Logos LP commentary for the month of February 2022, titled, "Paying The Piper." They discuss does the national debt matter? Climate change backsliding, when will China be #1, the cult of the startup, eternal youth, private v. public markets, lockdowns, what to learn from 2021, healthcare opportunities, American exceptionalism.
Q4 2021 hedge fund letters, conferences and more
Stocks slumped on Friday as increased tensions between Ukraine and Russia sent oil spiking and led investors to dump risky assets like equities. Shares were mostly flat on the day until Ukraine-related headlines in afternoon trading caused traders to dump stocks and buy Treasuries.
With about 2 hours left in the trading day, U.S. National Security Advisor Jake Sullivan said at a White House briefing that there were signs of Russian escalation at the Ukraine border and that it was possible that an invasion could take place during the Olympics, despite speculation to the contrary.
Both the U.S. and U.K. have called for their citizens to leave Ukraine as soon as possible. Sullivan noted that the U.S. is not certain that Russian President Vladimir Putin has made a final decision to invade Ukraine. But “it may well happen soon,”
This week’s volatility in the bond market started after a hotter-than-expected inflation reading on Thursday, which prompted St. Louis Fed President James Bullard to call for accelerating rate hikes — a full percentage point increase by the start of July.
Goldman Sachs shifted its expectations for the Fed this year, calling for seven rate hikes in an effort to cool an economy that has generated inflation far more persistent than policymakers had anticipated.
- Our Take
What a difficult environment. It’s as if with every passing day the macro environment deteriorates and the outlook for 2022 grows more fragile.
We believe that investors should avoid wasting time on things that are unknowable and unimportant and focus primarily on things that are knowable and important. Nevertheless, some unknowable questions such as the direction of interest rates, how high inflation will go and where the economy is headed are important.
Yet how do we confront their importance if they are unknowable? To study such questions, we practice looking at facts and deriving probabilistic statements. Not whether we will be right or wrong but rather: “What is the probability of this scenario versus another, and how does this information affect my assessment of value?”
When it comes to the unknowable yet important macro questions above, we believe as we stated back in November, that governments and central banks are caught between a rock and a hard place. They face persistent above trend inflation that is poorly understood while their economies’ fundamentals weaken, dependence on loose monetary policy becomes entrenched, debt burdens continue to rise, and politicians have gone all in on anti-growth/anti-business populism.
We still maintain this view, yet even after the historic selling which kicked off 2022, we see the potential for more downside as the piper collects his due. Both the Fed and Joe Biden’s credibility are now on the line as too many people are suffering from the effects of stubbornly “non-transitory” inflation. The issue is now political and with 40% of American voters holding no stake in asset markets, the Fed will find it very hard to pivot away from established tightening expectations.
The Fed will be tightening into fading cyclical growth momentum at peak valuations, significantly raising the probability of additional drawdowns.
Core to the slowing growth view are peak/declining readings on various well-known inputs like ISM New Orders, US Consumer Confidence, trade weighted US$, US BBB credit spreads, and Global Manufacturing PMIs. Bond markets seem to agree as the gap between the 2-year and 10-year Treasury yields has sunk to its lowest since late 2020.
Unfortunately, the Fed looks poised to tighten for the wrong reasons (slowing runaway inflation in an economy with a backdrop of weak fundamentals) rather than for the right reasons (slowing runaway inflation in an economy with a backdrop of strong fundamentals). It should also be noted that investors underestimated how much the Fed would raise rates in the last three tightening cycles, so there is a risk that the Fed may tighten more than expected this time around.
Bottom line, the probability of profit growth momentum peaking and slowing through 2022 and even into 2023 is high. With 4Q earnings underway, the slowdown is already apparent. The pace of positive surprise has slowed meaningfully in 4Q21 with fewer positive revisions to subsequent quarter forecasts and corporate guidance has returned to its mildly negative average. The slowing rate of change is how weakness begins…
China is also an important leading indicator (typically as goes China, goes the West) and their central bank has already begun an easing blitz with fresh rate cuts. A serious Chinese economic downturn would endanger growth everywhere.
Despite the above, we must stress that this environment is fluid. As a result, we will remain defensive yet will not hesitate to shift to offense if the pendulum swings too far towards extreme fear.
This is a challenging environment with the worst start to the year since January 2009, but for the long-term investor, there is always opportunity amidst volatility. The long-term investor’s portfolio is not, nor should it be, immune to rough patches. After all, to enjoy the benefits of compounding, such patches must be endured.
The long-term investor should remain focused on allocating capital to assets based on well-reasoned estimates of their potential and remain confident that with patience, the storm will pass as it always does.
“To make money in stocks, you need to have vision to see them, courage to buy them and patience to hold them. Patience is the rarest of the three.” -Thomas Phelps
- Musings
Looking back on 2021 at Logos LP with an eye to 2022 we’ve put most of our energy into honing the definition of our “circle of competence”.
“I’m no genius, but I’m smart in spots, and I stay around those spots.” -Tom Watson Sr.
As liquidity is drained and capital becomes more discerning, the ability to correctly evaluate “select” businesses is paramount. As opportunity sets improve, the importance of knowing our sweet spots increases.
At its core, our circle of competence includes durable, high-quality (growth security and deliverability) businesses that are trading at reasonable (or cheap) valuations relative to their long-term earnings power. If we are able to develop a deep understanding of these businesses and establish confidence in their long-term business results, we will build meaningful stakes.
No single strategy works in every kind of market yet we believe that long term, having a concentrated portfolio composed of such businesses will offer the best odds of outperformance.
As the Fed moves down a tightening path and elevated market volatility compresses multiples, dislocations are beginning to create attractive opportunity sets in our sphere of competence. One sector in which we are seeing the most attractive opportunity set of relative value per unit of fundamentals is healthcare/life sciences.
At present, the healthcare sector typifies the “quality value” factor trading at a roughly double discount relative to the broader market. This sector offers well above market FCF yield, double digit sales growth and low volatility of sales. Relative earnings for the sector (vs. other sectors) also appear to be poised for improvement which can support outperformance. This is before considering the secular forces of aging populations, growing demand for health and wellness as well as treatments for complex and chronic diseases. Such factors also underpin the secular trends currently fueling investment in healthcare sub-sectors including healthcare services, infrastructure, and research globally.
We believe these sub-sectors hold some of the most important innovations of our lifetime, in addition to possessing some of the most durable tailwinds we have seen in a post-Covid world. According to EvaluatePharma, by 2026, global pharmaceutical R&D spend is expected to reach $233 billion coinciding with US national healthcare expenditures increasing at a 5.5% CAGR between 2019 and 2028. These secular tailwinds should continue to drive greater demand for diagnostics and novel therapeutics, addressing the world's most complex and onerous disease threats, such as cancer, Alzheimer’s, and other life-altering diseases.
There are currently more compounds in Phases 1-3 of clinical trials than in any other period in history (Figure 1). Additionally, the number of biotech formations and catalysts (these are measured by FDA approvals, audits, readings, or patient output) has declined to 9-year lows due to: 1. Covid delays; 2. No FDA head for the 9 months prior to October 2021; 3. Fluctuating lockdowns impacting clinical trials (Figure 2). This has led to one of the lowest valuation troughs for the small-to-mid cap biotech sector over the past 20 years (Figure 3) and the longest (and largest) drawdowns for the XBI vs. the SPY in history (Figure 4).
Figure 1:
Source: Pharmaprojects 2020
Figure 2:
Source: Evaluate Pharma; Bloomberg; Wedbush Securities, Inc .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
