Will 2022 be the year for quality companies?

I have previously written 2022 will be a good one for equities. Historically, the performance of equities, especially growth equities, innovative companies, and those with pricing power, during periods when deflation (consecutive years of lower rates inflation) coincides with economic growth has been consistently strong. I believe 2022 will reinforce that historical track record.

Markets have experienced a great run

Since the GFC, we have all been beneficiaries of an ‘everything bubble’. And over the last decade-and-a-half, thanks in particular to sharply-declining interest rates and the advent of unconventional monetary policy, that bubble has accelerated.

From technology shares, that in aggregate have advanced more than 10-fold, to the tripling in price of low digit number plates in less than three years, and from digital currencies advancing 16,000% in less than eight years to boring old US Treasuries returning 250% over 15 years, it is easy to fall into the trap of believing one is a genius.

As John F. Kennedy once observed, a rising tide lifts all boats, and for many, the rising tide, not the boat captain, has been responsible for the wins. For this reason alone, investors need to be aware that all bubble’s, even ‘everything bubbles’, eventually pop.

If 2022 proves to be the year the bubble pops, investors, depending on where they’ve ventured, must consider their response.

Quality falls less and recovers first

You see, the optimistic combination of economic conditions – deflation and economic growth - doesn’t remove the ever-present risk of a setback. One should always operate on the assumption the market could pull back 10 or 15% and occasionally much more.

At one end of the spectrum are the investors who have ignored speculation and focused their portfolios in the securities of the highest quality companies – defined by the aforementioned characteristics and to which we can add little or no debt, and sustainable high rates of return on incremental capital. Their response will always be the same; do nothing. Their securities will be dragged down in any sell off; however, they should fear nothing because their securities tend to fall less and recover first.

This has hitherto been the case for the highest quality larger issues. And for investors in these highest quality issues – I might count Reece, ARB, Cochlear, REA Group and CSL among others in this group – and with additional cash flow, the temporary period of price weakness should be used to add more securities to each holding.

As Ben Graham once observed, buy stocks like you buy groceries.

'Profitless prosperity' will be treated harshly

Towards the other end of the spectrum are those investors who have strayed from quality and drifted up the risk curve, purchasing riskier securities such as those I refer to as ‘profitless prosperity’ stocks. These will be treated more harshly in any rush for the exits and falls of up to 95% should not be surprising.

These investors must consider their weighting in such securities and 2022 is as sensible a year as any to rebalance. Some investors, especially those guided by wise advisers, will have appropriately allocated a relatively small portfolio weighting to riskier issues. The everything bubble of course will have enlarged that weighting and now might be a wise time to bring it bring it back to its original position.

At the extreme end of the spectrum are those who have ventured into asset classes that are purely speculative: today, it might be cryptocurrencies or NFTs (Non-Fungible Tokens) such as those by Bored Ape Yacht Club, CryptoPunks or RTFKT. Younger investors, in particular, have been lured into this realm, driving capital gains, which have subsequently attracted older and wiser investors, even some institutions.

I believe there is merit in the long-term disruptive power of the blockchain. At the extreme, there are legacy technology companies today that are dead men walking. They will cease to exist when blockchain technology reaches its full potential.

But there is also merit in the argument many of the current crop of blockchain beneficiaries are nothing more than speculative junk, playing on hype and celebrity to attract further acolytes to drive prices even higher. Sprouting terms like Web 3.0 - an amorphous mess - to justify their ‘investment’ and in some cases of hundreds of millions of dollars, many have forgotten their gains are based on nothing but popularity.

The metaverse and decentralised blockchain technology is promoted as taking power away from centralised financial institutions, Facebook and Google and returning that power to the masses. But the reality is that the financial gains from this decentralised phoenix remains firmly in the hands of those who control it and those who issue the tokens. According to Chainalysis and Flipside, 80% of the NFT market is controlled by just 9% of accounts. In cryptocurrencies, 95% of Bitcoin is owned by just 2% of accounts. The more recent Web 3.0 projects are launching with the same concentration of control, voting power and ownership as the technology IPOs of yore.

Popularity is not investing

With Facebook renaming itself Meta, and with companies like Nike and Adidas issuing NFTs of their own, it is easy to succumb to the hype. But popularity is fickle and many investors in this space, amid a deflating bubble, if they aren’t nimble, will find themselves holding valueless digital art. With NFTs, one cannot own the physical art but is instead paying huge amounts of money to merely have their name listed as the owner on a digital distributed database. So what?

If 2022 proves to be the year of a setback, any pain will be temporary for some but permanent for others. It might be wise today to review your portfolio and where you sit on the risk spectrum.

First published on the Firstlinks Newsletter. A free subscription for nabtrade clients is available here.

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. Analysis as at 19 January 2022. This information has been provided by Firstlinks, a publication of Morningstar Australasia (ABN: 95 090 665 544, AFSL 240892), for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, we), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances.