have shaken the markets in the last quarter. Nothing to worry about for now, some would say. Sure, but we don’t get paid for considering what is happening today. We get paid for analysing and evaluating what tomorrow holds and, above all, the potential impact of tomorrow on our work and portfolios.

This is exactly what we have done: consider a challenge that has not yet materialised and we do not know if it will, but that we are ready for here at Bestinver. This we have done because it is our duty. This is how we see our fiduciary duty, repaying the trust you have placed in us by analysing each and every aspect that could affect how your savings are managed.

Not all shares are on an equal footing in the face of inflation

Bestinver has an investment team with a number of members who are going grey (or have even lost their hair completely) but none of them are old enough to remember having analysed or managed investments during a prolonged inflationary environment. Indeed, the vast majority of us investors have been immersed for so long in exactly the opposite environment that our thought processes, how we navigate through the markets (our “algorithm”), is not well suited to this type of scenario.

This is clearly a handicap compared to the investment managers of 40 or 50 years ago and others who are accustomed to operating in more inflationary markets than ours (emerging economies).

This is why the exercise we are carrying out is so important.

Fortunately, we are shareholders of a large number of businesses with very experienced owners and directors, and we also have the knowledge of Ignacio Arnau (manager of the Bestinver Latam fund) who has successfully dealt with this type of challenges in Latin America. We mustn’t overlook Eduardo Roque and his team either: investors who are well versed in evaluating inflation forecasts and spreads when they are setting the returns they expect on the bonds of the companies they are analysing.

In general, we are aware that shares offer decent protection against inflation. As a business owner, one receives nominal cash flows that grow over time as prices rise. This is a reality… albeit somewhat theoretical.

In practice, the truth is that inflation represents a considerable headwind for shares. Unfortunately, for other types of assets and for deposits, it is equivalent to a hurricane.

But not all shares are on an equal footing in the face of inflation. This headwind doesn’t affect every company in the same way. Our task is to find those that are better prepared to withstand it.

Operational winds

As shareholders of listed companies, we face two winds that we must guard against in a climate of high and longlasting inflation: operational wind and market wind.

The first of these batters any company that is unable to increase its returns as inflation rises. Alas, not every company is able to produce those “sparkles” they can get out of their assets or capital proportional to the continuous rise in prices in an economy affected by inflationary pressures.

If we somewhat excessively reduce the operational sauce down, we could say that the “sparkles” depend on sales or, better still, the margins that such sales generate. We will therefore need to analyse both a company’s cost structure – part of which is fixed and part variable – and its market positioning or power to set prices.

Of course there are many other factors to take into account but in general and from an operational perspective, we can say that a business with relatively fixed costs that can increase its prices and sales in line with inflation is a good shipmate.

In terms of the asset, the key here is how “efficient” that asset is at generating sales. Put another way, how much needs to be invested in the asset to replenish it (and continue generating sales) and how costly is such a reinvestment.

In an inflationary environment where the cost of capital is constantly rising, the less the asset “wears out”, the better.

If it does wear, the less costly or less “inflationary” the reinvestment needed to maintain it, also the better.

The companies which have the sparkle and right asset tend to have a long-lasting competitive advantage and a product with high turnover, and can grow when prices are going up without requiring much capital.

Market winds

The problem with these companies is that they don’t normally come cheap; quite the opposite, in fact. They are therefore not well equipped to sail in market winds. Winds that buffet valuation multiples and strongly in times of high inflation.

As we explained in our letter for the third quarter of last year, a company is worth the free cash flow or dividends it is able to generate over its lifetime, discounted at an appropriate rate or cost of capital. This cost of capital rises with inflation and therefore, erodes the company’s valuation.

It increases, in practice, because of the ball and chain effect of inflation on companies’ returns, and, in real times, these don’t tend to be sufficiently high to replenish or maintain capital.

This capital ends up being consumed, making it scarcer and, consequently, more costly. In response to this greater cost, investors then demand higher returns on their investments, in other word, paying lower valuation multiples.

We can therefore deduce that a company valued with competitive multiples, offering a comfortable margin of safety, will be much better equipped to shield itself from the inevitable deflation of valuations that inflation processes always cause.

Meritocratic winds

There is a third type of wind companies are exposed to: meritocratic wind.

This wind gives rise to natural selection in the business world, debilitating the weakest and bolstering the strongest (to the detriment of the former). Only those with a characteristic we haven’t mentioned until now: financial robustness, can ride this wind.

We talked before about the sparkle and asset but not about how this asset is financed. A solvent company, which finances its asset with capital and not debt, is better prepared for this Darwinian process we are referring to. Not only because the cost (interest rate) of any debt rises during periods of inflation but also because a company financed to survive a rainy day is one that can benefit from the opportunities that always flourish when operational and market winds strengthen.

Such financial solvency and the (marvellous) optionality this offers is fruit of past and future decisions a company’s management takes. It is therefore crucial to associate oneself with companies with an experienced and capable management team who have the talent to find their way across tumultuous seas and know how to protect capital when they need to and build it up when it is possible.

We are not deterministic or dogmatic

Broadly speaking, we have just described the main characteristics any company wanting to find its way through inflationary waters without difficulty must have. They must have a good combination of sparkle and asset – a vital structure to withstand operational winds. Their valuations must be competitive, with wide margins of safety that provide protection against market winds. And lastly, they have to be well managed and prudently financed to be able to exploit the opportunities that meritocratic winds bring.

Companies that we already boast in our portfolios, capable of generating wealth today and also able to protect it and make it grow if the risks we described at the beginning of this letter arise in the future.

We don’t know what this future holds for us and it cannot be disconnected from the economic context we lived through before Covid-19 hit. A decade and a half of monetary policies that appeared to be “extraordinary” but have become permanent and essential.

Policies that have driven significant inflation of assets that nobody talks about and a constant deflationary pressure in the system that, evidently, has not enabled the public sector to pare back its ever-burgeoning debt.

This is a challenging context in which it is impossible to determine if the unquestionable inflationary spark we will see in the coming months will be merely a flash or may become a more permanent economic wildfire.

We know the economic measures put in place to tackle the effects of the pandemic may be the icing on an inflationary cake that has been in the oven for some time. At the same time, however, we suspect the economic, geopolitical and even social ground we are walking on lacks the nutrients needed for the inflation seed to sprout.

We aren’t sure and we don’t want to be deterministic or dogmatic. Nothing is prewritten, much less an economic outcome that depends on a multitude of actions (and reactions) we cannot predict. Is there a lack of conviction? Yes, of course it could be interpreted that way, but we prefer to say there are strong arguments on both sides and we are not able to lean one way or the other.

Whatever the case, the aim of our analysis is not to take sides: black or white (we support the greys here in Bestinver), rather to examine and identify the dangers to the companies we are searching for and in the portfolios we manage of a widespread and prolonged increase in prices in the economy.

Bestinver is prepared

This is exactly what we have done. We don’t know if we will move into an inflationary climate in forthcoming years, but what we do know is that Bestinver is prepared for this eventuality.

We have an investment team with the talent needed to choose the operationally most appropriate companies. Our value investing philosophy means we have the temperament and patience needed to pay the right price for them and, of course, we have a major shareholder that brings solidity, solvency and permanence – always indispensable qualities but even more so should a ghost that is floating around the markets without spooking them decide to take a seat at the investment table. A ghost called Inflation.

Corporate information

We also wanted to update you on Bestinver Infra FCR. Bestinver’s new infrastructure fund is now up and running, and we have completed a first funding round of €100 million. This Bestinver fund offers investors the chance to invest in an alternative, stand-out global product focusing on real infrastructure assets. We plan to launch new funding rounds over the course of the year to achieve our final target of €300 million.

Lastly, we would like to invite you to read the managers’ updates on each of our funds. These round-ups summarise the managers’ vision, the main movements in each fund’s portfolio and the investment theses of some of the companies in which the funds have invested.

 

Best regards,

The investment team

BESTINVER

 

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